An Overview of Financial

Management
 What is Finance?
 Career Opportunities
 Issues of the New Millennium
 Forms of Businesses
 Goals of the Corporation
 Agency Relationships 1-1
What is Finance?
 It’s hard to define finance—the term
has many facets, which makes it
difficult to provide a clear and concise
definition.
 The discussion in this section will give
you an idea of what finance people do
and what you might do if you enter the
finance field after you graduate.
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Finance versus Economics and
Accounting
 Finance as we know it today grew out
of economics and accounting.
 Economists developed the notion that
an asset’s value is based on the future
cash flows the asset will provide, and
accountants provided information
regarding the likely size of those cash
flows.
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Finance within an
Organization
 Most businesses and not-for-profit
organizations have an organization
chart similar to the one shown in Figure
1- and Figure-2.

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Finance within an
Organization… (Fig-1)

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 Role of Finance in a Typical
Business Organization (Fig-2)
n Board of Directors

n President

n VP: Sales n VP: Finance n VP: Operations

n Treasurer n Controller

Credit Manager
n n Cost Accounting

n Inventory Manager n Financial Accounting

Capital Budgeting Director

n nTax Department

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 If the firm is publicly owned, the CEO and the
CFO must both certify to the Securities and
Exchange Commission (SEC) that reports
released to stockholders, and especially the
annual report, are accurate.
 If inaccuracies later emerge, the CEO and the
CFO could be fined or even jailed. This
requirement was instituted in 2002 as a part
of the Sarbanes-Oxley Act.
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Corporate Finance, Capital Markets,
and Investments
 Finance as taught in universities is
generally divided into three areas: (1)
financial management, (2) capital
markets, and (3) investments.

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Financial management
 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 buy assets,
and how to run the firm so as to maximize its
value.
 The same principles apply to both for-profit
and not-for-profit organizations

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Capital markets
 Capital markets relate to the markets where interest rates, along
with stock and bond prices, are determined. Also studied here
are the financial institutions that supply capital to businesses.
 Banks, investment banks, stockbrokers, mutual funds, insurance
companies, and the like bring together “savers” who have
money to invest and businesses, individuals, and other entities
that need capital for various purposes.
 Governmental organizations such as the Federal Reserve
System, which regulates banks and controls the supply of
money, and the SEC, which regulates the trading of stocks and
bonds in public markets, are also studied as part of capital
markets.

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Investments
 Investments relate to decisions concerning stocks and bonds and
include a number of activities: (1) Security analysis deals with
finding the proper values of individual securities (i.e., stocks and
bonds). (2) Portfolio theory deals with the best way to structure
portfolios, or “baskets,” of stocks and bonds. Rational investors
want to hold diversified portfolios in order to limit risks, so choosing
a properly balanced portfolio is an important issue for any investor.
(3) Market analysis deals with the issue of whether stock and bond
markets at any given time are “too high,” “too low,” or “about
right.” Behavioral finance, where investor psychology is examined in
an effort to determine if stock prices have been bid up to
unreasonable heights in a speculative bubble or driven down to
unreasonable lows in a fit of irrational pessimism, is a part of market
analysis.

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Finance versus Economics….
 Finance then grew out of and lies
between economics and accounting, so
people who work in finance need
knowledge of those two fields.
 Also, as discussed next, in the modern
corporation, the accounting department
falls under the control of the chief
financial officer (CFO).
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Career Opportunities in
Finance
 Money and capital markets
 Investments
 Financial management

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Responsibility of the Financial
Staff
 Maximize stock value by:
 Forecasting and planning
 Investment and financing decisions
 Coordination and control
 Transactions in the financial markets
 Managing risk

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Financial Management Issues
of the New Millennium
 The effect of
changing
technology
 The globalization
of business

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Percentage of Revenue and Net Income
from Overseas Operations for 10 Well-
Known Corporations, 2001
Company % of Revenue % of Net Income
from overseas from overseas
Coca-Cola 60.8 35.9
Exxon Mobil 69.4 60.2
General Electric 32.6 25.2
General Motors 26.1 60.6
IBM 57.9 48.4
JP Morgan Chase & Co. 35.5 51.7
McDonald’s 63.1 61.7
Merck 18.3 58.1
3M 52.9 47.0
Sears, Roebuck 10.5 7.8
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 FORMS OF BUSINESS
ORGANIZATION
 There are four main forms of business
organizations: (1) sole proprietorships, (2)
partnerships, (3) corporations, and (4)
limited liability companies (LLCs) and
limited liability partnerships (LLPs)

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Proprietorship, Partnership,
Corporation
 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 its owners and managers,
having unlimited life, easy transferability of
ownership, and limited liability.

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LLC and LLP
 Limited Liability Company (LLC); A relatively
new type of organization that is a hybrid
between a partnership and a corporation.
 Limited Liability Partnership (LLP); Similar to
an LLC but used for professional firms in the
fields of accounting, law, and architecture. It
has limited liability like corporations but is
taxed like partnerships.

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Alternative Forms of Business
Organization
 Sole proprietorship
 Partnership
 Corporation
 LLC/ LLP

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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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Financial Goals of the Corporation
 The primary financial goal is
shareholder wealth maximization,
which translates to maximizing stock
price.
 Do firms have any responsibilities to
society at large?
 Is stock price maximization good or bad
for society?
 Should firms behave ethically?
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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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Agency relationships
 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.
 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
 Shareholders (through managers) could
take actions to maximize stock price
that 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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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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 Basic Valuation Model
CF1 CF2 CFn
Value  1
 2

(1  k) (1  k) (1  k)n
n
CFt
 t
.
t 1 (1  k)

 To estimate an asset’s value, one estimates the

cash flow for each period t (CFt), the life of the
asset (n), and the appropriate discount rate (k)
 Throughout the course, we discuss how to estimate
the inputs and how financial management is used
to improve them and thus maximize a firm’s value.
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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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