Introduction To Financial

Management
Chapter 1
Topics
1. The basics of corporate financial
management decisions and the role of
the financial manager
2. The goal of corporate financial
management
3. The financial implications of the different
forms of business organizations
4. The conflicts of interest that can arise
between managers and owners

2
The Basics Of Corporate Financial
Management Decisions
 Define Asset:
 Examples: Cash, UPS Trucks, Buildings
 “Provide probable future economic benefit”

 Definition of Finance:
 How to allocate scarce resources across
assets over time in order to earn a return
 What should we invest in?
 Should we incur debt?

 How do we as individuals make investments,

conduct banking activities, incur debt?

3
The Basics Of Corporate Financial
Management Decisions
 Four basic areas of finance:
 Corporate finance
 How corporations allocate scarce resources
across assets over time
 Investments
 Stocks and Bonds, Risk and Return
 Financial institutions
 Banks, Exchanges, Insurance Co.
 International Finance
 All of the above but more than one country

4
Why do you need to know finance?
 Careers in:
Student Loans
 Finance
 Credit cards
 Accounting
 Investments
 Marketing
 Retirement Savings
 Sole proprietorship
 Banking
Security Analyst

5
Why Study Finance?
 Marketing
 Budgets, marketing research, marketing
financial products
 Accounting
 Dual accounting and finance function,
preparation of financial statements
 Management
 Strategic thinking, job performance,
profitability
 Personal finance
 Budgeting, retirement planning, college
planning, day-to-day cash flow issues
6
The Role Of The Financial
Manager
 Business Finance Questions
1. What
long-term investments should
you make
 Examples: equipment, buildings
2. Wherewill you get the long-term
financing?
 Profits? Equity? Debt?
3. Short-term cash management
1. How will you collect from customers and
pay your bills?
7
Financial Management Decisions
1. Capital Budgeting
 The process of planning and managing a
firm’s long-term investments
 Evaluating the size, timing, and risk of the
future cash flows
 Use NPV finance tool to decide (chapter 8)
2. Capital Structure
 The mixture of debt and equity
3. Working Capital
 The firm’s short-term assets and liabilities

8
The Role Of The Financial Manager
Board of Directors

Chairman of the Board and

CEO

President and
COO

VP Marketing VP Finance VP Production

CFO

Treasurer Controller

Cash Manager Credit Manager Tax Manager Cash Accounting

Manager

Capital Financial Financial Information

Expenditures Planning Accounting Systems
Manager Manager
9
Forms of Business Organization
 Three major forms in the united
states
 Sole proprietorship
 Partnership
 General
 Limited

 Corporation
 S-Corp
 Limited liability company

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Sole Proprietorship
Advantages Disadvantages
 Easiest to start  Limited to life of
 Least regulated owner
 Single owner  Equity capital

keeps all the limited to

profits owner’s personal
 Taxed once as wealth
personal income  Unlimited liability
 Difficult to sell
ownership
interest 11
Partnership
Advantages Disadvantages
 Two or more  Unlimited liability
owners  General
 More capital partnership
available  Limited

 Relatively easy partnership

to start  Partnership

 Income taxed dissolves when

once as personal one partner dies
income or wishes to sell
 Difficult to
12
Corporation
Advantages Disadvantages
 Limited liability  Separation of
 Unlimited life ownership and
 Separation of management
ownership and (agency
management problem)
 Double taxation
 Transfer of
ownership is (income taxed at
easy the corporate
 Easier to raise
rate and then
dividends taxed
capital 13
Figure 1.2

14
Forms of Business Organization
 Sole proprietorships
 Partnerships
 Corporations
 Fewest in number
 Account for more business transactions
than the other two types combined
 Limited Liability Company (LLC)
 Benefit of single taxation and limited
liability
15
Forms of Business Organization
 Sole Proprietorship (one person)
 Easy to set up
 No double taxation
 No liability insulation to deflect outside
claims (unlimited liability)
 When owner dies, business ends
 Difficult to transfer ownership
 Hard to raise capital (money to invest)
 Partnerships (More than one person)
 General partners fully liable
16
Forms of Business Organization
 Corporations
 Legal “person” separate from owners
 Can owe property, sue, be sued, enter into
contracts
 Limited Liability (owners only lose up to
investment, debt responsibility of corp.)
 Continuity of existence (Stock transferable –
when owner dies, corporation does not die)
 Separation of owner and manager
 Allows continual existence, however it
creates agency problem
 Easier to get external financing (equity & debt)
 Double taxation
17
Corporations
 Issue stock to stockholders
 Issue bonds to bondholders
 Carry out business activities for the
purpose of making profits
 Not-for-profit corporations carry out
charitable, educational, or other philanthropic
purposes and are beyond the scope of this
chapter
 Distribute the profits to their owners
 Pay interest to bondholders
 Reinvests earnings to buy more assets
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The Financial Implications Of The
Different Forms Of Business Organizations
 The corporate form is superior when it comes to
raising cash:
 Ease of transferring ownership
 Business does not end each time stock is sold

 Unlimited life
 When owners die, the business does not end

 Limited liability for business debts

 Owners can only loose up to the amount they have
invested
 For good ideas to be implemented which in turn
creates profits for owners, cash is required. Thus
the business form which can raise cash more
easily is more beneficial

24
Page 10 In Textbook
 Link to:
www.buisnessfinancemag.com
Is filled with ads…

 Better to go to www.Google.com
and click on News

25
The Goal Of Corporate Financial
Management

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The Goal Of Corporate Financial
Management
 Presume:
 The stockholders elect the BofD
 The BofD hire the managers
 The managers work for the stockholders
 Goal:
 The financial managers have a fiduciary duty
to identify goods and services that add value
to the firm because they are desired and
valued in the free marketplace, which in turn
increases current and future revenues, which
in turn increases stock price/equity value
27
The Goal Of Corporate Financial
Management
 The goal of financial management is to
maximize the current value per share of
existing stock (market value of equity)
 This is theoretically a good goal
 Do some managers employ creative accounting
so that it looks like stock value goes up?
 Financial managers should not take illegal
or unethical actions to increase stock
value

28
The Goal Of Corporate Financial
Management
1. Managers commit assets in a
particular direction in order to earn
a return
1. Capital budgeting using NPV model
(ch.9)
 Cash Flow is what the managers will
use to make decisions (ch.5)
2. Goal is to maximize returns at a given
risk level (risk and return are
considered together) (ch.11)
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The Goal Of Corporate Financial
Management
2. Corporation must continually get
cash to acquire assets to earn a
return
1. Corporation acquires cash from
financial markets through equity or
debt
2. Corporation reinvests earnings
(remaining amount paid to owners)
3. More assets, more sales, higher
return, higher stock value
(theoretically)
30
The Goal Of Corporate Financial
Management
3. All this is done to increase the
current stock price
1. Owners’ stock value is increased
2. Managers salaries should be based on
stock value and so their salaries increase
(theoretically)

31
Goal Of Financial Management
 What should be the goal of a corporation?
 Maximize profit?
 Minimize costs?
 Maximize market share?
 Maximize the current value of the company’s
stock?
 Does this mean we should do anything and
everything to maximize owner wealth?
 Sarbanes-Oxley Act
 Makes managers personally responsible for
financial statements

32
The Conflicts Of Interest That Can
Arise Between Managers And Owners
 Creative accounting so that it looks like
stock value goes up?
 Enron:
 Former Enron CFO Andrew Fastow, the alleged
mastermind behind Enron's complex network of offshore
partnerships and questionable accounting practices*
 World Com:
 Former CEO, Bernard Ebbers was convicted (2005) of
fraud and conspiracy in the largest (to date) accounting
scandal in U.S. history, as a result of WorldCom's false
financial reporting, and subsequent 11 billion dollar loss to
investors*
*Wikipedia
 Andrew and Bernard were agents that were
supposed to be serving the stockholders
33
Agency Problem
 How do you get managers inside the firm
(managers have custody of assets that belong
to owners) to act in the best interest of the
owners?
 We must incur agency costs to minimize problems

34
Agency Costs
 Direct
 Pay managers based on stock value (aligns
managers’ and owners’ interests)
 Allow external auditor to examine the
financial statements
 Have internal controls over assets and
accounting
 Have internal auditors report to BofD
 Sarbanes-Oxley Act
 Makes managers personally responsible for

financial statements

35
Agency Costs
 Indirect
 A profitable project that is risky may benefit
owners, but may put the manager’s job at
risk
 If manager does not take on project Cost

to owner
 Managers may create ways to pay themselves
great deals of money (accounting or other)
 Cost to owner

36
Financial Markets
 Primary Markets
 Original sale of equity or debt
 Corporation issues security

 Secondary Markets
 After original sale of equity or debt
 You sell/buy security

37
Financial Markets
 Secondary Markets:
 Dealer Markets (Over-the-counter markets
(OTC))
 Dealers buy and sell for themselves
 (think of car lot)
 Most debt is sold this way
 Example: NASDAQ
 Auction Markets (Exchanges)
 Brokers and agents match buyers and sellers
 (think of real estate agent)
 Most of the large firms’ equity is sold this way
 Example: NYSE
38
Summary Slide
 The Basics Of Corporate Financial Management Decisions
 Why do you need to know finance?
 The Role Of The Financial Manager
 Financial Management Decisions
 Forms of Business Organization
 The Financial Implications Of The Different Forms Of Business
Organizations
 The Goal Of Corporate Financial Management
 The Conflicts Of Interest That Can Arise Between Managers And
Owners
 Agency Problem
 Agency Costs
 Financial Markets
39