Chapter 1

An Overview of Financial
Management
Forms of Business Organization
Balancing Shareholder Value and Society Interests
Intrinsic Values, Stock Prices, and Managerial Incentives
Important Business Trends
Conflicts Between Managers, Stockholders, and
Bondholders
1-1
2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a
publicly accessible website, in whole or in part.

Finance Within the Organization

Board of Directors

Chief Executive Officer (CEO)

Chief Operating Officer
(COO)

Chief Financial Officer

(CFO)

Marketing, Production,
Human Resources, and Other
Operating Departments

Accounting, Treasury, Credit,

Legal, Capital Budgeting,
and Investor Relations
1-2

2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a
publicly accessible website, in whole or in part.

Forms of Business Organization

Proprietorship
Partnership
Corporation

1-3
2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a
publicly accessible website, in whole or in part.

Proprietorships and Partnerships

Advantages

Ease of formation
Subject to few regulations
No corporate income taxes

Disadvantages

Difficult to raise capital

Unlimited liability
Limited life

Often set up through LLCs/LLPs.

1-4

2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a
publicly accessible website, in whole or in part.

Corporation

Advantages

Unlimited life
Easy transfer of ownership
Limited liability
Ease of raising capital

Disadvantages

Double taxation
Cost of setup and report filing
1-5
2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a
publicly accessible website, in whole or in part.

Balancing Shareholder Value and Society

Interests

The primary financial goal of

management is shareholder wealth
maximization, which translates to
maximizing stock price.

Value of any asset is present value of cash

flow stream to owners.
Most significant decisions are evaluated in
terms of their financial consequences.
Stock prices change over time as

conditions change and as investors obtain

new information about a companys
prospects.

Managers recognize that being socially

responsible is not inconsistent with
1-6
maximizing
shareholder
value.
2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a
publicly accessible website, in whole or in part.

Stock Prices and Intrinsic Value

In equilibrium, a stocks price should

equal its true or intrinsic value.

Intrinsic value is a long-run concept.

Ideally, managers should avoid actions

that reduce intrinsic value, even if those
decisions increase the stock price in the
short run.

To the extent that investor perceptions

are incorrect, a stocks price in the short
run may deviate from its intrinsic value.

1-7
2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a
publicly accessible website, in whole or in part.

Determinants of Intrinsic Values and

Stock Prices
Managerial Actions, the Economic
Environment, Taxes, and the Political
Climate
True
Investor Cash
Flows

True
Risk

Perceived
Investor Cash
Flows

Stocks
Intrinsic
Value

Perceived
Risk

Stocks
Market Price
Market Equilibrium:
Intrinsic Value = Stock
Price

1-8

2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a
publicly accessible website, in whole or in part.

Chapter 1: An Overview of Financial

Management

1-9
2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a
publicly accessible website, in whole or in part.

Some Important Business Trends

Corporate scandals have reinforced the

importance of business ethics, and have
spurred additional regulations and
corporate oversight.

Increased globalization of business.

Stockholders now have more control of

corporate governance.

The effects of ever-improving information

technology have had a profound effect on
all aspects of business finance.

1-10
2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a
publicly accessible website, in whole or in part.

Conflicts Between Managers and

Stockholders

Managers are naturally inclined to act in

their own best interests (which are not
always the same as the interest of
stockholders).

But the following factors affect

managerial behavior:

Managerial compensation packages

Direct intervention by shareholders
The threat of firing
The threat of takeover

1-11

2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a
publicly accessible website, in whole or in part.

Conflicts Between Stockholders and

Bondholders

Stockholders are more likely to prefer

riskier projects, because they receive
more of the upside if the project
succeeds. By contrast, bondholders
receive fixed payments and 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
1-12
additional
debt
and
constrain
managers
2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a
publicly accessible website, in whole or in part.