CHAPTER 1

An Overview of Financial
Management
■ Finance VS Economics & Accounting
■ Responsibility of CFO
■ Three areas of Finance
■ Goal of Corporations
■ Intrinsic Value and Stock Price
■ Agency Relationships
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 Finance VS Economics &
Accounting
■ Finance can be defined as the science
and art of managing money.
■ Finance grew out of Economics and
Accounting
■ Economics suggested that assets value is
based on it’s ability to generate cash now
and in the future. (cost-benefit analysis)
■ Accountants provide information regarding
the likely size of those cash flows.(accrual
vs. cash, decision making) 1-2
 Career Opportunities in
Finance

■ Money and capital markets (e.g. Banks,

insurance companies, mutual funds)
■ Investments (e.g. Brokerage House)
■ Financial management

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Three areas of Finance

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Finance Within the Organization

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Responsibility of the Financial
Staff
■ Maximizing Shareholders’ Wealth by:
■ Forecasting and planning
■ Investment and financing decisions
■ Transactions in the financial markets
■ Managing risk
■ Coordination and Control

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 Equation of Accounting

ASSET = LIABILITIES + STOCKHOLDERS’ EQUITY

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Alternative Forms of Business
Organization
■ Sole proprietorship: An unincorporated business
owned by one individual

■ Partnership: An unincorporated business owned by

two or more persons.

■ Corporation: A legal entity created by a state,

separate and distinct from it’s owners and managers.
■ Ownership is divided into several segments called
shares/stocks and sold to the public, who become the
shareholder.
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Sole proprietorships &
Partnerships
■ Advantages
■ Ease of formation
■ Subject to few regulations
■ No corporate income taxes
■ Disadvantages
■ Difficult to raise capital
■ Unlimited liability
■ Limited life

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

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Goal of Corporation
■ Because the ownership and management are
separate in a corporation thus the goals of
corporation are different from those of proprietorship
and partnership.

■ The primary goal for managers of publicly owned

corporation implies that decisions should be made to
maximize the long-run value of the firm’s
shares/stocks, within some constraints.
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Financial Goals of the Corporation
■ The primary financial goal is
shareholder wealth maximization,
which translates to maximizing stock
price.

■ Should firms behave ethically?

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 Ethics in Financial Reporting
■ Standards of conduct by which one’s
actions are judged as right or wrong,
honest or dishonest, fair or not fair, are
Ethics.
■ Recent financial scandals include: Enron,
WorldCom, Xerox Corp. and others.
■ Effective financial reporting depends on
sound ethical behavior.

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 Is stock price maximization the
same as profit maximization?
■ No, despite a generally high correlation
amongst stock price, EPS, and cash flow.
■ Current stock price relies upon current
earnings, as well as future earnings and
cash flow.
■ Some actions may cause an increase in
earnings, yet cause the stock price to
decrease (and vice versa).

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Factors that affect stock price
■ Projected cash flows
to shareholders
■ Timing of the cash
flow stream
■ Riskiness of the cash
flows

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Factors that Affect the Level
and Riskiness of Cash Flows
■ Decisions made by financial managers:
■ Investment decisions
■ Financing decisions (the relative use of
debt financing)
■ Dividend policy decisions
■ The external environment

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Intrinsic Value and Stock Price
■ Economists’ theory of valuing an asset can be applied
to stocks as well. Thus a stock’s intrinsic value is
determined by it’s ability to generate cash now and in
the future.
■ Intrinsic value is an estimate of stock’s “true” value based on
accurate risk and historical return data. This value is an
estimate as future cash flows cannot be determined with
certainty.

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Intrinsic Value and Stock Price
■ Stock Prices are seldom equal to it’s
intrinsic value. The prices of stocks in
the market are determined by it’s
demand and supply.
■ The investors’ demand of stocks are
based on their “perceived” risk and
return. “Perceived” means what the
investors expect of the future.

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Equilibrium
■ The situation in which the actual market price

equals the intrinsic value so investors are

indifferent between buying and selling a

stock.

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 Determinants of Intrinsic
Value and Stock Price
Managerial Actions, the Economic Environment,
Taxes, and the Political Climate

“True” investor “True” “Perceived” investor “Perceived”

returns (cash flows) Risk returns (cash flows) Risk

Stock’s Intrinsic Stock’s Market

Value Price

Market Equilibrium:
Intrinsic Value = Market Price

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Agency relationships
■ Corporate Governance are the rules,
processes, and laws by which companies are
operated, controlled, and regulated.
■ An agency relationship exists whenever a
principal hires an agent to act on their behalf.
■ Within a corporation, agency relationships
exist between:
■ Shareholders and managers
■ Shareholders and creditors
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Shareholders versus Managers
■ Managers are naturally inclined to act in
their own best interests. (agency
problem)
■ But the following factors affect
managerial behavior:
■ Managerial compensation plans
■ Direct intervention by shareholders
■ The threat of firing
■ The threat of takeover
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Shareholders versus Bondholders
■ Stockholders are more likely to prefer riskier projects,
because they receive more of the upside if the
project succeeds. By contrast, bondholders receiving
fixed payments are more interested in limiting risk.
■ Bondholders are particularly concerned about the use
of additional debt.
■ Bondholders attempt to protect themselves by
including covenants in bond agreements that limit the
use of additional debt and constrain managers’
actions.

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Some Core Principles of
Finance…

■ The Risk-Return Trade off

■ The time value of Money
■ Cash – Not Profit – is our interest
■ Efficient Capital Market

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