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Fundamentals of
Financial
Management
CHAPTER 1
An Overview of Financial
Management

Copyright © 2002 by Harcourt, Inc. All rights reserved.

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Learning Objectives
◼To know what is Finance
◼Identify the pros and cons of
different forms of business
organization
◼Discuss the importance of business
Ethics.

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What is Finance?

◼ Finance is defined by Webster’s

Dictionary as “the system that
includes the circulation of money,
the granting of credit, the making of
investments, and the provision of
banking facilities.”
◼Finance prepares students for jobs in
banking, investments, insurance,
corporations and government.
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Finance within an Organization

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Finance is generally divided into three areas

Capital markets
➢ relate to the markets where interest rates,
along with stock and bond prices, are
determined.

Investments
➢ relate to decisions concerning stocks and
bonds and include a number of activities
which are Security analysis, Portfolio
Theory and Market Analysis.

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Finance is generally divided into three areas

Financial
management
➢ also called corporate
finance, focuses on
decisions relating to how
much and what types of
assets to acquire, how to
raise the capital needed
to purchase assets, and
how to run the firm so as
to maximize its value.

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Forms of Business Organization

◼Sole proprietorship
◼Partnership
◼Corporation
◼A limited liability company (LLC)
/limited liability partnership (LLP)

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Sole Proprietorship

➢is an unincorporated
business owned by
one individual. Going
into business as a sole
proprietor is easy—a
person begins
business operations.

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Sole Proprietorship
◼ Advantages:
⚫Ease of formation
⚫Subject to few
regulations
⚫No corporate income
taxes
◼ Disadvantages:
⚫Limited life
⚫Unlimited liability
⚫Difficult to raise capital
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Partnership
➢ A partnership is a legal arrangement between two
or more people who decide to do business together.

◼ A partnership has roughly the same advantages

and disadvantages as a sole proprietorship.

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Partnership

◼ Advantages:
⚫Ease of formation
⚫Subject to few regulations
⚫No corporate income taxes
◼ Disadvantages:
⚫Limited life
⚫Unlimited liability
⚫Difficult to raise capital

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Corporation
➢ is a legal entity created by a state,
and it is separate and distinct from
its owners and managers.
➢ It is this separation that limits
stockholders’ losses to the amount
they invested in the firm—the
corporation can lose all of its
money, but its owners can lose
only the funds that they invested in
the company.
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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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Limited Liability Company and Limited Liability
Partnership
◼ is a popular type of organization that is a hybrid
between a partnership and a corporation. A
limited liability partnership (LLP) is similar to an
LLC
◼ LLPs are used for professional firms in the fields
of accounting, law, and architecture, while LLCs
are used by other businesses. Similar to
corporations, LLCs and LLPs provide limited
liability protection, but they are taxed as
partnerships.
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Goals of the Corporation

The primary goal is

shareholder wealth
maximization, which translates
to maximizing stock price.

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Business ethics
• refers to implementing appropriate business
policies and practices with regard to
arguably controversial subjects.
• Some issues that come up in a discussion of
ethics include corporate governance, insider
trading, bribery, discrimination, social
responsibility, and fiduciary responsibilities.
• The law usually sets the tone for business
ethics, providing a basic guideline that
businesses can choose to follow to gain
public approval.
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What is the importance of Business
Ethics?
◼ Amidst growing scrutiny of business practices, it’s
more important than ever for companies to carry out
work the right way. Ethics programs are an exceptional
tool for promoting moral conduct. Organizations also
need employees dedicated to ethical decision-making.
◼ It reaches far beyond employee loyalty and morale or
the strength of a management team bond. As with all
business initiatives, the ethical operation of a company
is directly related to profitability in both the short and
long term.

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Shareholders versus Managers

◼It has long been recognized that

managers’ personal goals may compete
with shareholder wealth maximization.
◼In particular, managers might be more
interested in maximizing their own wealth
than their stockholders’ wealth; therefore,
managers might pay themselves
excessive salaries.

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Shareholders versus Managers

◼Managers are naturally inclined to act

in their own best interests.
◼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 Creditors

◼ Conflicts can also arise between stockholders

and debtholders. Debtholders, which include
the company’s bankers and its bondholders,
generally receive fixed payments regardless of
how well the company does, while
stockholders do better when the company
does better.
◼ This situation leads to conflicts between these
two groups, to the extent that stockholders
are typically more willing to take on risky
projects.
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Shareholders versus Creditors

◼Shareholders (through managers)

could take risky actions to
maximize stock price, but are
detrimental to creditors.
◼In the long run, such actions will
raise the cost of debt and
ultimately lower stock price.

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CHAPTER 2
FINANCIAL MARKETS
AND INSTITUTIONS

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The Capital Allocation Process

◼Businesses, individuals, and
governments often need to raise capital.
◼some individuals and firms have
incomes that exceed their current
expenditures, in which case they have
funds available to invest.
◼People and organizations with surplus
funds are saving today in order to
accumulate funds for some future use.
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The Capital Allocation Process

◼ Members of a household might save to pay for
their children’s education and the parents’
retirement, while a business might save to fund
future investments.
◼ Those with surplus funds expect to earn a
return on their investments, while people and
organizations that need capital understand that
they must pay interest to those who provide
that capital.

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The Capital Allocation
Process
◼ Direct transfers of money and
securities, as shown in the top
section, occur when a business sells
its stocks or bonds directly to
savers, without going through any
type of financial institution.
◼ The company sells its stocks or bonds to the investment bank, which
then sells these same securities to savers. The businesses’ securities
and the savers’ money merely “pass through” the investment bank.
◼ Transfers can also be made through a financial intermediary such as a
bank, an insurance company, or a mutual fund. Here the intermediary
obtains funds from savers in exchange for its securities.

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Types of Markets
I. Physical asset markets versus financial
asset markets.
◼ Physical asset markets (also called “tangible” or “real”
asset markets) are for products such as wheat, autos,
real estate, computers, and machinery.
◼ Financial asset markets, on the other hand, deal with
stocks, bonds, notes, and mortgages. Financial
markets also deal with derivative securities whose
values are derived from changes in the prices of other
assets.

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Types of Markets
II. Spot markets versus futures markets.
◼Spot markets are markets in which assets
are bought or sold for “on-the-spot”
delivery (literally, within a few days).
◼Futures markets are markets in which
participants agree today to buy or sell an
asset at some future date.

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Types of Markets
III. Money markets versus capital
markets
◼Money markets are the markets for short-
term, highly liquid debt securities.
◼Capital markets are the markets for
intermediate- or long-term debt and
corporate stocks.

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Types of Markets
IV. Primary markets versus secondary
markets.
◼ Primary markets are the markets in
which corporations raise new capital.
◼Secondary markets are markets in which
existing, already outstanding securities
are traded among investors.

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Types of Markets
V. Private markets versus public
markets.
◼ Private markets, where transactions are
negotiated directly between two or more
parties, are differentiated from public markets,
where standardized contracts are traded on
organized exchanges.

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Financial Institutions
◼ Direct funds transfers are common among individuals
and small businesses and in economies where
financial markets and institutions are less developed.
But large businesses in developed economies
generally find it more efficient to enlist the services of
a financial institution when it comes time to raise
capital.
◼ It is useful to understand the major categories of
financial institutions.

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Financial Institutions
◼ Investment banks traditionally
help companies raise capital.

◼ Commercial banks, such as

Bank of America, Citibank,
Wells Fargo, and JP Morgan
Chase, are the traditional
“department stores of finance”
because they serve a variety of
savers and borrowers.
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Financial Institutions
◼ Financial services
corporations are large
conglomerates that combine
many different financial
institutions within a single
corporation.

◼ Credit unions are cooperative

associations whose members
are supposed to have a
common bond, such as being
employees of the same firm.

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Financial Institutions
◼ Pension funds are
retirement plans funded
by corporations or
government agencies for
their workers and
administered primarily by
the trust departments of
commercial banks or by
life insurance
companies.

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Financial Institutions
◼ Life insurance
companies take
savings in the form of
annual premiums;
invest these funds in
stocks, bonds, real
estate, and mortgages;
and make payments to
the beneficiaries of the
insured parties.

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Financial Institutions
◼ Mutual funds are corporations that accept money
from savers and then use these funds to buy stocks,
long-term bonds, or short-term debt instruments
issued by businesses or government units.
◼ Exchange Traded Funds (ETFs) are similar to regular
mutual funds and are often operated by mutual fund
companies.
◼ Hedge funds are also similar to mutual funds
because they accept money from savers and use the
funds to buy various securities, but there are some
important differences.

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The Market for Common Stock

◼ Some companies are so small that their common
stocks are not actively traded; they are owned by
relatively few people, usually the companies’
managers.
◼ These firms are said to be privately owned, or
closely held, corporations; their stock is called closely
held stock. In contrast, the stocks of most large
companies are owned by thousands of investors,
most of whom are not active in management.
◼ These companies are called publicly owned
corporations, and their stock is called publicly held
stock.
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Types of Stock Market
Transactions

◼ Outstanding shares of established publicly owned companies

that are traded: the secondary market. Thus, the market for
outstanding shares, or used shares, is the secondary market.
The company receives no new money when sales occur in this
market.
◼ 2. Additional shares sold by established publicly owned
companies: the primary market. If Allied Food decides to sell (or
issue) an additional 1 million shares to raise new equity capital,
this transaction is said to occur in the primary market.

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