CHAPTER 1

An Overview of Financial
Management

all successful companies;

1. highly valued by customers
2. Make money

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What is Corporate Finance?
 What long term investment should be
done?
 Where will get the long term finance to
pay for your investment?
 How will you manage everyday financial
activates?

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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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 Role of Finance in a Typical
Business Organization
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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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
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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Alternative Forms of Business
Organization
 Sole proprietorship
 Partnership
 Corporation

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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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 Financial securities

 Debt, Equity or Derivatives

 If debt matures in more than a year, it is called a capital
market security. If the debt matures in less than a year,
it is a money market security
 stock has no maturity date, it is a capital market security
 derivatives are securities whose values depend
on, or are derived from, the values of some other
traded assets

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 Financial institutions

 Investment banks
 Savings and loan associations (S&Ls)
 Commercial banks
 Money market funds
 Hedge Funds
 Private equity (PE) funds
 Pension funds
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 The cost of Money

 production opportunities
 time preferences for consumption
 risk
 inflation

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Types of financial Markets

 Spot markets
 Futures markets
 Mortgage markets

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Primary job of manager is to increase the
intrinsic value of the company

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Global Financial Crisis 2008

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The Sub-Prime The Sub-prime
Mortgage Model Mortgage Crisis

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An Example

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Effects on the Economy and Response of the
Government

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 Estimated Losses by
IMF Worldwide in
2009:
$4.1 trillion
Examples of Bailout
Amounts by
Governments
Worldwide:

USA: $700bn
European Union:
£500bn
Britain: £39bn
Ireland: €400bn
Russia: $100bn
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The Role of Credit Default
Swaps

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