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Chapter

Introduction To Financial Management

McGraw-Hill/Irwin

Copyright 2006 by The McGraw-Hill Companies, Inc. All rights reserved.

Key Concepts and Skills


Know the basic types of financial management decisions and the role of the financial manager Know the financial implications of the different forms of business organization Know the goal of financial management Understand the conflicts of interest that can arise between owners and managers Understand the various types of financial markets
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Chapter Outline

Financial Management and the Financial Manager Forms of Business Organization The Goal of Financial Management The Agency Problem and Control of the Corporation Financial Markets and the Corporation

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Financial Management
Some important questions that are answered using finance
What long-term investments should the firm take on? Where will we get the long-term financing to pay for the investment? How will we manage the everyday financial activities of the firm?

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DEFINITION OF FINANCE
Art and science of managing money process, institutions, markets and instruments involved. (Gitman) Activities that earn and use of capital - collecting, using and managing. Concern with the maintenance & creation of economic value or wealth (Keown) Focuses on the decision making toward creating wealth.
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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
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Financial Management Decisions


Capital budgeting
What long-term investments or projects should the business take on?

Capital structure
How should we pay for our assets? Should we use debt or equity?

Working capital management


How do we manage the day-to-day finances of the firm?
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Forms of Business Organization


Three major forms
Sole proprietorship Partnership
General Limited

Corporation

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Sole Proprietorship
Advantages
Easiest to start Least regulated Single owner keeps all the profits Taxed once as personal income

Disadvantages
Limited to life of owner Equity capital limited to owners personal wealth Unlimited liability Difficult to sell ownership interest

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Partnership
Advantages
Two or more owners More capital available Relatively easy to start Income taxed once as personal income

Disadvantages
Unlimited liability
General partnership Limited partnership

Partnership dissolves when one partner dies or wishes to sell Difficult to transfer ownership

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Corporation
Advantages
Limited liability Unlimited life Separation of ownership and management Transfer of ownership is easy Easier to raise capital

Disadvantages
Separation of ownership and management Double taxation (income taxed at the corporate rate and then dividends taxed at the personal rate)

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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 companys stock?

Does this mean we should do anything and everything to maximize owner wealth?
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Goal Of Financial Management


1) Profit Maximization? this goal ignores:

a) TIMING of Returns (Time Value of Money) b) UNCERTAINTY of Returns

Goal Of Financial Management


2) Shareholder Wealth Maximization?
this is the same as:

a) Maximizing Firm Value b) Maximizing Stock Price c) Minimizing Cost of Capital

Principles Underlying the financial management


1) Risk - return trade-off 2) Time value of money 3) Cash - not profits - is king 4) Incremental cash flows count 5) The curse of competitive markets 6) Efficient capital markets 7) The agency problem 8) Taxes bias business decisions 9) All risk is not equal 10) Ethical behavior

The Agency Problem


Agency relationship
Principal hires an agent to represent his/her interest Stockholders (principals) hire managers (agents) to run the company. Creditors (principals) lend funds to firms (agents) and expect to receive returns from the loans.

Agency problem
Conflict of interest between principal and agent

Management goals and agency costs


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Managing Managers
Managerial compensation
Incentives can be used to align management and stockholder interests The incentives need to be structured carefully to make sure that they achieve their goal

Corporate control
The threat of a takeover may result in better management

Other stakeholders
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Financial Markets
Primary Market
Market in which new issues of a security are sold to initial buyers.

Secondary Market
Market in which previously issued securities are traded. Listed vs. over-the-counter securities NYSE Bursa Malaysia Main Board, Second Board & MESDAQ
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Initial Public Offering (IPO)


The first time the firms stock is sold to the general public.

Seasoned New Issue


A new stock offering by a firm that already has stock that is traded in the secondary market.

Islamic Capital Market vs Conventional Capital Market

Cash Flows between the firm and the Financial Markets


A. Firm issues securities

B. FIRM
Invest in assets E. Reinvested c/flow Current asset/Fixed C. Cash flow from firms asset

F. Dividend etc

FINANCIAL MARKET
Debt/equity

taxes
D. GOVERNMENT
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