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Chapter 1

Introduction to Financial Management

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Chapter Outline

Finance: A Quick Look Business Finance 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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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

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Basic Areas Of Finance

Corporate finance Investments Financial institutions International finance

A

B C

ACBD

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Investments

Work with financial assets such as stocks and bonds

Value of financial assets, risk versus return, and asset allocation

Job opportunities Stockbroker or financial advisor Portfolio manager Security analyst

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Financial Institutions

Companies that specialize in financial matters Banks – commercial and investment,

credit unions, savings and loans Insurance companies Brokerage firms

Job opportunities

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International Finance

This is an area of specialization within each of the areas discussed so far

It may allow you to work in other countries or at least travel on a regular basis

Need to be familiar with exchange rates and political risk

Need to understand the customs of other countries; speaking a foreign language fluently is also helpful

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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

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Business Finance

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 investments? How will we manage the everyday

financial activities of the firm?

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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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Financial Management DecisionsCompany

(2004 Revenue)

Capital Budgeting Financing

Boeing ($52.5b) $7b to design, build, test and sell 787 Dreamliner aircraft

Negotiate with suppliers to help to finance the Dreamliner project. A Japanese supplier, who will build the wing and fuselage, are raising and investing more than $1.5b

Bank of America ($48.9b)

Acquired Fleet Boston Financial for $49b

Issued about 600 million new shares to finance the acquisition

BP ($285b) Invested $ 600m to develop oil fields offshore in the Gulf of Mexico

Announced plans to return surplus cash flow to shareholders through share repurchase

LVMH ($17.1b) Acquired Glenmorangie PLC, a producer of scotch malt whiskies

Issued a 7-year bond in July 2004, raising the euro equivalent of $812 m

Pfizer ($52.5b) $7.7b on research and testing of new medicines

Finance the research and testing with reinvested cash flow generated by sales of pharmaceutical products

Toyota ($164b) Building an $800m automobile plant in San Antonio, Texas

Total borrowings increased by $2.9b, mainly due to issuance of short-term debt in US

Wal-Mart ($285b) Plan for 2005 call for up to 530 new retail stores in US and 165 stores in other countries

Issued $1883m long-term debt, maturing in 2036 and paying interest at 5.25% per year

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Balance Sheet Model of the Firm

Current Assets

Fixed Assets

1 Tangible

2 Intangible

Total Value of Assets:

Shareholders’ Equity

Current Liabilities

Long-Term Debt

Total Firm Value to Investors:

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The Capital Budgeting Decision

What long-term investments should the firm choose?

Current Assets

Fixed Assets

1 Tangible

2 Intangible

Total Value of Assets:

Shareholders’ Equity

Current Liabilities

Long-Term Debt

Total Firm Value to Investors:

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The Capital Structure Decision

Current Assets

Fixed Assets

1 Tangible

2 Intangible

Total Value of Assets:

How should the firm raise funds for the selected investments?

Shareholders’ Equity

Current Liabilities

Long-Term Debt

Total Firm Value to Investors:

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Short-Term Asset Management

How should short-term assets be managed and financed?

Current Assets

Fixed Assets

1 Tangible

2 Intangible

Total Value of Assets:

Shareholders’ Equity

Current Liabilities

Long-Term Debt

Total Firm Value to Investors:

Net Working Capital

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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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StockholdersStockholders

Board of DirectorsBoard of Directors

President, Vice-President, President, Vice-President, and Other Officersand Other Officers

Employees of the CorporationEmployees of the Corporation

Organizing and Managing a Corporation

Ultimate control.

Ultimate control.

Stockholders usually meet once a year.

Stockholders usually meet once a year.

Selected by a vote of the

stockholders.

Selected by a vote of the

stockholders.

Overall responsibility for managing the company.

Overall responsibility for managing the company.

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Hypothetical Organization Chart

Chairman of the Board and Chief Executive Officer (CEO)

Board of Directors

President and Chief Operating Officer (COO)

Vice President and Chief Financial Officer (CFO)

Treasurer Controller

Cash Manager

Capital Expenditures

Credit Manager

Financial Planning

Tax Manager

Financial Accounting

Cost Accounting

Data Processing

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Forms of Business Organization

Sole Proprietorship

Sole Proprietorship

PartnershipPartnership CorporationCorporation

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Forms of Business Organization

Three major forms in the United States Sole proprietorship Partnership

General Limited

Corporation Limited liability company

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Sole Proprietorship Advantages

Easiest to start Least regulated Single owner keeps all

of the profits Taxed once as personal

income

Disadvantages Limited to life of owner Equity capital limited to

owner’s personal wealth Unlimited liability Difficult to sell ownership

interestSole

Proprietorship

Sole Proprietorship

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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

PartnershipPartnership

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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 (agency problem)

Double taxation (income taxed at the corporate rate and then dividends taxed at personal rate, while dividends paid are not tax deductible)CorporationCorporation

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A Comparison  Corporation Partnership

Liquidity Shares can be easily exchanged

Subject to substantial restrictions

Voting Rights Usually each share gets one vote

General Partner is in charge; limited partners may have some voting rights

Taxation Double Partners pay taxes on distributions

Reinvestment and dividend payout

Broad latitude All net cash flow is distributed to partners

Liability Limited liability General partners may have unlimited liability; limited partners enjoy limited liability

Continuity Perpetual life Limited life

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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 company’s stock?

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Goal of Financial Management

Goal: Maximize the current value per share of existing stock

More general goal: Maximize the market value of the existing owner’s equity

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Goal of Financial Management

Does this mean we should do anything and everything to maximize owner wealth?

Sarbanes-Oxley Act

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The Agency Problem Agency relationship

Principal hires an agent to represent its interests

Stockholders (principals) hire managers (agents) to run the company

Agency problem Conflict of interest between

principal and agent Management goals and agency

costs

I hire you to run my

company OK!

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Managerial Goals

Managerial goals may be different from shareholder goals Expensive perquisites Survival Independence

Increased growth and size are not necessarily equivalent to increased shareholder wealth

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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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Options are given to key employees to motivate them to: focus on company performance, take a long-run perspective, and remain with the company.

Options are given to key employees to motivate them to: focus on company performance, take a long-run perspective, and remain with the company.

Stock Options

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Example: Work the Web

The Internet provides a wealth of information about individual companies

One excellent site is finance.yahoo.com Click on the Web surfer to go to the site,

choose a company and see what information you can find!

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Financial Markets

Cash flows to the firm Ultimately, the firm must be a cash generating

activity. The cash flows from the firm must exceed the

cash flows from the financial markets. Primary vs. secondary markets

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Figure 1.2

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Financial Markets

Primary Market Issuance of a security for the first time

Secondary Markets Buying and selling of previously issued securities Securities may be traded in either a dealer or

auction market Dealer vs. auction markets Listed vs. over-the-counter securities

NYSE NASDAQ

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Financial Markets

FirmsInvestors

Secondary Market

money

securitiesSueBob

Stocks and Bonds

Money

Primary Market

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Quick Quiz

What are the four basic areas of finance? What are the three types of financial

management decisions, and what questions are they designed to answer?

What are the three major forms of business organization?

What is the goal of financial management? What are agency problems, and why do they

exist within a corporation? What is the difference between a primary

market and a secondary market?