Chapter 1 - An Introduction to Financial Management Chapter 1 - An Introduction to Financial...

Chapter 1 - An Introduction toChapter 1 - An Introduction to Financial ManagementFinancial Management

2005, Pearson Prentice Hall

FinanceFinance

The art and science of managing The art and science of managing moneymoney

Financial ManagementFinancial Management

Is concerned with the maintenance Is concerned with the maintenance and creation of economic value or and creation of economic value or wealthwealth

Goal of the FirmGoal of the Firm

1) Profit Maximization?1) Profit Maximization?

this goal ignores:this goal ignores:

a) TIMING of Returnsa) TIMING of Returns(Time Value of Money - Ch. 5)(Time Value of Money - Ch. 5)

b) UNCERTAINTY of Returnsb) UNCERTAINTY of Returns(Risk - Ch. 6)(Risk - Ch. 6)

Goal of the FirmGoal of the Firm

2) Shareholder Wealth 2) Shareholder Wealth Maximization?Maximization?

this is the same as:this is the same as:

a) Maximizing Firm Valuea) Maximizing Firm Value

b) Maximizing Stock Priceb) Maximizing Stock Price

Legal Forms of BusinessLegal Forms of Business

1) Sole Proprietorship1) Sole Proprietorship A business owned by a single individual and that A business owned by a single individual and that

has a minimum amount of legal structurehas a minimum amount of legal structure Advantages:Advantages:

Easily established with few complicationsEasily established with few complications Minimal organizational costsMinimal organizational costs Does not have to share profits or control with othersDoes not have to share profits or control with others

Disadvantages:Disadvantages: Unlimited liability of the ownerUnlimited liability of the owner Owner must absorb all lossesOwner must absorb all losses Equity capital limited to the owner’s personal Equity capital limited to the owner’s personal

investmentinvestment Business terminates immediately upon death of ownerBusiness terminates immediately upon death of owner


2) Partnership2) Partnership An association of two or more An association of two or more

individuals joining together as co-individuals joining together as co-owners to operate a business for owners to operate a business for profit.profit.

2a) General Partnership2a) General Partnership Relationship between partners I dictated Relationship between partners I dictated

by the partnership agreementby the partnership agreement Advantages:Advantages:

Minimal organizational requirementsMinimal organizational requirements

DisadvantagesDisadvantages All partners have unlimited liabilityAll partners have unlimited liability Difficult to raise large amounts of capitalDifficult to raise large amounts of capital Partnership dissolved by the death or Partnership dissolved by the death or

withdrawal of general partnerwithdrawal of general partner


2b) Limited Partnership2b) Limited Partnership Consists of at least one general partner and one or more Consists of at least one general partner and one or more

limited partners (investors)limited partners (investors) Advantages:Advantages:

For limited partners, liability limited to the amount of capital For limited partners, liability limited to the amount of capital invested in the companyinvested in the company

Withdrawal or death of a limited partner does not affect Withdrawal or death of a limited partner does not affect continuity of the businesscontinuity of the business

Stronger inducement in raising capitalStronger inducement in raising capital Disadvantages:Disadvantages:

For general partners, they have unlimited liability in the For general partners, they have unlimited liability in the partnershippartnership

Names of limited partners may not appear in the name of the firmNames of limited partners may not appear in the name of the firm Limited partners may not participate in the management of the Limited partners may not participate in the management of the

businessbusiness More expensive to organize than general partnership, as written More expensive to organize than general partnership, as written

agreement is mandatoryagreement is mandatory


2c) Limited Liability Company 2c) Limited Liability Company (LLC)(LLC)

Cross between a partnership and a Cross between a partnership and a corporation.corporation.

Owners have limited liability, but the Owners have limited liability, but the firm runs and is taxed like a firm runs and is taxed like a partnership.partnership.


3) Corporation3) Corporation A business entity having the power to purchase, A business entity having the power to purchase,

sell, and own assets and to incur liabilities while sell, and own assets and to incur liabilities while existing separately and apart from its owners.existing separately and apart from its owners.

Advantages:Advantages: Limited liability of ownersLimited liability of owners Ease of transferability, i.e., by the sale of one’s shares Ease of transferability, i.e., by the sale of one’s shares

of stockof stock Death of an owner does not result in the discontinuity of Death of an owner does not result in the discontinuity of

the firm’s lifethe firm’s life Ability to raise large amounts of capital is increasedAbility to raise large amounts of capital is increased

Disadvantages:Disadvantages: Most difficult and expensive form of business to Most difficult and expensive form of business to

establishestablish Control of corporation not guaranteed by partial Control of corporation not guaranteed by partial

ownership of stockownership of stock..


Vice President for Finance, also called Vice President for Finance, also called th Chief Financial Officer (CFO)th Chief Financial Officer (CFO)

Serves under the corporation’s CEO and is Serves under the corporation’s CEO and is responsible for overseeing financial responsible for overseeing financial planning, corporate strategic planning, planning, corporate strategic planning, and controlling the firm’s cash flowand controlling the firm’s cash flow

Treasurer and controller serve under the Treasurer and controller serve under the CFO.CFO.

Role of the Financial Role of the Financial Manager in a CorporationManager in a Corporation

TreasurerTreasurer Handles the firm’s financial activities, Handles the firm’s financial activities,

including cash and credit including cash and credit management, making capital management, making capital expenditure decisions, raising funds, expenditure decisions, raising funds, financial planning, and managing any financial planning, and managing any foreign currency received by the firmforeign currency received by the firm


ControllerController Responsible for managing the firm’s Responsible for managing the firm’s

accounting duties, including accounting duties, including producing financial statements, cost producing financial statements, cost accounting, paying taxes, and accounting, paying taxes, and gathering and monitoring the data gathering and monitoring the data necessary to overseenecessary to oversee


The Corporation and The Corporation and Financial MarketsFinancial Markets

Government

Corporation Investors


cash

Government

securities

Corporation InvestorsRaising capital


Government

cash

securities

Corporation Investors

Secondarymarkets

Raising capital


cash Investors

Secondarymarkets

Government

securities

Cash flow

reinvest

tax

Corporation

dividends, int., etc.

Raising capital

Primary MarketPrimary Market Market in which new issues of a Market in which new issues of a

security are sold to initial security are sold to initial buyers.buyers.

Secondary MarketSecondary Market Market in which previously Market in which previously

issued securities are traded.issued securities are traded.


Initial Public Offering (IPO)Initial Public Offering (IPO) The first time the firm’s stock is The first time the firm’s stock is

sold to the general public.sold to the general public.

Seasoned New IssueSeasoned New Issue A new stock offering by a firm A new stock offering by a firm

that already has stock that is that already has stock that is traded in the secondary market.traded in the secondary market.


Ten Principles of Financial ManagementTen Principles of Financial Management

Principle 1: Principle 1:

Risk-return tradeoff - we won't take Risk-return tradeoff - we won't take additional risk unless we expect to be additional risk unless we expect to be compensated with additional return.compensated with additional return.



Time value of money - a dollar received Time value of money - a dollar received today is worth more than a dollar received today is worth more than a dollar received in the future.in the future.



Cash -- Not Profits -- is KingCash -- Not Profits -- is King

-- In measuring value we will use cash flows In measuring value we will use cash flows rather than accounting profits because it rather than accounting profits because it is only cash flows that the firm receives is only cash flows that the firm receives and is able to reinvest.and is able to reinvest.



Incremental cash flows count - In making Incremental cash flows count - In making business decisions we will only concern business decisions we will only concern ourselves with what happens as a result ourselves with what happens as a result of that decision.of that decision.



The curse of competitive marketsThe curse of competitive markets - In competitive markets, extremely large profits - In competitive markets, extremely large profits

cannot exist for very long because of cannot exist for very long because of competition moving in to exploit those large competition moving in to exploit those large profits. As a result, profitable projects can only profits. As a result, profitable projects can only be found if the market is made less competitive, be found if the market is made less competitive, either through product differentiation or by either through product differentiation or by achieving a cost advantage.achieving a cost advantage.



Efficient Capital Markets Efficient Capital Markets

- The markets are quick and the prices are - The markets are quick and the prices are right.right.



The agency problem - managers won't The agency problem - managers won't work for the owners unless it's in their work for the owners unless it's in their best interest. The agency problem is a best interest. The agency problem is a result of the separation between the result of the separation between the decision makers and the owners of the decision makers and the owners of the firm. As a result managers may make firm. As a result managers may make decisions that are not in line with the goal decisions that are not in line with the goal of maximization of shareholder wealth.of maximization of shareholder wealth.



Taxes bias business decisions.Taxes bias business decisions.



All risk is not equal - since some risk can All risk is not equal - since some risk can be diversified away and some cannot. be diversified away and some cannot. The process of diversification can reduce The process of diversification can reduce risk, and as a result, measuring a risk, and as a result, measuring a project’s or an asset's risk is very project’s or an asset's risk is very difficult.difficult.



Ethical dilemmas are everywhere in finance. Ethical dilemmas are everywhere in finance. Ethical behavior is doing the right thing, and Ethical behavior is doing the right thing, and

it is important in financial management, just it is important in financial management, just as it is important in everything we do. as it is important in everything we do. Unfortunately, precisely how we define what Unfortunately, precisely how we define what is and what is not ethical behavior is is and what is not ethical behavior is sometimes difficult. Nevertheless, we should sometimes difficult. Nevertheless, we should not give up the quest.not give up the quest.

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