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Chapter 1Chapter 1

Introduction to Financial Introduction to Financial ManagementManagement

Key Concepts and SkillsKey Concepts and Skills Know the basic types of financial Know the basic types of financial

management decisions and the role of management decisions and the role of the financial managerthe financial manager

Know the financial implications of the Know the financial implications of the different forms of business organizationdifferent forms of business organization

Know the goal of financial managementKnow the goal of financial management Understand the conflicts of interest that Understand the conflicts of interest that

can arise between owners and can arise between owners and managersmanagers

Basic Areas Of FinanceBasic Areas Of Finance

Corporate financeCorporate finance InvestmentsInvestments Financial institutionsFinancial institutions International financeInternational finance

Why Study Finance?Why Study Finance?

MarketingMarketing• Budgets, marketing research, marketing Budgets, marketing research, marketing

financial productsfinancial products AccountingAccounting

• Dual accounting and finance function, Dual accounting and finance function, preparation of financial statementspreparation of financial statements

ManagementManagement• Strategic thinking, job performance, Strategic thinking, job performance,

profitabilityprofitability Personal financePersonal finance

• Budgeting, retirement planning, college Budgeting, retirement planning, college planning, day-to-day cash flow issuesplanning, day-to-day cash flow issues

Business FinanceBusiness Finance

Some important questions that are Some important questions that are answered using financeanswered using finance• What long-term investments should What long-term investments should

the firm take on?the firm take on?• Where will we get the long-term Where will we get the long-term

financing to pay for the investment?financing to pay for the investment?• How will we manage the everyday How will we manage the everyday

financial activities of the firm?financial activities of the firm?

Financial ManagerFinancial Manager

Financial managers try to answer some Financial managers try to answer some or all of these questionsor all of these questions

The top financial manager within a firm The top financial manager within a firm is usually the Chief Financial Officer is usually the Chief Financial Officer (CFO)(CFO)• Treasurer – oversees cash management, Treasurer – oversees cash management,

credit management, capital expenditures, credit management, capital expenditures, and financial planningand financial planning

• Controller – oversees taxes, cost Controller – oversees taxes, cost accounting, financial accounting, and data accounting, financial accounting, and data processingprocessing

Capital BudgetingCapital Budgeting

The process of planning and The process of planning and managing a firm’s investments in managing a firm’s investments in fixed assets.fixed assets.

The key concerns are the size, The key concerns are the size, timing, and riskiness of future cash timing, and riskiness of future cash flows.flows.

Capital StructureCapital Structure

The mix of debt (borrowing) and The mix of debt (borrowing) and equity (ownership interest) used by equity (ownership interest) used by the firm.the firm.

What are the least expensive sources What are the least expensive sources of funds?of funds?

Is there an optimal mix of debt and Is there an optimal mix of debt and equity?equity?

When & where should the firm raise When & where should the firm raise funds?funds?

Working Capital MgtWorking Capital Mgt

Mgt of short-term assets & liabilities.Mgt of short-term assets & liabilities. How much inventory should the firm How much inventory should the firm

carry?carry? What credit policy is best?What credit policy is best? Where will the firm obtain its short-Where will the firm obtain its short-

term loans?term loans?

Forms of Business OrganizationForms of Business Organization

Three major forms in the united Three major forms in the united statesstates• Sole proprietorshipSole proprietorship• PartnershipPartnership

GeneralGeneral LimitedLimited

• CorporationCorporation S-CorpS-Corp C-CorpC-Corp Limited liability company - LLCLimited liability company - LLC

Sole ProprietorshipSole Proprietorship

AdvantagesAdvantages• Easiest to startEasiest to start• Least regulatedLeast regulated• Single owner keeps Single owner keeps

all the profitsall the profits• Taxed once as Taxed once as

personal incomepersonal income

DisadvantagesDisadvantages• Limited to life of Limited to life of

ownerowner• Equity capital Equity capital

limited to owner’s limited to owner’s personal wealthpersonal wealth

• Unlimited liabilityUnlimited liability• Difficult to sell Difficult to sell

ownership interestownership interest

PartnershipPartnership

AdvantagesAdvantages• Two or more Two or more

ownersowners• More capital More capital

availableavailable• Relatively easy to Relatively easy to

startstart• Income taxed once Income taxed once

as personal incomeas personal income

DisadvantagesDisadvantages• Unlimited liabilityUnlimited liability

General partnershipGeneral partnership Limited partnershipLimited partnership

• Partnership Partnership dissolves when one dissolves when one partner dies or partner dies or wishes to sellwishes to sell

• Difficult to transfer Difficult to transfer ownershipownership

CorporationCorporation

AdvantagesAdvantages• Limited liabilityLimited liability• Unlimited lifeUnlimited life• Separation of Separation of

ownership and ownership and managementmanagement

• Transfer of Transfer of ownership is easyownership is easy

• Easier to raise Easier to raise capitalcapital

DisadvantagesDisadvantages• Separation of Separation of

ownership and ownership and management management (agency problem)(agency problem)

• Double taxation Double taxation (income taxed at (income taxed at the corporate rate the corporate rate and then dividends and then dividends taxed at personal taxed at personal rate) (except sub-S rate) (except sub-S & LLC)& LLC)

Goal Of Financial ManagementGoal Of Financial Management

What should be the goal of a corporation?What should be the goal of a corporation?• Maximize profit?Maximize profit?• Minimize costs?Minimize costs?• Maximize market share?Maximize market share?• Maximize the current value of the company’s Maximize the current value of the company’s

stock?stock? Does this mean we should do anything Does this mean we should do anything

and everything to maximize owner and everything to maximize owner wealth?wealth?

Sarbanes-Oxley ActSarbanes-Oxley Act

The Agency ProblemThe Agency Problem

Agency relationshipAgency relationship• Principal hires an agent to represent Principal hires an agent to represent

their interesttheir interest• Stockholders (principals) hire managers Stockholders (principals) hire managers

(agents) to run the company(agents) to run the company Agency problemAgency problem

• Conflict of interest between principal Conflict of interest between principal and agentand agent

Management goals and agency costsManagement goals and agency costs

Managing ManagersManaging Managers

Managerial compensationManagerial compensation• Incentives can be used to align Incentives can be used to align

management and stockholder interestsmanagement and stockholder interests• The incentives need to be structured The incentives need to be structured

carefully to make sure that they achieve carefully to make sure that they achieve their goaltheir goal

Corporate controlCorporate control• The threat of a takeover may result in The threat of a takeover may result in

better managementbetter management Other stakeholdersOther stakeholders

Figure 1.2Figure 1.2

Financial MarketsFinancial Markets

Cash flows to the firmCash flows to the firm Primary vs. secondary marketsPrimary vs. secondary markets

• Dealer vs. auction marketsDealer vs. auction markets• Listed vs. over-the-counter securitiesListed vs. over-the-counter securities

NYSENYSE NASDAQNASDAQ

Quick QuizQuick Quiz

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

management decisions and what management decisions and what questions are they designed to answer?questions are they designed to answer?

What are the three major forms of What are the three major forms of business organization?business organization?

What is the goal of financial What is the goal of financial management?management?

What are agency problems and why do What are agency problems and why do they exist within a corporation?they exist within a corporation?

HomeworkHomework

Now Chapter 1Now Chapter 1 Answer Questions 1.1, 1.2, 1.3, 1.5, Answer Questions 1.1, 1.2, 1.3, 1.5,

1.6, 1.7, 1.9, 1.10, 1.15 …. 1.21.6, 1.7, 1.9, 1.10, 1.15 …. 1.2 Read Chapter 2Read Chapter 2 Concepts: 2.1, 2.1, 2.2, 2.4, 2.5, 2.7Concepts: 2.1, 2.1, 2.2, 2.4, 2.5, 2.7 Problems: 1, 2, 3, 4, 6, 7, 14, 21Problems: 1, 2, 3, 4, 6, 7, 14, 21

Answers to Concepts Review Answers to Concepts Review and Critical Thinking Questionsand Critical Thinking Questions

1.1. Capital budgeting (deciding on whether to Capital budgeting (deciding on whether to expand a manufacturing plant), capital structure expand a manufacturing plant), capital structure (deciding whether to issue new equity and use (deciding whether to issue new equity and use the proceeds to retire outstanding debt), and the proceeds to retire outstanding debt), and working capital management (modifying the working capital management (modifying the firm’s credit collection policy with its customers).firm’s credit collection policy with its customers).

2.2. Disadvantages: unlimited liability, limited Disadvantages: unlimited liability, limited life, difficulty in transferring ownership, hard to life, difficulty in transferring ownership, hard to raise capital funds. Some advantages: simpler, raise capital funds. Some advantages: simpler, less regulation, the owners are also the less regulation, the owners are also the managers, sometimes personal tax rates are managers, sometimes personal tax rates are better than corporate tax rates.better than corporate tax rates.

3.3. The primary disadvantage of the corporate form is the double The primary disadvantage of the corporate form is the double taxation to shareholders of distributed earnings and dividends. Some taxation to shareholders of distributed earnings and dividends. Some advantages include: limited liability, ease of transferability, ability to raise advantages include: limited liability, ease of transferability, ability to raise capital, and unlimited life.capital, and unlimited life.

4.4. The treasurer’s office and the controller’s office are the two The treasurer’s office and the controller’s office are the two primary organizational groups that report directly to the chief financial primary organizational groups that report directly to the chief financial officer. The controller’s office handles cost and financial accounting, tax officer. The controller’s office handles cost and financial accounting, tax management, and management information systems. The treasurer’s management, and management information systems. The treasurer’s office is responsible for cash and credit management, capital budgeting, office is responsible for cash and credit management, capital budgeting, and financial planning. Therefore, the study of corporate finance is and financial planning. Therefore, the study of corporate finance is concentrated within the functions of the treasurer’s office.concentrated within the functions of the treasurer’s office.

5.5. To maximize the current market value (share price) of the equity To maximize the current market value (share price) of the equity of the firm (whether it’s publicly traded or not).of the firm (whether it’s publicly traded or not).

6.6. In the corporate form of ownership, the shareholders are the In the corporate form of ownership, the shareholders are the owners of the firm. The shareholders elect the directors of the corporation, owners of the firm. The shareholders elect the directors of the corporation, who in turn appoint the firm’s management. This separation of ownership who in turn appoint the firm’s management. This separation of ownership from control in the corporate form of organization is what causes agency from control in the corporate form of organization is what causes agency problems to exist. Management may act in its own or someone else’s best problems to exist. Management may act in its own or someone else’s best interests, rather than those of the shareholders. If such events occur, they interests, rather than those of the shareholders. If such events occur, they may contradict the goal of maximizing the share price of the equity of the may contradict the goal of maximizing the share price of the equity of the firm.firm.

7.7. A primary market transaction.A primary market transaction.

8.8. In auction markets like the NYSE, brokers and agents meet at a In auction markets like the NYSE, brokers and agents meet at a physical location (the exchange) to buy and sell their assets. Dealer physical location (the exchange) to buy and sell their assets. Dealer markets like Nasdaq represent dealers operating in dispersed locales who markets like Nasdaq represent dealers operating in dispersed locales who buy and sell assets themselves, usually communicating with other dealers buy and sell assets themselves, usually communicating with other dealers electronically or literally over the counter.electronically or literally over the counter.

9.9. Since such organizations frequently pursue social or political Since such organizations frequently pursue social or political missions, many different goals are conceivable. One goal that is often missions, many different goals are conceivable. One goal that is often cited is revenue minimization; i.e., providing their goods and services to cited is revenue minimization; i.e., providing their goods and services to society at the lowest possible cost. Another approach might be to observe society at the lowest possible cost. Another approach might be to observe that even a not-for-profit business has equity. Thus, an appropriate goal that even a not-for-profit business has equity. Thus, an appropriate goal would be to maximize the value of the equity.would be to maximize the value of the equity.

10.10. An argument can be made either way. At one extreme, we could An argument can be made either way. At one extreme, we could argue that in a market economy, all of these things are priced. This argue that in a market economy, all of these things are priced. This implies an optimal level of ethical and/or illegal behavior and the implies an optimal level of ethical and/or illegal behavior and the framework of stock valuation explicitly includes these. At the other framework of stock valuation explicitly includes these. At the other extreme, we could argue that these are non-economic phenomena and extreme, we could argue that these are non-economic phenomena and are best handled through the political process. The following is a classic are best handled through the political process. The following is a classic (and highly relevant) thought question that illustrates this debate: “A firm (and highly relevant) thought question that illustrates this debate: “A firm has estimated that the cost of improving the safety of one of its products has estimated that the cost of improving the safety of one of its products is $30 million. However, the firm believes that improving the safety of the is $30 million. However, the firm believes that improving the safety of the product will only save $20 million in product liability claims. What should product will only save $20 million in product liability claims. What should the firm do?”the firm do?”

11.11. The goal will be the same, but the best course of action toward The goal will be the same, but the best course of action toward that goal may require adjustments due different social, political, and that goal may require adjustments due different social, political, and economic climates.economic climates.

12.12. The goal of management should be to maximize the share price The goal of management should be to maximize the share price for the current shareholders. If management believes that it can improve for the current shareholders. If management believes that it can improve the profitability of the firm so that the share price will exceed $35, then the profitability of the firm so that the share price will exceed $35, then they should fight the offer from the outside company. If management they should fight the offer from the outside company. If management believes that this bidder or other unidentified bidders will actually pay believes that this bidder or other unidentified bidders will actually pay more than $35 per share to acquire the company, then they should still more than $35 per share to acquire the company, then they should still fight the offer. However, if the current management cannot increase the fight the offer. However, if the current management cannot increase the value of the firm beyond the bid price, and no other higher bids come in, value of the firm beyond the bid price, and no other higher bids come in, then management is not acting in the interests of the shareholders by then management is not acting in the interests of the shareholders by fighting the offer. Since current managers often lose their jobs when the fighting the offer. Since current managers often lose their jobs when the corporation is acquired, poorly monitored managers have an incentive to corporation is acquired, poorly monitored managers have an incentive to fight corporate takeovers in situations such as this.fight corporate takeovers in situations such as this.

13.13. We would expect agency problems to be less severe in other We would expect agency problems to be less severe in other countries, primarily due to the relatively small percentage of individual countries, primarily due to the relatively small percentage of individual ownership. Fewer individual owners should reduce the number of diverse ownership. Fewer individual owners should reduce the number of diverse opinions concerning corporate goals. The high percentage of institutional opinions concerning corporate goals. The high percentage of institutional ownership might lead to a higher degree of agreement between owners ownership might lead to a higher degree of agreement between owners and managers on decisions concerning risky projects. In addition, and managers on decisions concerning risky projects. In addition, institutions may be better able to implement effective monitoring institutions may be better able to implement effective monitoring mechanisms on managers than can individual owners, given an mechanisms on managers than can individual owners, given an institutions’ deeper resources and experiences with their own institutions’ deeper resources and experiences with their own management. The increase in institutional ownership of stock in the United management. The increase in institutional ownership of stock in the United States and the growing activism of these large shareholder groups may States and the growing activism of these large shareholder groups may lead to a reduction in agency problems for U.S. corporations and a more lead to a reduction in agency problems for U.S. corporations and a more efficient market for corporate control.efficient market for corporate control.

14.14. How much is too much? Who is worth more, Lee Raymond or Tiger How much is too much? Who is worth more, Lee Raymond or Tiger Woods? The simplest answer is that there is a market for executives just as Woods? The simplest answer is that there is a market for executives just as there is for all types of labor. Executive compensation is the price that there is for all types of labor. Executive compensation is the price that clears the market. The same is true for athletes and performers. Having clears the market. The same is true for athletes and performers. Having said that, one aspect of executive compensation deserves comment. A said that, one aspect of executive compensation deserves comment. A primary reason executive compensation has grown so dramatically is that primary reason executive compensation has grown so dramatically is that companies have increasingly moved to stock-based compensation. Such companies have increasingly moved to stock-based compensation. Such movement is obviously consistent with the attempt to better align movement is obviously consistent with the attempt to better align stockholder and management interests. In recent years, stock prices have stockholder and management interests. In recent years, stock prices have soared, so management has cleaned up. It is sometimes argued that much soared, so management has cleaned up. It is sometimes argued that much of this reward is simply due to rising stock prices in general, not of this reward is simply due to rising stock prices in general, not managerial performance. Perhaps in the future, executive compensation managerial performance. Perhaps in the future, executive compensation will be designed to reward only differential performance, i.e., stock price will be designed to reward only differential performance, i.e., stock price increases in excess of general market increases. increases in excess of general market increases.

15.15. The biggest reason that a company would “go dark” is because of The biggest reason that a company would “go dark” is because of the increased audit costs associated with Sarbanes-Oxley compliance. A the increased audit costs associated with Sarbanes-Oxley compliance. A company should always do a cost-benefit analysis, and it may be the case company should always do a cost-benefit analysis, and it may be the case that the costs of complying with Sarbox outweigh the benefits. Of course, that the costs of complying with Sarbox outweigh the benefits. Of course, the company could always be trying to hide financial issues of the the company could always be trying to hide financial issues of the company! This is also one of the costs of going dark: Investors surely company! This is also one of the costs of going dark: Investors surely believe that some companies are going dark to avoid the increased believe that some companies are going dark to avoid the increased scrutiny from SarbOx. This taints other companies that go dark just to scrutiny from SarbOx. This taints other companies that go dark just to avoid compliance costs. This is similar to the lemon problem with used avoid compliance costs. This is similar to the lemon problem with used automobiles: Buyers tend to underpay because they know a certain automobiles: Buyers tend to underpay because they know a certain percentage of used cars are lemons. So, investors will tend to pay less for percentage of used cars are lemons. So, investors will tend to pay less for the company stock than they otherwise would. It is important to note that the company stock than they otherwise would. It is important to note that even if the company delists, its stock is still likely traded, but on the over-even if the company delists, its stock is still likely traded, but on the over-the-counter market pink sheets rather than on an organized exchange. the-counter market pink sheets rather than on an organized exchange. This adds another cost since the stock is likely less to be liquid now. All This adds another cost since the stock is likely less to be liquid now. All else the same, investors pay less for an asset with less liquidity. Overall, else the same, investors pay less for an asset with less liquidity. Overall, the cost to the company is likely a reduced market value. Whether this is the cost to the company is likely a reduced market value. Whether this is good or bad for investors depends on the individual circumstances of the good or bad for investors depends on the individual circumstances of the company. It is also important to remember that there are already many company. It is also important to remember that there are already many small companies that file only limited financial information already.small companies that file only limited financial information already.

HAVE A GREAT WEEK!HAVE A GREAT WEEK!