McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 1.0 Chapter 1 Introduction to...

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved

1.1

Chapter

1Introduction to Financial Management


1.2

Key Concepts and Skills

Know the basic types of financial management decisions and the role of the financial manager

Know the goal of financial managementKnow the financial implications of the different

forms of business organizationUnderstand the conflicts of interest that can arise

between owners and managers


1.3

Chapter Outline

Finance: A Quick Look Business Finance and The Financial Manager Forms of Business Organization The Goal of Financial Management The Agency Problem and Control of the

Corporation Financial Markets and the Corporation


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1.1 Finance: A Quick Look

The Four Basic AreasWhy Study Finance


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The Four Basic Areas of Finance

• Corporate (or business) finance • The basic financial ideas and principles

• Covered in the section 1.2

• Investments• Financial institutions• International finance


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The Four Basic Areas of Finance

• Investments: • Deals with financial assets such as stocks and

bonds• Value/price of the financial asset• Potential risks and rewards of investing• Asset Allocation

• “Mixture” of different types of financial assets to hold


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The Four Basic Areas of Finance• Investment Career opportunities

• Stockbroker or Financial advisor• Advise customers on what types of investments to

consider and helps them make buy and sell decisions• Portfolio manager

• Manage money for investors, pension funds, insurance companies, and other types of institutions

• Security analyst• Research individual investments, such as stock in a

particular company• Make a determination as to whether the price is right


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The Four Basic Areas of FinanceFinancial Institutions

Companies that specialize in financial mattersBanks – commercial and investment, credit unions,

savings and loansInsurance companies

Job opportunitiesBanking: Commercial Loan OfficerInsurance: analyst – decide whether a particular

risk was suitable for insuring and what the premium should be


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The Four Basic Areas of FinanceInternational Finance

Involves “international aspects” of either corporate finance, investments, or financial institutions Some portfolio managers and security analysts specialize in

non-U.S. companies Banks make loans across country lines Many U.S. businesses have extensive overseas operations

Need employees familiar with: exchange rates, political risk, the customs of other countries, and the language

It may allow you to work in other countries or at least travel on a regular basis


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Why Study Finance?Marketing and Finance

Marketers constantly work with budgets Marketing research, the design of marketing and distribution

channels, and product pricing Analyzing costs and benefits of projects of all types

Financial analysts rely heavily on marketing analysts The two frequently work together to evaluate the profitability of

proposed projects and products Sales projections are a key input in almost every type of new

product analysis and are often developed jointly between marketing and finance.

The finance industry employees marketers to help sell financial products: bank products, insurance policies, mutual funds


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Why Study Finance?

Accounting and FinanceAccountants are often required to make financial

decisions as well as perform traditional accounting duties

Accountants must know finance to understand the implications of many financial contracts and the impact they have on financial statements

Financial analysts are some of the most extensive and important end users of accounting information


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Why Study Finance?

Management and FinanceManagement strategists must have a clear

understanding of the financial implications of business plans

Management employees are expected to have a strong understanding of how their jobs impact profitability and to be able to work within their areas to improve profitability

Studying finance teaches you: the characteristics of activities that create value!


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Why Study Finance?

You and FinanceYou’ll have to make financial decisions that will be

very important to you personally Personal budgeting and day-to-day cash flow issues How to invest your retirement funds Start your own business Determine loan payments “before” you take out a loan

Student loanCar loanHome mortgage


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1.2 Business Finance and The Financial Manager

What is Business Finance

The Financial Manager

Financial Management Decisions


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What is Business Finance?Business Finance Answers the following three

questions:1. What long-term investments should you take on?

What lines of business will you be in and what sorts of buildings, machinery, and equipment will you need?

2. Where will you get the long-term financing to pay for your investment? Bring in other owners or borrow

3. How will you manage your everyday financial activities Collecting from customers, paying suppliers, etc.

We’ll look at each of these topics in the chapters ahead.


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The Financial ManagerThe financial management function is usually associated

with a top officer of the firm, often called the chief financial officer (CFO) or vice president of finance (Figure 1.1 – Page 7)

The CFO or VP of Finance coordinates the activities of the treasurer and the controller

The controller’s office: handles cost and financial accounting, tax payments, and management information systems.

The treasurer’s office: is responsible for managing the firm’s cash and credit, its financial planning, and its capital expenditures.


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The Financial ManagerThe treasury activities are all related to the three

general questions raised previously: 1. What long-term investments should you take on? 2. Where will you get the long-term financing to pay for your

investment? 3. How will you manage your everyday financial activities?

Our study concentrates mainly on activities usually associated with the treasurer’s office. the chapters ahead deal primarily with these issues.


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The financial manager must be concerned with three basic types of questions:Capital budgetingCapital structureWorking capital management


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Financial Management DecisionsCapital Budgeting: The process of planning and

managing a firm’s long-term investments The financial manager tries to identify investment opportunities

that are: “worth more to the firm than they cost to acquire” i.e. the value of the cash flow generated by an asset exceeds the cost

of that asset. Regardless of the specific investment, the financial manager

must be concerned with: How much cash is expected to be received (Size) When it is expected to be received (Timing) How likely it is to be received (Risk)

Size, Timing, and Risk of cash flows are by far the most important considerations when evaluating a business decision.


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Financial Management DecisionsCapital Structure (or financial structure):

Refers to the specific mixture of long-term debt and equity the firm uses to finance its operations

Two main concerns: How much should the firm borrow?What are the least expensive sources of funds for the

firm? Long term financing expenses can be considerable Different possibilities must be carefully considered

Various lenders and loan types


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Working Capital: A firm’s short-term assets (cash, inventory, etc.) and liabilities (money owed suppliers, etc)

Working Capital Management – is the day-to-day activity that ensures the firm has sufficient resources to continue operations and avoid costly interruptionsActivities related to the firm’s receipt and

disbursement of cash


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1.3 Forms of Business Organization

Sole Proprietorship

Partnership

Corporation


1.23

Forms of Business Organization

Three major forms in the united statesSole proprietorshipPartnership

General Limited

Corporation S-Corp Limited liability company


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Sole Proprietorship:A business owned by one person

Advantages Easiest to start Least regulated Single owner keeps all the

profits Taxed once as personal

income No distinction between

personal and business income

Disadvantages Limited to life of owner Equity capital limited to

owner’s personal wealth May be unable to exploit new

opportunities due to insufficient capital

Unlimited liability for business debts

Creditors can look to the proprietor’s personal assets for payment

Difficult to sell ownership interest


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Partnership: A business formed by two or more individuals or entitiesGeneral Partnership: all the partners share

in gains or losses, and all have unlimited liability for all partnership debts, not just some particular share.

Limited Partnership: one or more general partners run the business and have unlimited liability and there will be one or more limited partners which do not actively participate in the business


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Partnership: A business formed by two or more individuals or entities

A “limited” partner’s liability for business debts is limited to the amount that partner contributes to the partnership.

However, if the limited partner becomes deeply involved in the business decisions they will assume the obligations of a general partner


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Partnership: Advantages and Disadvantages are basically the same as those for a proprietorship.Advantages

Two or more owners More capital available

But still limited to the partners’ combined wealth which limits the ability of such a business to grow

Relatively easy to start Income taxed once as personal

income

Disadvantages General partners have

unlimited liability for partnership debts

Limited Life: the partnership dissolves when one general partner dies or wishes to sell

Ownership by a general partner is not easily transferred because a new partnership must be formed


1.28Corporation: A business created as a “distinct legal entity” (“person”) owned by one or more individuals or entities. A Corporation is separate and distinct from its owners. Advantages

Separation of ownership and management

Stockholders elect a board of directors who select managers

Limited liability to owners/stockholders

Limited to the amount of their investment

Unlimited life Transfer of ownership is easy Easier to raise capital – sell

stock

Disadvantages More complicated to start:

Articles of Inc. and Bylaws Separation of ownership

and management Double taxation (income

taxed at the corporate rate and then dividends taxed at personal rate)


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1.4 The Goal of Financial Management

Profit Maximization

The Goal of Financial Management in a Corporation

A More General Financial Management Goal


1.30

Profit MaximizationProfit Maximization - is probably the most commonly

cited business goal and may refer to some sort of “long-run” or “average” profits? It’s unclear exactly what this means. Do we mean profits this year with the following undesirable

activities??? Deferring maintenance Letting inventories run down Other short-run cost-cutting measures

Do we mean accounting net income or earnings per share? Does this mean we should do anything and everything to maximize

owner wealth? What’s the appropriate trade-off between current and future profits?


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The Goal Of Financial Management

The financial manager in a corporation makes decisions for the stockholders of the firm.

From the stockholders’ point of view, what’s a good financial management decision? Good decisions increase the value of the stock, and poor

decisions decrease it.

The goal of financial management is to maximize the current value per share of the existing stock. i.e. Maximizing the market price per share


1.32

A More General Financial Management GoalWhat is the appropriate goal when the firm has

no traded stock?The total value of the stock in a corporation is

simply equal to the value of the owners’ equity.Therefore, a more general way of stating our

goal is:Maximize the market value of the existing

owners’ equity.


1.33

A More General Financial Management GoalWith this goal in mind, it doesn’t matter whether the

business is a proprietorship, a partnership, or a corporation.

For each of these, good financial decisions increase the market value of the owners’ equity and poor financial decisions decrease it. Identifying goods and services that add value to the firm because

they are desired and valued in the free marketplace.Finally, our goal “does not imply” that the financial

manager should take illegal or unethical actions in the hope if increasing the value of the equity in the firm.


1.34

1.5 The Agency Problem and Control of the Corporation

Agency Relationships

Management Goals

Do Managers Act in the Stockholders’ Interests?

Stakeholders


1.35

Agency Relationships

In large corporations ownership can be spread over a huge number of stockholders

This dispersion of ownership arguably means that management effectively controls the firm

Will management act in the best interests of the stockholders?

Might not management pursue its own goals at the stockholders’ expense?


1.36

Agency RelationshipsThe relationship between stockholders and management

is called an agency relationship. Such a relationship exits whenever someone (the principal) hires

another (the agent) to represent his or her interest.Agency Problem – the possibility of conflict of interest

between the owners and management of a firm Agency problems exist whenever there is a separation of

ownership and management The way an agent is compensated is one factor that affects

agency problems. Car sell example page 13

Flat fee vs. commission


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Management GoalsManagement and Stockholder interests might differAgency Problem Example 1, Page 13:

For instance: A new investment is expected to favorably impact the stock price, but is also a relatively risky venture

The owners of the firm: will wish to take the investment (because the share value will rise)

The management: may not because there’s the possibility that things will turn out badly and management jobs will be lost.

If management doesn’t take the investment, the stockholders may lose a valuable opportunity


1.38

Management GoalsOr Agency Problem Example 2, Page 13:

Left to themselves, managers tend to maximize the amount of resources over which they have control

Increase their business Power or Wealth! Build their domain or empire!

May lead to an overemphasis on business size or growth Overpaying to buy another company just to increase the size of the

business or demonstrate corporate power Such a purchase does not benefit the owners of the purchasing

company. Or management may tend to overemphasize organizational

survival to protect job security.


1.39

Management GoalsDo Managers Act in the Stockholders’ Interests?Depends on two factors:

How closely are management goals aligned with stockholder goals? Relates to the way managers are compensated

Can management be replaced if they don’t pursue stockholder goals? Relates to control of the firm


1.40

Management GoalsManagerial CompensationManagement frequently has a significant

economic incentive to increase share value for two reasons:1. Managerial compensation, particularly at

the top, is usually tied to financial performance in general and oftentimes to share value in particular. For example, managers are frequently given the option to buy

stock at a fixed price - the more the stock is worth, the more valuable is the option


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Management GoalsManagerial Compensation

2. Better performers within the firm will tend to get promoted. Those managers who are successful in pursuing stockholder

goals will be in greater demand in the labor market and thus command higher salaries.

Promotion of Managers “only” if the firm prospers, helps ensure managers act in the best interest of owners.


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Management GoalsManagerial CompensationTherefore:Incentives can be used to align management and

stockholder interestsThe incentives need to be structured carefully to

make sure that they achieve their goal


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Management GoalsControl of the FirmControl of the firm ultimately rests with stockholders.They elect the board of directors, who, in turn, hire and

fire management.The mechanism used by unhappy stockholders to replace

existing management is called a proxy fight.A proxy is the authority to vote someone else’s stock.A proxy fight develops when a group solicits proxies in

order to replace the existing board, and thereby replace existing management.


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Management GoalsControl of the FirmAnother way management can be replaced is by

takeover.Those firms that are poorly managed are more

attractive as acquisitions than well-managed firms because a greater profit potential exists.

Thus, avoiding a takeover by another firm gives management another incentive to act in the stockholders’ interests.


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Management GoalsStakeholdersStakeholder: Someone other than a stockholder

or creditor who potentially has a claim on the cash flows of the firm.Employees, customers, suppliers, and even the

government all have a financial interest in the firm.These groups will also attempt to exert control over

the firm, perhaps to the detriment of the owners.


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Management GoalsRecap:Recap:The following help ensure managers act in the best

interest of owners? A compensation package for managers that ties their salary

to the firm’s share price. Managers are promoted only if the firm prospers. The threat that if the firm does poorly, shareholders will use

a proxy fight to replace the existing management. There’s a high degree of likelihood the firm will become a

takeover candidate if the firm performs poorly.


1.47

1.6 Financial Markets and The Corporation

Cash Flows to and from the Firm

Primary versus Secondary Markets


1.48

Cash Flows to and from the FirmFinancial Markets play an extremely important role in

corporate finance.Figure 1.2 (Page 16): Cash flows between the firm and

the “financial markets”: A. Firm issues securities to raise cash. B. Firm invest in assets. C. Firm’s operations generate cash flow.

D. Cash is paid to government as taxes and other stakeholders may receive cash.

E. Reinvested cash flows are plowed back into the firm. F. Cash is paid out to investors in the form of interest and

dividends.


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Cash Flows to and from the Firm

A financial market, like any market, is just a way of bringing buyers and sellers together.

In financial markets, it’s debt and equity securities that are bought and sold.


1.50

Primary versus Secondary MarketsThe term primary market – refers to the original

sale of securities by governments and corporations.

The secondary markets are those in which these securities are bought and sold after the original sale.

Equities are issued solely by corporations.Debt securities are issued by both governments

and corporations.


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Primary versus Secondary MarketsPrimary MarketsIn a primary-market transaction, the

corporation is the seller, and the transaction raises money for the corporation.


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Primary versus Secondary MarketsPrimary Markets

Two types of primary-market transactions: Public Offering: involves selling (debt and equity) securities to

the general public Must be registered with the Securities and Exchange Commission (SEC). The accounting, legal, and selling costs of public offerings can be

considerable Private Placement: is a negotiated sale involving a specific buyer.

Life insurance companies or mutual funds Avoids various regulatory requirements and the expense of public

offerings Does not have to be registered with the SEC or require the involvement of

underwriters (investment banks that specialize in selling securities to the public)


1.53

Primary versus Secondary MarketsSecondary MarketsA secondary-market transaction involves one owner or

creditor selling to anotherThe secondary markets provide the means for

transferring ownership of corporate securities.Although a corporation is only directly involved in a

primary-market transaction (when it sells securities to raise cash), the secondary markets are still critical to large corporations: Investors are much more willing to purchase securities in a

primary-market transaction when they know that those securities can later be resold if desired.


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Primary versus Secondary MarketsDealer versus auction marketsThere are two kinds of secondary markets:

Auction markets (NYSE) Brokers and Agents match buyers and sellers They do not actually own the commodity that is bought or sold A real estate agent, for example, does not normally buy and sell

houses. Dealer markets (Nasdaq)

Dealers buy and sell for themselves, at their own risk. A car dealer, for example, buys and sells automobiles Dealer markets in stocks and long-term debt are called over-the-counter

(OTC) markets Most trading in debt securities takes place over the counter. Dealers are connected electronically.


1.55

Primary versus Secondary MarketsDealer versus auction marketsAuction markets differ from dealer markets in

two ways:1. An auction market, or exchange, has a physical

location (like Wall Street - NYSE).2. In a dealer market (Nasdaq)most of the buying and

selling is done by the dealer.


1.56

Primary versus Secondary MarketsTrading in corporate securitiesThe equity shares of most of the large firms in

the United States trade in organized “Auction Markets”.The largest such market is the New York Stock

Exchange (NYSE) which accounts for more than 85% of all the shares traded in auction markets.

Other auction exchanges include the American Stock Exchange (AMEX) and regional exchanges such as the Pacific Stock Exchange.


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Primary versus Secondary MarketsTrading in corporate securitiesIn addition to the stock exchanges, there is a large OTC

market for stocks. OTC markets have no physical location

In 1971, the National Association of Securities Dealers (NASD) made available to dealers and brokers an electronic quotation system called NASDAQ There are roughly three times as many companies on Nasdaq as

on NYSE, but they tend to be much smaller in size and trade less actively.

Exceptions: Microsoft and Intel The total value of Nasdaq stocks is significantly less than the

total value of NYSE stocks.


1.58

Primary versus Secondary MarketsListingStocks that trade on an organized exchange are said to be

listed on that exchange.In order to be listed, firms must meet certain minimum

criteria, which differ for different exchanges, regarding: Asset size, number of shareholders, etc.

NYSE has the most stringent requirements of the exchanges in the United States. Market Value of at least $60 million At least 2,000 shareholders with at least 100 shares each Additional minimums on earnings, assets, and the number of

shares outstanding.


1.59

Quick Quiz

What are the four basic areas of finance?What are the three types of financial

management decisions and what questions are they designed to answer?

What are the three major forms of business organization?

What is the goal of financial management?What are agency problems and why do they

exist within a corporation?


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Chapter 1: Homework and Test Review Know chapter theories, concepts, and definitions

Re-read the chapter Review the Power Point Presentation Slides Review Critical Thinking and Concept Review Questions on

Page 19: 3, 4, 5, 6, 7, 8, and 12

*Remember you may have one 8 1/2 x 11 formula sheet (front and back) for each test with anything you want on it. This chapter represents approximately 1/5th of the 1st exam or approximately 8 of 40 multiple choice questions.

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 1.0 Chapter 1 Introduction to...

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