Chapter 1

An Overview of Financial
Management and the
Financial Environment
 Topics in Chapter
CH1

• Attributes of successful companies

• Forms of business organization
• Objective of the firm: maximize
wealth
• Determinants of fundamental value
• Financial securities, financial
institutions, and financial markets

1-2
 Attributes of Successful
Companies
CH1

• Like a stool needs all three legs to

stand, a successful business relies
on:
– Skilled people
– Strong external relationship
– Sufficient capital

1-3
 The Corporate Life Cycle
CH1

• No two companies will develop in exactly

the same way
• A business usually begins as a small
potato and hopefully finishes up as a
major giant
• Structures of business organizations:
– Sole proprietorship
– Partnership
– Corporation

1-4
 Starting as a Proprietorship
CH1

• Advantages:
– Ease of formation
– Subject to few regulations
– No corporate income taxes
• Disadvantages:
– Difficult to raise capital to support
growth
– Unlimited liability
– Limited life span

1-5
 Starting as or Growing into a
Partnership
CH1

• A partnership involves two or more

entities with various privileges and
responsibilities
– General vs. limited partner
– Limited liability partnership
• A partnership has roughly the same
advantages and disadvantages as
a sole proprietorship.
1-6
 Becoming a Corporation
CH1

• A corporation is a legal entity

separate from its owners and
managers.
• File papers and prepare reports
with Corporation Register.
– Articles of incorporation
– Bylaws

1-7
 Advantages and Disadvantages
of a Corporation
CH1

• Advantages:
– Unlimited life
– Easy transfer of ownership
– Limited liability
– Ease of raising capital
• Disadvantages:
– Double taxation
– Higher setup cost
– Endless report filing

1-8
 What should be management’s
primary objective?
CH1

• The primary objective should be

shareholder wealth maximization, which
translates to maximizing the fundamental
share price, not just the current market
price.
• Should firms behave ethically? YES!
• Business ethics are a company’s attitude
and conduct toward its employees,
customers, community and shareholders

1-9
 Stock Price Maximization and
CH1
Social Welfare
• Do firms have any responsibilities
to society at large? Yes!
• Unethical behavior destroys public
trust and confidence.
• Maximizing share price is good for
society. Why?
• Shareholders are also members of
society.
1-10
 Is Maximizing stock price
CH1
good for consumers?
• Consumer welfare is higher in
capitalist free market economies
than in communist or socialist
economies due to competition
• Consumers can improve quality of
life by the direct or the indirect
investments in the stock market

1-11
 Is maximizing stock price good for
employees?
CH1

• Employment growth is higher in

firms that try to maximize stock
price. On average, employment
goes up in:
– firms that make managers into owners
(such as LBO firms)
– firms that were owned by the
government but that have been sold to
private investors
1-12
 How do managers affect
shareholder wealth?
CH1

• Improve a firm’s ability to generate

cash flows now and in the future by
focusing on:
– Amount of expected cash flows
(bigger is better)
– Timing of the cash flow stream
(sooner is better)
– Risk of the cash flows (less risk is
better)
1-13
 Free Cash Flows (FCF)
CH1

• There are many ways firms can

increase free cash flows
• FCF are cash flows available (or
free) for distribution to all investors
(stockholders and creditors).
• FCF = sales revenues - operating
costs - operating taxes - required
investments in operating capital.
1-14
 What is the weighted average
cost of capital (WACC)?
CH1

• WACC is the average rate of return

required by all of the company’s
investors.
• WACC is affected by:
– Capital structure (the firm’s relative amounts
of debt and equity)
– Interest rates
– Risk of the firm
– Investors’ overall attitude toward risk

1-15
 Determinants of a Firm’s Value
CH1

1-16
 Who are the providers (savers) and
users (borrowers) of capital?
CH1

• Households: Net savers

• Non-financial corporations: Net
users (borrowers)
• Governments: Net borrowers
• Financial corporations: Slightly net
borrowers, but almost breakeven

1-17
 Capital Allocation Process
CH1

1-18
 Transfer of Capital from
Savers to Borrowers
CH1

• Direct transfer (e.g., corporation issues

commercial paper to insurance
company)
• Indirect transfer through an investment
banker (e.g., IPO, seasoned equity
offering, or debt placement)
• Indirect transfer through a financial
intermediary (e.g., individual deposits
money in bank, bank loans to a firm)

1-19
 Cost of Money
CH1

• Supply and demand of funds

determine the price of money.
• What do we call the price (or cost)
of debt capital? Of equity capital?
– Interest rate
– Cost of equity = required return = dividend
yield + capital gain
• Both are the rate fund users pay to
fund providers
1-20
 What four fundamental factors
affect the cost of money?
CH1

• Production opportunities
• Time preferences for consumption
• Risk
• Expected inflation

1-21
 What economic conditions affect
the cost of money?
CH1

• Central Bank policies

• Budget deficits/surpluses
• Level of business activity (recession or
boom)
• International trade deficits/surpluses
• Country risk depending on its economic,
political, and social environment
• Exchange rate risk

1-22
 Financial Securities
CH1

• Financial securities are contracts

granting owners specific rights and
claims on specific values
• Vary in risk and maturity
• Nature of claims: debt, equity, and
derivatives
• Money market instrument (T<1),
and capital market instrument (T≥1)
1-23
 Financial Securities
CH1

Debt Equity Derivatives

Money •T-Bills
•Banker’s Acceptances
•Options
•Futures
Market •Commercial papers •Forward
•MMMFs contract
•EuroCanadian dollars

Capital •Canadian •Common stock •LEAPS

Market Government-Bonds •Preferred stock
•Mortgages •Swaps
•Corporate bonds

1-24
 Typical Rates of Return
CH1

Instrument Rate (April 2009)

Government T-bills 2.05%
Banker’s acceptances 3.57
Commercial paper 5.39
Money Market mutual funds 3.50

EuroCanadian market time 3.45

Commercial loans:
Tied to prime 5.25 +
or LIBOR 3.05 +

1-25
 Typical Rates (cont’d)
CH1

Instrument Rate (April 2009)

Governmental bonds 3.56%
Mortgages 6.50
Corporate bonds 5.11
Leases 5.11
Common Stock 10.9

1-26
 What are some financial
institutions?
CH1

• Investment banks
• Commercial banks
• Trust companies
• Credit unions
• Life insurance companies
• Mutual funds
– Money Market Funds (MMMFs)
– Exchanged Traded Funds (ETFs)
• Pension funds
• Hedge funds
1-27
 Types of Financial Markets
CH1

• A financial market brings together

savers and borrowers.
• Physical asset vs. financial asset
markets
• Spot versus future markets
• Money versus capital markets
• Primary versus secondary markets
• Private versus public markets
1-28
 Physical- vs. Financial-asset
CH1
Markets
• Physical (tangible or real) asset
markets
– Products as wheat, autos and real
estates
• Financial asset markets
– Primitive securities and derivative
securities

1-29
 Spot vs. Futures Markets
CH1

• Spot (cash) markets

– Assets are bought or sold for “on-the-
spot” delivery
• Futures markets
– Assets are bought or sold for delivery
at some future date

1-30
 Primary vs. Secondary
Markets
CH1

• Primary
– New issue (IPO or seasoned)
– Key factor: issuer receives the
proceeds from the sale.
• Secondary
– Existing owner sells to another party.
– Issuing firm doesn’t receive proceeds
and is not directly involved.

1-31
 Private vs. Public Markets
CH1

• Private markets
– Transactions are worked out directly
between two parties
– Lack of liquidity
• Public markets
– Standardized contracts are traded on
an organized
– More liquid and transparent

1-32