CHAPTER 1

An Overview of Financial
Management
 What is Finance?
 Areas of Finance
 Forms of Businesses
 Goals of the Corporation
 Agency Relationships
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What is Finance?
 Finance is defined by Webster's
Dictionary as “the system that includes
the circulation of money, the granting
of credit, the making of investments,
and the provision of banking facilities.”

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Areas of Finance
 Financial management
 Capital markets
 Investments

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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.

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Capital markets
 Capital markets relate to the markets
where interest rates, along with stock
and bond prices, are determined.
 Banks, investment banks, stockbrokers,
mutual funds, and the like bring together
“savers” who have money to invest and
businesses, individuals, and other entities
that need capital for various purposes.
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Investments
 Investments relate to decisions
concerning stocks and bonds and
include a number of activities:
- Security analysis
- Portfolio theory
- Market analysis

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Role of Finance in a Typical
Business Organization

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Alternative Forms of Business
Organization
 Proprietorships
 Partnerships
 Corporations
 Limited liability companies (LLCs)

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Proprietorships
 A proprietorship is an unincorporated
business owned by one individual
Advantages
 Ease of formation
 Subject to few regulations
 Lower corporate income taxes
Disadvantages
 Difficult to raise capital
 Unlimited liability
 Limited life

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Partnerships
 A partnership is a legal arrangement
between two or more people who
decide to do business together.
Advantages
 Ease of formation
 No corporate income taxes
Disadvantages
 Difficult to raise capital
 Unlimited personal liability

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Corporation
 A corporation is a legal entity created by a
state, and it is separate and distinct from its
owners and managers.
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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Limited liability companies
(LLCs)
 A limited liability company (LLC) is a
popular type of organization that is a
hybrid between a partnership and a
corporation.

 Limited liability
 Taxed as partnerships
 Structured in very complicated ways

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Financial Goals of the Corporation
 The primary financial goal is
shareholder wealth maximization,
which translates to maximizing stock
price.
 Keep in mind that a company’s
stockholders are not just an abstract
group—they represent individuals and
organizations.

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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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Intrinsic Value
 An estimate of a stock’s “true” value
based on accurate risk and return
data.
 Management’s goal should be to take
actions designed to maximize the
firm’s intrinsic value, not its current
market price.

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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

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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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Example

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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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