Chapter 1

Introduction to Financial Management

Key Concepts and Skills

Know the basic financial management decisions and the financial manager’s role

Know the forms of business organization and the advantages/disadvantages of each

Know the goal of financial management Know the conflicts of interest that may

arise between owners and managers

Chapter Overview Finance: An Overview Business Finance and the Financial

Manager Forms of Business Organization The Goal of Financial Management The Agency Issue and Control of

the Corporation Financial Markets

Areas of Finance

Corporate finance Investments Financial Institutions International finance

Investments! Work with financial assets Value of financial assets, risk

versus return, asset allocation Job opportunities

Financial planner, stockbroker Portfolio manager Securities analyst CalPers and CalStrs

Financial Institutions

Banks: commercial banks, credit unions, savings and loans

Insurance companies Brokerage houses

Schwab Merrill Lynch Scottrade, Etrade

International Finance A specialized area within the other

areas of finance Work in foreign countries and travel Requires knowledge of exchange

rates and political risk Requires knowledge of other

cultures and possibly the ability to speak foreign language(s)

Reasons to Study Finance

Marketing Create budgets, perform marketing research,

market financial products Accounting

Preparation of financial statements, dual accounting/financial functions

Management Strategic thinking, performance, and

profitability Personal finance

Retirement planning, investing, daily cash flow

Business Finance

Questions the financial manager will answer: What long-term investments should

we make? How will we obtain long-term

financing to pay for the investments? How will we manage the daily

financial activities of the firm?

Financial Manager

Chief Financial Officer (CFO), the highest-level financial manager within a firm Treasurer: Oversees cash

management, credit management, capital expenditures, financial planning functions

Controller: Oversees taxes, cost accounting, financial accounting, and data processing functions

Forms of Business Organization There are three major forms of business

organization in the United States Sole proprietorship Partnership

General partnership Limited partnership

Corporation S-Corp Limited liability company (LLC)

Sole Proprietorship

Advantages Easiest to start Least regulated Single owner

retains profits Income taxed

once at personal income tax rate

Disadvantages Limited to the life

of the owner Equity capital

limited to owner’s personal wealth

Unlimited liability Difficult to sell

ownership interest

Partnership

Advantages Two or more

owners More available

capital Easy to start Income taxed

once at the personal income tax rate

Disadvantages Unlimited liability Partnership

dissolves when one partner dies or sells

Difficult to transfer ownership

Corporation Advantages

Limited liability Unlimited life Separation of

ownership and management

Ease of transfer of ownership

Ability to raise capital

Disadvantages Separation of

ownership and management (agency problem)

Double taxation(Income taxed at the corporate tax rate and dividends taxed at the personal tax rate)problem)

Goal of Financial Management

The goal of a corporation is to maximize the value of the firm’s stock

Sarbanes-Oxley Act Adopted in 2002 in response to

corporate mismanagement Scandals involved Enron, WorldCom,

Tyco, and Adelphia

Agency Issues The agency relationship

An agency relationship occurs when a principal hires an agent to represent his/her interest

Stockholders (principals) hire managers (agents) to represent their interests and manage the company

Agency problem A potential conflict of interest between the

owners and management of a firm Management interests and stockholders’

interests might differ - agency costs

Managerial Compensation and Control Managerial compensation

Incentives can help to align management and stockholders’ interests

Incentives must be carefully designed to ensure that they align management and stockholders’ interests

Corporate Control A hostile takeover threat/attempt may

result in better management

Managerial Compensation and Control (continued)

Employees, customers, suppliers, and the government (stakeholders) have a financial interest in the firm

Financial Markets Cash flows to the firm Primary market

The original sale of securities by governments and corporations

Secondary market One owner or creditor selling to

another Provide the means for transferring

ownership of corporate securities

Financial Markets (continued)

NASDAQ National Association of Securities

Dealers Automated Quotations system

A dealer market – an over-the-counter (OTC) market

Less stringent listing requirements than NYSE

Financial Markets (continued)

New York Stock Exchange An auction market Has a physical location on Wall Street Accounts for more than 85% of all

shares traded in auction markets

Quiz What are the major areas of corporate

finance? What is the capital budgeting decision? What is the mixture of long-term debt

and equity that a firm chooses to use called?

What are the three forms of business organization?

What is the difference between a general and a limited partnership?

Quiz (continued) What are the primary advantages and

disadvantages of sole proprietorships and partnerships?

What is the goal of financial management?

What is a dealer market? What is the largest auction market in

the United States? What does OTC stand for? What is the

largest OTC market for stocks called?