Chapter 1 -- An Overview of Financial Management

 What is finance: cash flows between capital markets and firm’s operations
 The goal of a firm
 Forms of business organization
 Intrinsic value and market price of a stock
 Important business trends
 Business ethics
 Agency problem
 Career opportunities in finance

 What is finance: cash flows between capital markets and firm’s operations

(2) (1)
Firm’s Capital
Operation Financial (4a) Markets
(Real Assets) Managers (Financial
(3) (4b) Assets)

(1) Cash raised by selling financial assets in financial markets

(2) Cash invested in firm’s operations and used to purchase real assets
(3) Cash generated from firm’s operations
(4a) Cash reinvested in firms’ operations
(4b) Cash returned to investors

Financing decisions vs. investment decisions: raising money vs. allocating money
Activity (1) is a financing decision
Activity (2) is an investment decision
Activities (4a) and (4b) are financing decisions

The role of a financial manager

Forecasting and planning of firms’ financial needs
Making financing and investment decisions
Coordinating with other departments/divisions
Dealing with financial markets
Managing risks

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 Finance within an organization: importance of finance

Finance includes three areas

(1) Financial management: corporate finance, which deals with decisions related
to how much and what types of assets a firm needs to acquire, how a firm should
raise capital to purchase assets, and how a firm should do to maximize its
shareholders wealth - the focus of this class

(2) Capital markets: study of financial markets and institutions, which deals with
interest rates, stocks, bonds, government securities, and other marketable
securities. It also covers Federal Reserve System and its policies.

(3) Investments: study of security analysis, portfolio theory, market analysis, and
behavioral finance

 The goal of a firm

To maximize shareholder’s wealth (or firm’s long-run value)
Why not profit or EPS maximization?
Profit maximization usually ignores timing and risk of cash flows
EPS sometimes can be manipulated or misleading

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• Financial Management
• Financial markets
o Money market
o Capital market
o Spot market(prices will be determined by current market and demand)
o Primary market
o Secondary market

• Financial Assets: Stocks and Bonds

• Personal finance: This is finance for the household. Financial management deals with how
businesses deal with finance whereas personal finance deals with families.
• Public finance : It started as managing money of the country in general.

Easiest to start Limited to life of owner

Least regulated Equity capital limited to
Single owner keeps owner’s personal wealth
all of the profits Unlimited liability
Taxed once as Difficult to sell
personal income ownership interest

Two or more owners Unlimited liability

More capital available Partnership dissolves when
Relatively easy to one partner dies or sells
start Difficult to transfer
Income taxed once ownership
as personal income

Limited liability Separation of ownership and

Unlimited life management (agency problem)
Separation of ownership Double taxation (income taxed at
& management the corporate
Transfer of ownership is rate and then dividends taxed at
easy personal rate, while dividends
Easier to raise capital paid are not tax deductible)
 DECISION FUNCTIONS OF FINANCIAL MANAGEMENT

Q INVESTMENT DECISION :The total amount of asset to be bought is decided, whether to buy a new fixed asset or modify an
existing one, the mix or compositions of current and fixed assets, and the optimal level of each type of current asset to be
maintained.
Most important of the three decisions. Forecasting and planning
What is the optimal firm size? - Investment and financing decisions
What specific assets should be acquired?
> Coordination and control
-

What assets (if any) should be reduced or eliminated? Transactions in the financial markets
>
-
- Managing risk
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2. FINANCING DECISION:
Determine how the assets (LHS of balance sheet) will be financed (RHS of balance sheet)
– What is the best type of financing?
– What is the best financing mix?
– What is the dividend policy?
– A dividend policy is the policy a company uses to decide how much it will pay out to shareholders in the form of
dividends.

O
3. Asset Management Decisions:
How do we manage existing assets efficiently?
Greater emphasis on current asset management than fixed asset management.

GOAL Of THE FIRM

-

>
-

MAKE MONEY ,
GENERATE MORE REVENUES THAN EXPENSES.
Es AND WHAT IS LEFT IS FOR THE OWNER TO KEEP,
EITHER REINVEST IT AS RETAINED EARNINGS OR
TAKE IT AS DIVIDENDS.
• Efficient managers requires existences of some goals and
objectives
• Shares of common stock gives evidence of ownership in a
corporation.
• Shareholder wealth is represented by market price per
share of firms common stock
• Reflection of firms investment , financing and asset
management decision

VALUE CREATION RESPONSIBILITY OF FINANCIAL-STAFF

• Profit maximization • Maximize stock value by:

• Earning per share • The market price of firm stock takes into account present and
• Investment in projects expected future earning per share, timing, duration, risk of
• Time value of money, investment at margin, return on these earning, DV Policy and other factors that bear on market
investment, financial Risk price of the stock.
• Dividend policy • Market price serves as barometer for business performance it
indicates how well is management is doing on behalf of its
IS STOCK PRICE MAY SAME AS PROFIT MAX
shareholder
• Management is under continuous review

• No, despite a generally high correlation amongst stock UNLE

WHAT DETERMINES A FIRMS
price, EPS, and cash flow.
• Current stock price relies upon current earnings, as well as is in future
future earnings and cash flow. >
-

company's ability to
generate cash now

•Any financial asset is valuable only to the extent that it generates

• Some actions may cause an increase in earnings, yet
cash flows
cause the stock price to decrease (and vice versa).
•The timing of cash flows matter, cash received sooner is better '
•Investors are averse to risk, so all else equal they will pay more for
a stock whose cash flows are relatively certain than for one whose
cash flows are more risky
Financial
Management :

Concerned with the acquisition, financing, and management of assets

with some overall goal in mind.
 Forms of business organization
Proprietorship: an unincorporated business owned by one individual
Advantages:
Easy and inexpensive to form
Subject to less government regulations
Lower income taxes

Disadvantages:
Unlimited personal liability
Limited lifetime of business
Difficult to raise capital

Partnership: an unincorporated business owned by two or more people

Advantages vs. disadvantages: similar to those of proprietorship, in general

Corporation: legal entity created by a state

Advantages:
Limited liability
Easy to transfer the ownership
Unlimited lifetime of business
Easy to raise capital

Disadvantages:
Double taxation (at both corporate and individual levels)
Cost of reporting

S Corporation: allows small business to be taxed as proprietorship or partnership

Restrictions: no more than 100 shareholders; for small and privately owned firms

Limited Liability Company (LLC) and Limited Liability Partnership (LLP):

Hybrid between a partnership and a corporation - limited liability but taxed as
partnership

LLPs are used in professional fields of accounting, law, and architecture while
LLCs are used by other businesses

 Intrinsic value and market price of a stock

Intrinsic value is an estimate of a stock’s “fair” value (how much a stock should
be worth)

Market price is the actual price of a stock, which is determined by the demand and
supply of the stock in the market
Maximization of Shareholder Wealth: Basic Goal
What is shareholders wealth?
Shareholder’s wealth is simply the value of the assets owned by shareholders.
What are shares outstanding?
Intrinsic Value
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What is market price of a share? (Discounted value)
Risk : True versus perceived
Determinants of intrinsic value and stock price

Intrinsic value is supposed to be estimated using the “true” or accurate risk and
return data. However, since sometimes the “true” or accurate data is not directly
observable, the intrinsic value cannot be measured precisely.

Market value is based on perceived risk and return data. Since the perceived risk
and return may not be equal to the “true” risk and return, the market value can be
mispriced as well.

Stock in equilibrium: when a stock’s market price is equal to its intrinsic value the
stock is in equilibrium

Stock market in equilibrium: when all the stocks in the market are in equilibrium
(i.e. for each stock in the market, the market price is equal to its intrinsic value)
then the market is in equilibrium

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 Actual prices vs. intrinsic values

When the intrinsic value of a stock is higher than the market price of the stock, we
say that the stock in the market is under-valued (under-priced)
For example, if the intrinsic value for a stock is $26 and the market price is $25,
then the stock is under-valued.

When the intrinsic value of a stock is lower than the market price of the stock, we
say that the stock in the market is over-valued (over-priced)
For example, if the intrinsic value for a stock is $30 and the market price is $32,
then the stock is over-valued.

When the intrinsic value of a stock is equal to the market price of the stock, we
say that the stock in the market is fairly priced (the stock is in equilibrium)

 Important business trends

Globalization
Improving information technology
Corporate governance

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 Business ethics
Standards of conduct or moral behavior toward its employees, customers,
community, and stockholders - all its stakeholders

Measurements: tendency of its employees, adhere to laws and regulations, moral

standards to product safety and quality, fair employment practice, fair marketing
and selling practice, proper use of confidential information, community
involvement, and no illegal payments or practice to obtain business

 Agency problem
A potential conflict of interest between two groups of people

Stockholders vs. managers

Instead of shareholders’ wealth maximization, managers may be interested in
their own wealth maximization
Incentives:
Performance shares, executive stock options (positive)
Threat of firing, hostile takeover (negative)

Stockholders vs. bondholders

Stockholders prefer high-risk projects for higher returns
Bondholders receive fixed payment and therefore prefer lower risk projects

 Career opportunities in finance

Banking
Investments
Insurance
Corporations
Government

 Exercise
ST-1
Questions: 1-8