CHAPTER 1

INTRODUCTION
TO FINANCIAL
MANAGEMENT
 INTRODUCTION TO
FINANCIAL MANAGEMENT

1. Finance in Business
2. The Financial Function
3. Business Organization
4. The Financial Crisis
 1. Finance in Business

• Finance applies specific value to

– things owned
– services used
– decisions made
• Financial management
– organization’s approach to valuation
2. The Financial Function
External Financing

Capital Budgeting

Corporate
Finance Financial Management

Functions
Corporate Governance

Risk Management
 The External Financing Function

• Raising capital to support companies’ operations and

investment programs externally, from
– either shareholders (equity) or
– creditors (debt).
• Corporations can raise equity capital privately,
• or they may go public by conducting an initial public
offering (IPO) of stock.

5
The Financial Management
Function
• Managing firms’ internal cash flows,
• and its mix of debt and equity financing,
• to maximize the value of the debt and equity
claims on firms, and
• to ensure that companies can pay off their
obligations when they come due.
 Involves obtaining seasonal financing, managing inventories, paying
suppliers, collecting from customers, and investing surplus cash
 The Capital Budgeting Function

Capital Budgeting – selecting the

best projects in which to invest
the resources of the firm, based
on each project’s perceived risk
and expected return.

Select investments for which the marginal benefits exceed

7
the marginal costs.
The Risk Management Function

• Managing firms’ exposures to all types of risk,

• both insurable (such as loss caused by fire or flood)
and uninsurable,
• in order to maintain optimum risk-return trade-offs
and thereby maximize shareholder value.
• Modern risk management focuses on adverse
interest rate movements, commodity price changes,
and currency value fluctuations.
 The Corporate Governance Function

Developing ownership and corporate governance structures for

companies that ensure that managers behave ethically and
make decisions that benefit shareholders.
• Boards of directors
Dimensions of • Compensation packages
corporate • Auditors
governance • Country’s legal environment - in U.S.,
Sarbanes-Oxley Act of 2002

The takeover market disciplines firms that do not govern

themselves.
 3. Business Organizational
Forms
• No distinction between business
Sole and person
Proprietorships • Easy to set up, operate; taxed as
personal income
• Personal liability, limited life,
difficult to transfer

• Two or more business owners

Partnerships
• Partners - liable for every partner’s
actions
 Business Organizational Forms

• One or more general partners &

Limited many limited partners
Partnerships • Limited liability of corporation, tax
benefits of partnership

• Legal entity with all the economic

rights and responsibilities of a person
Corporations • Incorporation occurs at state level;
based on state law
• Strengths - limited liability for
investors, unlimited business life
Subareas of Finance

• Investments
– involves methods and
techniques for making
decisions about what kinds of
securities to own
 Subareas of Finance

• Financial management
– Decisions about acquiring and using cash

– Examples include
• Organizing and raising capital

• Tax decisions

• Projects to fund
 Subareas of Finance

• Financial institutions and markets

– Facilitate flow of capital between investors and companies

• International finance
– Finance theory used in global business environment
 4. The Financial Crisis

• Subprime Mortgage Borrowers

– Higher-risk borrowers charged higher interest
rates due to higher risk of default
• Securitization
– Loan originators sell the loan repayment rights to
other financial institutions or investors
 The Financial Crisis

• Sparked by collapse of U.S. home prices in late

2006 and 2007
• Spread to other financial institutions via
affected mortgage-backed securities
• Resulted in credit tightening by financial
institutions; loss of confidence by consumers