CHAPTER 1.

AN OVERVIEW OF
FINANCIAL MANAGEMENT
Learning outcomes

• After finishing this chapter, you should be able to:

▫ Have an overall view of financial management,
basic types of financial management decisions
and the role of the financial manager
▫ Identify the advantages and disadvantages of
different forms of business organization
▫ Explain the goals of financial management
▫ Explain the determinants of stock prices and
intrinsic value
▫ Identify the conflicts of interest that can arise in a
corporation
▫ Understand principles of financial management
and common terms in finance
1. What is Financial Management?

• What is Finance?
▫ “The system that includes the circulation of
money, the granting of credit, the making of
investments, and the provision of banking
facilities” - Webster’s Dictionary
▫ “Finance is a term for matters regarding the
management, creation, and study of money and
investments” - Wikipedia
▫ Finance as taught in universities is generally
divided into three areas: (1) financial
management, (2) capital markets, and (3)
investments OR (1) personal finance, (2)
corporate finance, and (3) public finance
1. What is Financial Management?

• What is Financial management?

▫ “Financial management is the activity concerned with
planning, raising, controlling and administering of
funds used in the business.” – Guthman and Dougal
▫ “Financial management is that area of business
management devoted to a judicious use of capital and
a careful selection of the source of capital in order to
enable a spending unit to move in the direction of
reaching the goals.” – J.F. Brandley
▫ “Financial management is the operational activity of a
business that is responsible for obtaining and
effectively utilizing the funds necessary for efficient
operations.” - Massie
1. What is Financial Management?

• What is 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 purchase assets, and
how to run the firm so as to maximize its value”
1. What is Financial Management?

• Basic activities of an organization

▫ Operating activities: manufacturing and
distributing products and/or providing services
(day-to-day operations)
▫ Investing activities: acquiring and disposal of
property, plant and equipment (PP&E) (long-term
assets)
▫ Financing activities: raising capital from investors
(bondholders and shareholders) and profit
distribution (equity and long-term liabilities)
1. What is Financial Management?

• Financial Perspective
▫ Each of the 3 activities involves the flow of cash
▫ All three activities must be coordinated if an
organization wants to pursue its goals effectively
▫ Someone or a group in an organization has to
monitor, direct and evaluate the flow of cash into
and out of each activity to make sure the
organizational goals are served effectively
1. What is Financial Management?

• Investment (Capital Budgeting) Decisions

▫ Most important of the three decisions
▫ The process of planning and management of
longterm investments of the firm
▫ Financial managements identify investment
opportunities that are worth more to the firm than
the cost to acquire
 What is the optimal firm size?
 What specific assets should be acquired?
 What assets (if any) should be reduced or
eliminated?
Balance Sheet Model of the Firm
Total Value of Assets: Total Firm Value to Investors:
Current
Liabilities
Current
Assets Long-Term
Debt

Fixed Assets
1 Tangible
Shareholders’
2 Intangible Equity
The Capital Budgeting Decision

Current
Liabilities
Current
Assets Long-Term
Debt

Fixed Assets
What long-
1 Tangible term Shareholders’
2 Intangible
investments Equity
should the
firm choose?
1. What is Financial Management?

• Financing (Capital Structure) Decisions

▫ Determine how the assets will be financed
▫ Ways in which the firm obtains and manages the
longterm financing it needs to support its longterm
investments
▫ A firm’s capital structure is the specific mixture of
longterm debt and equity the firm uses to finance
its operations
 What is the best type of financing?
 What is the best financing mix?
 What is the best dividend policy?
The Capital Structure Decision

Current
Liabilities
Current
Assets Long-Term
How should the Debt
firm raise funds
for the selected
Fixed Assets
investments?
1 Tangible
Shareholders’
2 Intangible Equity
1. What is Financial Management?

• Asset Management (Working Capital) Decisions

▫ How do we manage existing assets efficiently?
▫ Working capital refers to a firm’s shortterm assets and
its shortterm liablilites
▫ Managing the firm’s working capital is a day to day
activity that ensures the firm has sufficient resources to
continue its operations and avoid costly interruptions
▫ Greater emphasis on current asset management than
fixed asset management
 How much cash & inventory the firm should keep in hand?
 Should the firm sell on credit? To whom? What terms?
 How will the firm obtain any needed shortterm financing?
Short-Term Asset Management

Current
Liabilities
Current
Net
Assets Working Long-Term
Capital Debt

How should
Fixed Assets
short-term
1 Tangible assets be
Shareholders’
managed and
2 Intangible financed? Equity
1. What is Financial Management?

• Overall, Financial management addresses the

following three questions:
▫ What long-term investments should the firm choose?
▫ How should the firm raise funds for the selected
investments?
▫ How should short-term assets be managed and
financed?
1. What is Financial Management?

• Hypothetical Organization Chart

1. What is Financial Management?

• Hypothetical Organization Chart

1. What is Financial Management?

• Financial Manager
▫ Financial managers try to answer some or all of these
questions
▫ The top financial manager within a firm is usually the
Chief Financial Officer (CFO)
 Treasurer – oversees cash management, credit
management, capital expenditures and financial planning
 Controller – oversees taxes, cost accounting, financial
accounting and data processing
2. Forms of business Organization

• What is a business?
▫ An organization that is oriented towards making a
profit for its owners so as to maximize their wealth and
that can be regarded as an entity separate from its
owners
• Legal forms of business organization
▫ Sole Proprietorship
▫ Partnership
▫ Corporation
▫ Limited Liability Company and Limited Liability
Partnership
Video
2. Forms of business Organization

Proprietorship
An unincorporated business owned by one individual
• Advantages • Disadvantages
▫ Easiest to start ▫ Limited to life of owner
▫ Least regulated ▫ Equity capital limited to
▫ Single owner keeps all owner’s personal wealth
the profits ▫ Unlimited liability
▫ Taxed once as personal ▫ Difficult to transfer
income ownership
2. Forms of business Organization

Partnership
An incorporated business owned by 2 or more persons
• Advantages • Disadvantages
▫ Two or more owners ▫ Unlimited liability*
▫ More capital available ▫ Partnership dissolves
▫ Relatively easy to start when one partner die or
▫ Income taxed once wishes to sell
▫ Difficult to transfer
ownership
2. Forms of business Organization
Corporation
A legal entity separate and distinct from its owners and
managers, having unlimited life, easy transferability of
ownership and limited liability
• Advantages • Disadvantages
▫ Limited liability ▫ Separation of ownership
▫ Unlimited life and management
▫ Separation of ownership ▫ Double taxation (income
and management taxed at corporate rate
▫ Transfer of ownership is and then dividends
easy taxed at personal rate)
▫ Easier to raise capital
3. Goal of Financial Management?

• What should be the goal of a corporation?

▫ Maximize profit?
▫ Minimize costs?
▫ Maximize market share?
▫ Maximize the market price of the firm’s stock?
• What is the main financial goal?
▫ Maximize shareholder wealth

So, how that wealth is determined?

=> Stock valuation
3. Goal of Financial Management?

• Determinants of value
3. Goal of Financial Management?

• Determinants of value
3. Goal of Financial Management?
3. Goal of Financial Management?

• Stock prices and Intrinsic value

▫ Intrinsic value is a long-run concept
▫ Management’s goal should be to maximize the firm’s
intrinsic value, not its current market price
▫ In equilibrium, a stock’s price should equal its “true” or
intrinsic value
▫ To the extent that investor perceptions are incorrect, a
stock’s price in the short run may deviate from its
intrinsic value
▫ Ideally, managers should avoid actions that reduce
intrinsic value, even if those decisions increase the
stock price in the short run
3. Goal of Financial Management?

• Consequences of having a short-run focus

▫ Some Wall Street executives received huge bonuses
for engaging in risky transactions that generated short-
term profits. Subsequently, the value of these
transactions collapsed, causing many of these Wall
Street firms to seek a massive government bailout
▫ The need for corporate governance
▫ Corporate Governance: Establishment of rules
and practices by Board of Directors to ensure that
managers act in shareholders‘ interests while
balancing the needs of other key constituencies
4. Stakeholders in the business

• Stakeholder – literally a person or group of persons who

has a stake in the organization. They have an interest to
protect in respect of what the organization does and how
it performs
Stakeholders
Primary Owners (Shareholders)
Secondary Directors / managers
Employees and trade unions
Customers, Suppliers. Lenders
Government and its agencies
The local community and the public
The natural environment
5. Stockholder-Manager Conflicts

• Stockholder-Manager Conflict (The Agency Problem)

▫ There exists a SEPARATION between owners and
managers in a corporation
▫ Management acts as an agent for the owners
(shareholders) of a firm
▫ Agency relationship: Stockholders (principals) hire
managers (agents) to run the company
▫ Agency problem: Conflict of interest between principal
and agent

Video
5. Stockholder-Manager Conflicts

▫ Managers are naturally inclined to act in their own best

interests (which are not always the same as the
interest of shareholders): expensive perquisites,
survival…
▫ Increased growth and size are not necessarily
equivalent to increased shareholder wealth
▫ But the following factors affect managerial behavior:
 Managerial compensation packages
 Direct stock holder intervention
 The threat of hostile takeover
5. Stockholder-Manager Conflicts

▫ Managerial compensation
 Should be sufficient to attract and retain managers, but
they should not go beyond what is needed
 Should be structured so that managers are rewarded on
the basis of the stock’s performance over the long run
 Need to be structured carefully to make sure that they
achieve their goal (stock awards)
5. Stockholder-Manager Conflicts

▫ Direct stockholder intervention – Firing threat

 Institutional investors may exercise considerable
influence over firms’ operations. When such large
stockholders speak, companies listen
 Some research highlights the important role that activists
play in insuring that managers act in shareholders’
interests
▫ Threat of hostile takeover
 If a firm’s stock is undervalued, corporate raiders will see
it as a bargain and will attempt to capture the firm in a
hostile takeover (the acquisition of a company over the
opposition of its management)
 The threat of a takeover may result in better
management
6. Stockholder/Manager-Debtholder Conflicts

▫ The firm’s bankers and bondholders generally receive

fixed payment, while stockholders do better when the
firm does better.
▫ The conflicts occurs because stockholders are
typically more willing to take on risky projects
▫ Another type of conflict arises over the use of
additional debt
▫ Bondholders attempt to protect themselves by
including covenants in the bond agreements that limit
firms’ use of additional debt and constrain managers’
actions
7. Balancing Shareholder interests and interests of Society

▫ Managers know that this does not mean maximize

shareholder value “at all costs.” Managers have an
obligation to behave ethically, and they must follow the
laws and other society-imposed constraints
▫ Interestingly, some companies have taken more
explicit steps to recognize broader needs of society
▫ There is a very wide range of opinions regarding the
appropriate balance between the interests of
shareholders and other societal stakeholders
7. Balancing Shareholder interests and interests of Society
8. Business Ethics
▫ Ethics: “standards of conduct or moral behavior” -
Webster’s Dictionary
▫ Business ethics can be thought of as a company’s
attitude and conduct toward its employees, customers,
community, and stockholders
▫ A firm’s commitment to business ethics can be
measured by the tendency of its employees to adhere
to laws, regulations, and moral standards relating to
product safety and quality, fair employment practices,
fair marketing and selling practices, the use of
confidential information for personal gain, community
involvement, and the use of illegal payments to obtain
business
8. Business Ethics
• What companies are doing
▫ Most firms today have strong written codes of ethical
behavior; companies also conduct training programs
to ensure that employees understand proper behavior
in different situations
▫ When conflicts arise involving profits and ethics,
ethical considerations sometimes are so obviously
important that they dominate
8. Business Ethics
• Consequences of unethical behavior
▫ Ethical lapses have led to a number of bankruptcies. In
other cases, companies avoid bankruptcy but face a
damaging blow to their reputation
▫ The perception of widespread improper actions has
caused investors to lose faith in business and to turn
away from the stock market, which makes it difficult for
firms to raise the capital they need
▫ -> Unethical actions can have adverse consequences
far beyond the companies that perpetrate them
• How should employees deal with unethical behavior?
Questions
• All questions in chapter 1