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Chapter 1 An Overview of Financial Management

1-1 What is Finance?1-1a Finance vs. Economics and Accounting

Finance grew out of economics and accounting.

Economists - asset value is based on the future cash flows

the asset will provide

Accountants- provided information regarding the likely

size of cash flows

1-1b Finance within an Organization

BOD- top governing body

CEO- chairperson of the board; highest-ranking individual

COO - firm's president; directs the firm's operations

(marketing, manufacturing, sales, human resources, and

other operating depts.

CFO- senior VP; 3rd ranking officer; in charge of

accounting, financing, credit policy, decisions regarding asset

acquisitions and investor relations-communication with

stockholders and press.

Sarbanes-Oxley Act - law passed by congress that

requires the CEO to certify that their firm's financial statements

are accurate

1-1c Corporate Finance, Capital Markets and Investments

1. Financial Management (Corporate Finance)

- decisions relating to how much and what types of

assets to acquire

- how to raise the capital needed to buy assets

- how to run the firm so as to maximize its value

2. Capital Markets

- markets where interest rates, stock and bond prices

are determined

- financial institutions that supply capital to business

3. Investments - decisions concerning stocks and bonds and

include a number of activities:

1) Security Analysis - finding the proper values of

individual securities

2)Portfolio Theory - best way to structure portfolio of

stock and bonds

3)Market Analysis - issue whether stock and bond

markets at any given time are "too high, too low" or "about

right"

Behavioral finance- investor psychology is

examined in an effort to determine if stock prices have been bid

up to unreasonable heights in a speculative bubble or driven

down to unreasonable lows in a fit of irrational pessimism.

1-2 Jobs in Finance

Value-based management - management decisions are

evaluated in terms of their effects on the firm's value

Defined contribution pension plans - each year the company

puts a specified amount of money into an account that belongs to

the employee the employee must decide how those funds are to

be invested

1-3 Forms of Business Organization

1) Proprietorship - an unincorporated business owned by one

individual

Advantages:easily and inexpensively formed, subject to

few government regulations, subject to lower income taxes than

corporation

Disadvantages:unlimited personal liability, limited life,

difficult to raise capital

2) Partnership - an unincorporated business owned by two or

more persons

established relatively easy and inexpensively

income allocated on a pro rata basis to the partners

taxed on an individual basis

unlimited personal liability

difficulty to raise large amounts of capital

3) Corporation - a legal entity created by state, separate and

distinct from its owners and managers having unlimited life, easy

transferability of ownership and limited liability

subject to double taxation-earnings are taxed and then when

its after tax earnings are paid out as dividends, those earnings are

taxed again as personal income. (C Corporation)

S Corporation - a special designation that allows a small

business that meets the qualifications to be taxed as if it were a

proprietorship/partnership rather than a corporation.

- firm can have no more 75 stockholders

4) Limited Liability Company (LLC) - relatively new type of

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organization that is a hybrid bet a partnership and a corporation

Limited Liability Partnership (LLP) - similar to an LLC but

used for professional firms; limited liability like corporation but

is taxed like partnership

1-4 Stock Prices and Shareholder Value

Primary Goal of a Co.- maximize its owners' value

Primary Goal of the Mgmt. - shareholder wealth maximization

Shareholder wealth maximization - the primary goal for

managers of publicly owned companies implies that decisions

should be made to maximize the long-run value of the firm's

common stock

1-5 Intrinsic Values, Stock Prices and Executive Compensation

Determinants of Intrinsic Value and Stock Prices

Managerial Actions, Economy, Taxes, and Political Conditions

- determine stock prices thus investors' returns

*investors like high returns but dislike risk so the larger the

expected profits and the lower the perceived risk the higher the

stock price.

True Expected Returns and True Risk

- investor would expect if they had all of the info. thatexisted about the company

Perceived Returns and Perceived Risk

- what investors expect given the limited info. theyactually have

Intrinsic Value

- an estimate of a stock's true value based on accurate riskand return data; can be estimated but not measured

precisely

Market Price

- the stock value based on perceived but possiblyincorrect info. as seen by the marginal investor

Marginal investor

- views determine the actual stock priceMarket Equilibrium

- Intrinsic Value = Stock Price

1-6 Important Business Trends

1) Sarbanes-Oxley bill- requires the CEO and CFO of a firm to

certify that the firm's financial statements are accurate.

2)Increased globalization of business.

3)Ever-improving information technology.

4) Corporate governance- way the top managers operate and

interface with stockholders

1-7 Business Ethics

Ethics - standards of conduct or moral behavior

Business ethics - company's attitude and conduct toward its

employees, customers, community and stockholders

1-8 Conflicts between Managers, Stockholders, and Bondholders

1-8a Managers versus Stockholders

Useful motivational tools to motivate managers to act in

their shareholders best interest:

1) Compensation packages

- should be sufficient to attract and retain able managers, should

not go beyond what is needed; managers rewarded on the basis of

the stock's performance over the long run.

2) Firing of managers who don't perform well

- stockholders can intervene directly with managers

3) Threat of hostile takeovers

Corporate Raider -an individual who targets a

corporation for takeover because it is undervalued

Hostile Takeover - the acquisition of a company over

the opposition of the management

1-8b Stockholders versus Bondholders

1)Bondholders generally receive fixed payment

regardless of how well the company does while stockholders do

better when the company does better

2) The use of additional debt