Text: Financial Management:

Principles & Applications (13th

Financial Edition) by Titman, Keown and

Martin

Management
(FN540) Session_01: Overview of
Financial Management
 Importance of finance and the three primary business
Understand decisions made by financial managers.

Key differences among the three major legal forms of

Learning
Identify business.

outcomes Understand Goals of financial manager.

Discuss Five basic principles of finance.

 The study of how people and businesses evaluate investments
and raise capital to fund them.

Answers the three following questions:

Q1. a) What long-term investments should the firm undertake?
(capital budgeting decision)

Finance?
b) How can the firm best manage its cash flows as they arise in its
day-to-day operations? (working capital management)

Q2. How should the firm raise money to fund these investments?
(capital structure decision)

Q3. How much of the firm’s earnings should be distributed to the

owners? (dividend decision)
 • Financial tools aid in making good corporate as
well as personal decisions.
Need to study
• Financial decisions are everywhere.
Finance?
• Finance is an inherent part of decision making in
other management disciplines as well.
• This course restricts to finance tools and
techniques for the business world.
 Business
Forms

Sole
Proprietorship Partnerships
Corporations
s

General

Limited

Figure 1.1 Forms of organization

Sole-Proprietorship
• It is a business owned by a single individual who is entitled to all of
the firm’s profits and is also responsible for all of the firm’s debt.
• The sole proprietors typically raise money by investing their own
funds and by borrowing from a bank.
Sole-Proprietorship
Advantages:
• Easy to form
• No need to consult others while making decisions
• Profits are taxed at the owner’s tax rate
Disadvantages:
• Personally liable for the business debts
• The business ceases on the death of the proprietor
• Limited access to external sources of financing
Partnership
A general partnership is an association of two or more persons who
come together as co-owners for the purpose of operating a business for
profit.
Advantages:
• Relatively easy to start
• Taxed at the personal tax rate
• Access to funds from multiple partners
Disadvantages:
• Partners jointly share unlimited liability
• It is not always easy to transfer ownership
Partnership
• In limited partnerships, there are two classes of partners: general and
limited.

• The general partner runs the business and faces unlimited liability for
the firm’s debts

• The limited partner is liable only up to the amount the limited partner
invested. The life of the partnership is tied to the life of the general
partner.
Corporation
• If very large sums of money are needed to build a business, then the
typical organizational form chosen is the corporation.
• Corporation legally functions separately and apart from its owners
(the shareholders). Corporation can individually sue and be sued and
can purchase, sell, or own property.
• The corporation is legally owned by its current set of stockholders, or
owners.
• The Board of directors are elected by the shareholder, and the board
appoints the senior management of the firm.
Corporation
Advantages
• Liability of owners is limited to invested funds
• Life of corporation is not tied to the status of the investors
• Easier to raise Capital
Disadvantages
• Greater regulation
• Double taxation of dividends

Limited liability company (LLC) combines the tax benefits of a partnership (no
double taxation of earnings) with the limited liability benefit of corporation (the
owner’s liability is limited to what they invested).
Figure 1.2 Finance Area Fitted into a Corporation
The Goal of the Financial Manager
• The goal of the financial manager must be consistent with the mission
of the corporation, which is to maximize shareholder’s wealth.
• While shareholder wealth maximization is included in Coca-Cola’s
vision statement, it also includes other broader goals (such as social
responsibility) that will ultimately benefit shareholders in the long-
run.
Coca-Cola’s Vision & mission
To achieve sustainable growth, we have established a vision with clear goals for:
• Profit
• People
• Portfolio
• Partners
• Planet
Five Principles of Finance
I. Time value of MONEY

• A dollar received today is worth more valuable than a dollar received

in the future.
• We can invest the dollar received today to earn interest. Thus, in the
future, we will have more than one dollar, as we will have earned
interest on the investment.
Five Principles of Finance
II. Risk Return trade-off

• Investors tend to be risk-averse and

prefer certain return to an uncertain
return.
• Investors will hold risky investments
if they expect to be compensated
with additional return.
• Higher the risk, higher will be the
expected return.
• Note expected return may not be
equal to the realized rate of return.
Thus, higher risk does not guarantee
higher rate of return.
Five Principles of Finance
III. Cash flows are source of value

• Profit is an accounting concept and measures a business’s performance.

• Cash flow is the amount of cash that can be taken out of the business.
• Company’s profits can differ dramatically from its cash flows.
• It is possible for a company to report profits without generating any cash.
• Financial decisions in a firm should consider marginal, or “incremental”,
cash flows i.e., the difference between the cash flows the company will
produce with the potential new investment and the cash flows that
would be produced without the investment.
Five Principles of Finance
IV. Market Prices Reflect Information

Investors respond to new information by buying and selling their investments.

The speed of investor reaction and speed of price adjustment determines the
efficiency of market.

Release of Good News ==> Higher stock prices

Release of Bad News ==> Lower stock price

Five Principles of Finance
V. Individuals Respond to Incentives

• Managers (as agents) respond to incentives they are given in the

workplace.
• If the incentives are not properly aligned with those of the firm’s
stockholders (the principal) they may not make decisions that are
consistent with increasing shareholder value leading to agency costs.
Five Principles of Finance
V. Individuals Respond to Incentives

The agency problems/costs can be mitigated through:

1. Compensation plans that reward managers when they act to maximize
shareholder wealth
2. Monitoring by the board of directors
3. Monitoring by financial markets (such as auditors, bankers, security
analysts, credit agencies)
4. The underperforming firms seeing their stock prices fall and face threat of
being taken over and have their management teams replaced.