Learning Goals

1. Define finance, its major areas and

opportunities available in this field, and the
legal forms of business organization.
2. Describe the managerial finance function and
its relationship to economics and accounting.
3. Identify the primary activities of the
financial manager.
4. Explain the goal of the firm, corporate
governance, the role of ethics, and
the agency issue.

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Learning Goals (cont.)

5. Understand financial institutions and

markets, and the role they play in
managerial finance.
6. Discuss business taxes and their
importance in financial decisions.

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What is Finance?

• Finance can be defined as the art and

science of managing money.
• Finance is concerned with the process,
institutions, markets, and instruments
involved in the transfer of money among
individuals, businesses, and governments.

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The Financial System
FIGURE 1-2

CHAPTER 1 - An Introduction to Finance 1-4

Major Areas & Opportunities in
Finance: Financial Services
• Financial Services is the area of finance
concerned with the design and delivery of
advice and financial products to
individuals, businesses, and government.
• Career opportunities include banking,
personal financial planning, investments,
real estate, and insurance.

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Major Areas & Opportunities in
Finance: Managerial Finance
• Managerial finance is concerned with
the duties of the financial manager in the
business firm.
• The financial manager actively manages the
financial affairs of any type of business, whether
private or public, large or small, profit-seeking or
not-for-profit.
• They are also more involved in developing
corporate strategy and improving the firm’s
competitive position.

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Major Areas & Opportunities in
Finance: Managerial Finance (cont.)
• Increasing globalization has complicated
the financial management function by
requiring them to be proficient in
managing cash flows in different
currencies and protecting against the risks
inherent in international transactions.
• Changing economic and regulatory
conditions also complicate the financial
management function.

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Business Finance
• Some important questions that are
answered using finance
– What long-term investments should the firm
take on?
– Where will we get the long-term financing to
pay for the investments?
– How will we manage the everyday financial
activities of the firm?

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Financial Manager
• Financial managers try to answer some, or
all, of these questions
• The top financial manager within a firm is
usually the Chief Financial Officer (CFO)
– Treasurer – oversees cash management, credit
management, capital expenditures, and financial
planning
– Controller – oversees taxes, cost accounting,
financial accounting, and data processing

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Financial Management Decisions
• Capital budgeting
– What long-term investments or projects
should the business take on?
• Capital structure
– How should we pay for our assets?
– Should we use debt or equity?
• Working capital management
- How do we manage the day-to-day
finances of the firm?
• Dividend decision
- how much to distribute to shareholder 11
Legal Forms of Business Organization

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Corporate Organization

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Career Opportunities

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The Managerial Finance Function

• The size and importance of the managerial

finance function depends on the size of the firm.
• In small companies, the finance function may
be performed by the accounting department.
• As the business expands, finance typically
evolves into a separate department linked to the
vice president as was previously described in
Figure 1.1.

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The Managerial Finance Function:
Relationship to Economics
• The field of finance is actually an
outgrowth of economics.
• In fact, finance is sometimes referred to as
financial economics.
• Financial managers must understand the
economic framework within which they
operate in order to react or anticipate to
changes in conditions.
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The Managerial Finance Function:
Relationship to Economics (cont.)
• The primary economic principal used by
financial managers is marginal
cost-benefit analysis which says that
financial decisions should be implemented
only when added benefits exceed added
costs.

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Managerial Finance Function:
Relationship to Economics (cont.)

•Nord Department Stores is applying marginal-cost

benefit analysis to decide whether to replace a
computer:

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The Managerial Finance Function:
Relationship to Accounting
• The firm’s finance (treasurer) and
accounting (controller) functions are
closely-related and overlapping.
• In smaller firms, the financial manager
generally performs both functions.

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The Managerial Finance Function:
Relationship to Accounting (cont.)
• One major difference in perspective and
emphasis between finance and
accounting is that accountants generally
use the accrual method while in finance,
the focus is on cash flows.
• The significance of this difference
can be illustrated using the following
simple example.

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The Managerial Finance Function:
Relationship to Accounting (cont.)
• The Nassau Corporation experienced the
following activity last year:
Sales $100,000 (1 yacht sold, 100% still uncollected)
Costs $ 80,000 (all paid in full under supplier terms)

• Now contrast the differences in

performance under the accounting method
versus the cash method.

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The Managerial Finance Function:
Relationship to Accounting (cont.)

INCOME STATEMENT SUMMARY

ACCRUAL CASH
Sales $100,000 $ 0
Less: Costs (80,000) (80,000)
Net Profit/(Loss) $ 20,000 $(80,000)

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The Managerial Finance Function:
Relationship to Accounting (cont.)
• Finance and accounting also differ with respect
to decision-making.
• While accounting is primarily concerned with the
presentation of financial data, the financial
manager is primarily concerned with analyzing
and interpreting this information for
decision-making purposes.
• The financial manager uses this data as a vital
tool for making decisions about the financial
aspects of the firm.

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Primary Activities of
the Financial Manager

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Goal of the Firm: Maximize Profit???

• Profit maximization fails to account for differences in the

level of cash flows (as opposed to profits), the timing of
these cash flows, and the risk of these cash flows.

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Goal of the Firm:
Maximize Shareholder Wealth!!!
• Why?
• Because maximizing shareholder wealth properly
considers cash flows, the timing of these cash flows, and
the risk of these cash flows.
• This can be illustrated using the following simple stock
valuation equation:
level & timing
of cash flows
Share Price = Future Dividends
Required Return risk of cash
flows

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Goal of the Firm:
Maximize Shareholder Wealth!!! (cont.)
• The process of shareholder wealth
maximization can be described using the
following flow chart:

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Goal of the Firm:
What About Other Stakeholders?
• Stakeholders include all groups of individuals who have
a direct economic link to the firm including employees,
customers, suppliers, creditors, owners, and others who
have a direct economic link to the firm.
• The "Stakeholder View" prescribes that the firm make a
conscious effort to avoid actions that could be
detrimental to the wealth position of its stakeholders.
• Such a view is considered to be "socially responsible."

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Corporate Governance

• Corporate Governance is the system used to

direct and control a corporation.
• It defines the rights and responsibilities of key
corporate participants such as shareholders, the
board of directors, officers and managers, and
other stakeholders.
• The structure of corporate governance was
previously described in Figure 1.1.

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Individual versus Institutional Investors

• Individual investors are investors who purchase

relatively small quantities of shares in order to earn a
return on idle funds, build a source of retirement income,
or provide financial security.
• Institutional investors are investment professionals who
are paid to manage other people’s money.
• They hold and trade large quantities of securities for
individuals, businesses, and governments and tend to
have a much greater impact on corporate governance.

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The Role of Ethics: Ethics Defined

• Ethics is the standards of conduct or

moral judgment—have become an
overriding issue in both our society and
the financial community
• Ethical violations attract widespread
publicity
• Negative publicity often leads to negative
impacts on a firm
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The Sarbanes-Oxley Act of 2002

• The Sarbanes-Oxley Act of 2002 (commonly called

SOX) eliminated many disclosure and conflict of interest
problems that surfaced during the early 2000s.
• SOX:
– established an oversight board to monitor the
accounting industry;
– tightened audit regulations and controls;
– toughened penalties against executives who commit
corporate fraud;
– strengthened accounting disclosure requirements;
– established corporate board structure guidelines.

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The Role of Ethics: Considering Ethics

• Robert A. Cooke, a noted ethicist, suggests that

the following questions be used to assess the
ethical viability of a proposed action:
– Does the action unfairly single out an individual
or group?
– Does the action affect the morals, or legal rights of
any individual or group?
– Does the action conform to accepted
moral standards?
– Are there alternative courses of action that are less
likely to cause actual or potential harm?

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The Role of Ethics:
Considering Ethics (cont.)
• Cooke suggests that the impact of a proposed decision
should be evaluated from a number of perspectives:
– Are the rights of any stakeholder being violated?
– Does the firm have any overriding duties to any stakeholder?
– Will the decision benefit any stakeholder to the detriment of
another stakeholder?
– If there is a detriment to any stakeholder, how should it be
remedied, if at all?
– What is the relationship between stockholders
and stakeholders?

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The Role of Ethics:
Ethics & Share Price
• Ethics programs seek to:
– reduce litigation and judgment costs
– maintain a positive corporate image
– build shareholder confidence
– gain the loyalty and respect of
all stakeholders
• The expected result of such programs is
to positively affect the firm's share price.

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The Agency Issue:
The Agency Problem
• Whenever a manager owns less than 100% of the firm’s
equity, a potential agency problem exists.
• In theory, managers would agree with shareholder
wealth maximization.
• However, managers are also concerned with their
personal wealth, job security, fringe benefits,
and lifestyle.
• This would cause managers to act in ways that do not
always benefit the firm shareholders.

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The Agency Issue:
Resolving the Problem
• Market Forces such as major
shareholders and the threat of a hostile
takeover act to keep managers in check.
• Agency Costs are the costs borne by
stockholders to maintain a corporate
governance structure that minimizes
agency problems and contributes to the
maximization of shareholder wealth.

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The Agency Issue:
Resolving the Problem (cont.)
• Examples would include bonding or
monitoring management behavior, and
structuring management compensation to
make shareholders interests their own.
• A stock option is an incentive allowing
managers to purchase stock at the market
price set at the time of the grant.

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The Agency Issue:
Resolving the Problem (cont.)
• Performance plans tie management
compensation to measures such as EPS
growth; performance shares and/or cash
bonuses are used as compensation under
these plans.
• Recent studies have failed to find a strong
relationship between CEO compensation
and share price.

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Marginal cost and benefit analysis

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Agency problem, cost and solution

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Financial Institutions & Markets

• Firms that require funds from external

sources can obtain them in three ways:
– through a bank or other financial institution
– through financial markets
– through private placements

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Financial Institutions & Markets:
Financial Institutions
• Financial institutions are intermediaries that
channel the savings of individuals, businesses,
and governments into loans or investments.
• The key suppliers and demanders of funds are
individuals, businesses, and governments.
• In general, individuals are net suppliers of
funds, while businesses and governments are
net demanders of funds.

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Financial Institutions & Markets:
Financial Markets
• Financial markets provide a forum in which
suppliers of funds and demanders of funds can
transact business directly.
• The two key financial markets are the money
market and the capital market.
• Transactions in short term marketable securities
take place in the money market while
transactions in long-term securities take place in
the capital market.

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Financial Institutions & Markets:
Financial Markets (cont.)
• Whether subsequently traded in the money or
capital market, securities are first issued through
the primary market.
• The primary market is the only one in which a
corporation or government is directly involved in
and receives the proceeds from the transaction.
• Once issued, securities then trade on the
secondary markets such as the New York
Stock Exchange or NASDAQ.

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The Money Market

• The money market exists as a result of the

interaction between the suppliers and
demanders of short-term funds (those having
a maturity of a year or less).
• Most money market transactions are made in
marketable securities which are short-term
debt instruments such as T-bills and
commercial paper.
• Money market transactions can be executed
directly or through an intermediary.

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The Capital Market

• The capital market is a market that enables suppliers

and demanders of long-term funds to make transactions.
• The key capital market securities are bonds (long-term
debt) and both common and preferred stock (equity).
• Bonds are long-term debt instruments used by
businesses and government to raise large sums of
money or capital.
• Common stock are units of ownership interest or equity
in a corporation.

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Major Securities Exchanges:
Organized Exchanges
• Organized securities exchanges are tangible
secondary markets where outstanding securities
are bought and sold.
• Only the largest and most profitable companies
meet the requirements necessary to be listed
on the New York Stock Exchange.

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Major Securities Exchanges:
Organized Exchanges (cont.)

•Trading is conducted through an auction

process where specialists “make a market”
in selected securities.
•As compensation for executing orders,
specialists make money on the spread (bid
price – ask price).

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Major Securities Exchanges:
Over-the-Counter Exchange
• The over-the-counter (OTC) market is an
intangible market for securities transactions.
• Unlike organized exchanges, the OTC is both a
primary market and a secondary market.
• The OTC is a computer-based market where
dealers make a market in selected securities
and are linked to buyers and sellers through the
NASDAQ System.
• Dealers also make money on the “spread.”

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Major Securities Exchanges:
International Capital Markets
• The foreign bond market is a market for
foreign bonds, which are bonds issued by a
foreign corporation or government that is
denominated in the investor’s home currency
and sold in the investor’s home market.

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Major Securities Exchanges:
International Capital Markets (cont.)
• Finally, the international equity market
allows corporations to sell blocks of
shares to investors in a number of
different countries simultaneously.
• This market enables corporations to raise
far larger amounts of capital than they
could raise in any single national market.

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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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