CHAPTER 1

Overview of Financial
Management and the Financial
Environment

Topics in Chapter
 Forms of business organization
 Objective of the firm: Maximize wealth
 Determinants of fundamental value
 Financial securities, markets and
institutions

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 Finance & Financial
Management
 All entities (households, businesses, governments)
earn/raise and spend/invest money. Finance is the art and
science of managing money. It is associated with the
process, institutions and instruments that facilitate the
transfer of money between entities.
 Finance: Economics, Accounting (and Mathematics)
 Economists developed the notion that an asset’s value is
determined by the future cash-flows that it generates. In fact,
finance as a separate discipline has grown out of economics.
 Accountants help you assess the likely size of those cash-flows.
 Mathematics is ubiquitous in any logical field of inquiry.

Finance & Financial

Management (contd.)
 Financial Management: Part of finance that deals with
decisions as to how to raise and use money to maximize
the firm value. Unless otherwise stated the context is
assumed to be of a corporation and, therefore, FM is often
termed as Corporate Finance.
 It provides the skills managers need to:
 Identify and select the corporate strategies and

individual projects that add value to their firm.

 Forecast the funding requirements of their company,

and devise strategies for acquiring those funds.

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Business Organization from Start-
up to a Major Corporation
 Sole proprietorship
 Partnership
 Corporation

(More . .)

Starting as a Proprietorship
 Advantages:
 Ease of formation
 Subject to few regulations
 No corporate income taxes
 Disadvantages:
 Limited life
 Unlimited liability
 Difficult to raise capital to support growth

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Starting as or Growing into a
Partnership
 A partnership has roughly the same
advantages and disadvantages as a sole
proprietorship.

Becoming a Corporation
 A corporation is a legal entity separate
from its owners and managers.
 File papers of incorporation with state.
 Charter
 Bylaws

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Advantages and Disadvantages of
a Corporation
 Advantages:
 Unlimited life
 Easy transfer of ownership
 Limited liability
 Ease of raising capital
 Disadvantages:
 Double taxation
 Cost of set-up and report filing

Finance Within the Corporation

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Agency Problems and
Corporate Governance
 Agency problem: managers may act in their
own interests and not on behalf of owners
(stockholders)
 Corporate governance is the set of rules that
control a company’s behavior towards its
directors, managers, employees,
shareholders, creditors, customers,
competitors, and community.
 Corporate governance can help control
agency problems.
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What should be management’s

primary objective?
 The primary objective should be
shareholder wealth maximization, which
translates to maximizing the
fundamental stock price.
 Should firms behave ethically? YES!
 Do firms have any responsibilities to
society at large? YES! Shareholders are
also members of society.

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Is maximizing stock price good for
society, employees, and customers?

 Employment growth is higher in firms

that try to maximize stock price. On
average, employment goes up in:
 firms that make managers into owners
(such as LBO firms)
 firms that were owned by the government
but that have been sold to private
investors
(Continued)
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Is maximizing stock price good?

(Continued)

 Consumer welfare is higher in capitalist

free market economies than in
communist or socialist economies.
 Fortune lists the most admired firms.
In addition to high stock returns, these
firms have:
 high quality from customers’ view
 employees who like working there

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 What determines a firm’s
fundamental, or intrinsic, value?
Intrinsic value is the sum of all the future expected free cash
flows when converted into today’s dollars:
FCF1 + FCF2 +… FCF∞
Value =
(1 + WACC)1 (1 + WACC)2 (1 + WACC)∞

Free cash flows (FCF) are the cash flows that are available (or free) for
distribution to all investors (stockholders and creditors).
Weighted Average Cost of Capital (WACC) is the average rate of return
required by all of the company’s investors. It is affected by risk & capital
structure of the firm, interest rates, and investors’ overall attitude toward risk
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What three aspects of cash flows

affect an investment’s value?
 Amount of expected cash flows (bigger is
better)
 Timing of the cash flow stream (sooner is
better)
 Risk of the cash flows (less risk is better)

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Who are the providers (savers)
and users (borrowers) of capital?
 Households: Net savers
 Non-financial corporations: Net users
(borrowers)
 Governments: Net borrowers
 Financial corporations: Slightly net
borrowers, but almost breakeven

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Transfer of Capital from

Savers to Borrowers
 Direct transfer (e.g., corporation issues
commercial paper to insurance company)
 Through an investment banking house (e.g.,
IPO, seasoned equity offering, or debt
placement)
 Through a financial intermediary (e.g.,
individual deposits money in bank, bank
makes commercial loan to a company)

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 Cost of Money
 What do we call the price, or cost, of debt capital?
 The interest rate

 What do we call the price, or cost, of equity capital?

 Cost of equity = Required return = dividend yield +

capital gain
 Certain fundamental economic factors, economic
conditions and policies, and international factors affect
the demand and supply of loanable funds and their cost.

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Cost of Money affected by …

 Factors:
 Production opportunities – ability to turn capital into benefits.
 Time preferences for consumption (present)
 Risk (of return on investment)
 Expected inflation
 Economic Conditions:
 Central Bank policies
 Budget deficits/surpluses
 International Conditions:
 Country risk.
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 Exchange rate risk.
 Transfer of Capital from
Savers to Borrowers (contd.)

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What are some financial

institutions?
 Credit unions – Cooperatives of people with common bond (employees of a
firm, residents of a locality)
 Commercial banks
 Investment banks – Specialized financial institutions (or division of banks)
that assist in raising and management of capital and provide advisory
services. They do underwriting, M&A consulting, wealth management for
individuals/institutions, brokerage. e.g., JP Morgan, Merrill Lynch
 Investment funds
 Mutual Funds (open) and Exchanged Traded Funds (ETFs)
 Hedge funds - Small number of large investors invests in many securities including
derivatives)
 Private equity funds - Small number of investors typically owns virtually all
shares in a firm (private company or public company tuned private).
 Life insurance companies and Pension funds etc.
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 Financial Securities
 Financial securities are pieces of paper (or even computer
entries) with contractual provisions that entitle their owners
to specific rights and claims (ownership/creditor) on specific
cash flows.
 Notice that debt and equity represent claims upon the cash
flows generated by real assets, such as the cash flows
generated by a firm’s factories and operations.
 Some securities are a mix of debt, equity, and derivatives. For
example, preferred stock has features of both debt and equity, while
convertible debts has features of both debt & derivatives.
 Some securities are created from packages of other securities, a
process called securitization.
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Typical Rates of Return

Instrument Rate (April 2006)
U.S. T-bills 4.79%
Commercial paper 4.97
Negotiable CDs 5.07
Eurodollar deposits 5.10
Commercial loans:
Tied to prime 7.75 +
or LIBOR 5.13 +
(More . .)

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Typical Rates (Continued)
Instrument Rate (April 2006)
U.S. T-notes and T-bonds 5.04%
Mortgages 6.15
Municipal bonds 4.66
Corporate (AAA) bonds 5.93
Preferred stocks 6 to 9%
Common stocks (expected) 9 to 15%

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What are some types of

markets?
 A market is a method of exchanging
one asset (usually cash) for another
asset.
 Physical assets vs. financial assets
 Spot versus future markets
 Money versus capital markets
 Primary versus secondary markets

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Types of Orders
 Instructions on how a transaction is to
be completed
 Market Order– Transact as quickly as
possible at current price
 Limit Order– Transact only if specific
situation occurs. For example, buy if price
drops to $50 or below during the next two
hours.

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THANKS

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