Chapter Outline

Introduction to Finance
Risk-Return Tradeoff
Forms of Organizations
Corporate Governance
Goals of Financial Management
Social Responsibility and Finance
Role of Financial Markets

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Financial Management
Financial Management or business finance
is concerned with managing an entitys
money.
For example, a company must decide:
where to invest its money.
whether or not to replace an old asset.
when to issue new stocks and bonds. 1-2
whether or not to pay dividends.
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Relationship between Finance,

Economics and Accounting
Economics provides structure for decision
making in many important areas.
Provides a broad picture of economic
environment.

Accounting provides financial data in various

forms.
Income statements, balance sheets, and
statement of cashflows.
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Finance links economic theory with the

numbers of accounting.

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Evolution in the Field of Finance

At the turn of the century: Emerged as a
field separate from economics.
By 1930s: Financial practices revolved
around such topics as:
Preservation of capital.
Maintenance of liquidity.
Reorganization of financially troubled
corporation.
Bankruptcy.

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Evolution in the Field of Finance

(contd)
By mid-1950s: Finance becomes more
analytical.
Financial Capital (accounting capital/ money)
was used to purchase Real Capital (economic
capital/ long-term plant and equipment).
Cash and inventory management
Capital structure theory
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Dividend policy
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Recent Issues in Finance

Recent focus has been on:
Risk-return relationships.
Maximization of returns for a given level of risk.
Portfolio management.
Capital structure theory.

New financial products with a focus on

hedging are being widely used.
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Recent Issues in Finance (contd)

The following are significant to financial
managers during decision making:
Effects of inflation and disinflation on financial
forecasting.
Required rates of return for capital budgeting
decisions.
Cost of capital.
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Advances in Internet and Finance

Internet and its acceptance has enabled
acceleration of e-commerce solutions for old
economy companies.
E-commerce solutions for existing companies
B2C
B2B

Spurt in new business models and companies

Amazon.com
eBay

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Advances in Internet and Finance

(contd)
For a financial manager e-commerce
impacts financial management because it
affects the pattern and field through which
cash flows through the firm.
B2C Model: Products are bought with credit
cards, credit card checks are performed, and
selling firms get the cash flow faster.
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B2B: Orders can be placed, inventory managed,
and bids to supply products can be accepted
all online.
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The Balance-Sheet Model

of the Firm
Total Value of Assets:

Total Firm Value to Investors:

Current Liabilities

Current Assets
Long-Term Debt

Fixed Assets
1 Tangible
2 Intangible

Shareholders
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Equity

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The Balance-Sheet Model

of the Firm
The Capital Budgeting Decision
Current Liabilities
Current Assets
Long-Term Debt

Fixed Assets
1 Tangible
2 Intangible

What longterm
Shareholders
investments
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Equity
should the
firm engage
in?
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The Balance-Sheet Model

of the Firm
The Capital Structure Decision
Current Liabilities
Current Assets
Long-Term Debt

Fixed Assets
1 Tangible
2 Intangible

How can the

firm raise the
money for the
required
investments?

Shareholders
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Equity

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The Balance-Sheet Model

of the Firm
The Net Working Capital Investment Decision
Current Liabilities
Current Assets
Net
Working
Capital

Fixed Assets
1 Tangible
2 Intangible

How much
short-term cash
flow does a
company need
to pay its bills?

Long-Term Debt

Shareholders
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Equity

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Capital Structure
The value of the firm can be
thought of as a pie.
The goal of the manager is to
increase the size of the pie.

The Capital Structure decision

can be viewed as how best to slice
up the pie.

25% Debt
70%
50%30%
Debt
Equity
75%
50%
Equity

1-14

If how you slice the pie affects the size of the pie, then the
capital structure decision matters.
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Restructuring
Restructuring can result in:
Changes in the capital structure (liabilities and
equity on the balance sheet).
Selling of low-profit-margin divisions with the
proceeds of the sale reinvested in better
investment opportunities.
Removal or large reductions in the of current
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management team.

It has resulted in acquisitions and mergers.

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Hypothetical Organization Chart

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The Financial Manager

To create value, the financial manager
should:
1. Try to make smart investment decisions.
2. Try to make smart financing decisions.
3. Asset Management Decisions.
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Functions of the Financial Manager

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Risk-Return Trade-Off
Influences operational side (capital versus
labor/ Product A versus Product B)
Influences financial mix (stocks versus
bonds versus retained earnings)
Stocks are more profitable but riskier.
Savings accounts are less profitable and less
risky (or safer)
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Financial manager must choose appropriate

combinations
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Return Maximization and Risk

Minimization
Investors can choose risk level that meets
their objective and maximizes return for that
given level of risk.
Companies that are rewarded with highpriced securities can raise new funds in the
money and capital markets at a lower cost
compared to competitors.
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Firms pay a penalty for failing to perform
competitively.
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The Firm and the Financial Markets

Firm issues securities (A)
Invests
in assets
(B)

Short-term debt
Cash flow
from firm (C)

Ultimately, the firm must

be a cash generating
activity.

Dividends and
debt payments (E)
Taxes (D)

Current assets
Fixed assets

Retained
cash flows (F)
Long-term debt
Equity shares

The cash1-21
flows from
the firm must exceed
the cash flows from
the financial markets.

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Corporate Securities as Contingent

Claims on Total Firm Value
The basic feature of a debt is that it is a promise
by the borrowing firm to repay a fixed dollar
amount of by a certain date.
The shareholders claim on firm value is the
residual amount that remains after the
debtholders are paid.
If the value of the firm is less than the amount
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promised to the debtholders, the shareholders
get nothing.
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Debt and Equity as Contingent Claims

Payoff to
debt holders
If the value of the firm is
more than $F, debt
holders get a maximum
of $F.

Payoff to
shareholders
If the value of the firm is
less than $F, share
holders get nothing.

$F

$F
Value of the firm (X)
If the value of the firm is
Debt holders are promised $F.
more than $F,
share
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If the value of the firm is less than $F, they get
holders get everything
the whatever the firm if worth.
above $F.
Algebraically, the bondholders claim is:
Algebraically, the shareholders claim is:
Min[$F,$X]
Max[0,$X $F]
$F
Value of the firm (X)

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Combined Payoffs to Debt and

Equity
If the value of the firm is less
Combined Payoffs to debt holders
than $F, the shareholders claim
and shareholders
is: Max[0,$X $F] = $0 and the
debt holders claim is Min[$F,$X]
= $X.
The sum of these is = $X
Payoff to
$F
shareholders
If the value of the firm is more
Payoff to debt
than $F, the shareholders claim
holders
is: Max[0,$X $F] = $X $F and
$F
the debt holders claim
is:
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Value of the firm (X)
Debt holders are promised
$F.

Min[$F,$X] = $F.
The sum of these is = $X

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The Corporate Firm

The corporate form of business is the
standard method for solving the problems
encountered in raising large amounts of
cash.
However, businesses can take other forms.
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Forms of Business Organization

The Sole Proprietorship
The Partnership
General Partnership
Limited Partnership

The Corporation
Advantages and Disadvantages

Liquidity and Marketability of Ownership

Control
Liability
Continuity of Existence
Tax Considerations

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Sole Proprietorship
Represents single-person ownership
Advantages:
Simplicity of decision-making.
Low organizational and operational costs.

Drawback
Unlimited liability to the owner.
Profits and losses are taxed as though1-27they
belong to the individual owner.
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Partnership
Similar to sole proprietorship except there
are two or more owners.
Articles of partnership: Specifies ownership
interest, the methods for distributing profits, and
the means of withdrawing from the partnership.
Limited partnership: One or more partners are
designated as general partners and have
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unlimited liability of the debts of the firm;
partners designated limited partners and are
liable only for their initial contribution.
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Corporation
Corporation
Articles of incorporation: Specify the rights and
limitations of the entity.
Its owned by shareholders who enjoy the
privilege of limited liability.
Has a continual life.

Key feature is the easy divisibility of

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ownership interest by issuing shares of
stock.
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A Comparison of Partnership
and Corporations
Corporation

Partnership

Liquidity

Shares can easily be

exchanged.

Subject to substantial
restrictions.

Voting Rights

Usually each share

gets one vote

Taxation

Double

General Partner is in
charge; limited
partners may have
some voting rights.
Partners pay taxes on
distributions.

Reinvestment and
dividend payout

Broad latitude

All net cash flow is

distributed to partners.

Liability

Limited liability

Continuity

Perpetual life

General partners
may
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have unlimited liability.
Limited partners enjoy
limited liability.
Limited life

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Goals of the Corporate Firm

The traditional answer is that the managers
of the corporation are obliged to make
efforts to maximize shareholder wealth.

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Corporate Governance
Agency theory
Examines the relationship between
the owners and managers of the firm.

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The Set-of-Contracts Perspective

The firm can be viewed as a set of contracts.
One of these contracts is between shareholders
and managers.
The managers will usually act in the shareholders
interests.
The shareholders can devise contracts that align the
incentives of the managers with the goals of the
shareholders.
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The shareholders can monitor the managers behavior.

This contracting and monitoring is costly.

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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 the same thing as increased
1-34
shareholder wealth.
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Separation of Ownership and Control

Board of Directors

Assets

1-35

Equity

Shareholders

Debt

Debtholders

Management

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Do Shareholders Control
Managerial Behavior?
Shareholders vote for the board of directors,
who in turn hire the management team.
Contracts can be carefully constructed to be
incentive compatible.
There is a market for managerial talentthis
may provide market discipline to the
managersthey can be replaced.
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If the managers fail to maximize share price,
they may be replaced in a hostile takeover.
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The Role of Financial Markets

Financial markets are indicators of
maximization of shareholder value and the
ethical or the unethical behavior that may
influence the value of the company.
Participants in the financial market range
over the public, private and government
institutions.
1-37
Public financial markets
Corporate financial markets

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Structure and Functions of the Financial

Markets
Money markets
Securities in this market include commercial
paper sold by corporations to finance their daily
operations or certificates of deposit with
maturities of less than 12 months sold by banks.

Capital markets
Long-term markets
1-38
Securities include common stock, preferred
stock and corporate and government bonds.
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Stocks versus Bonds

Stock = ownership or equity
Stockholders own the company

Bond = debt or IOU

Bondholders are owed $ by company
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Allocation of Capital
Primary market
When a corporation uses the financial markets
to raise new funds, the sale of securities is
made by way of a new issue.

Secondary market
When the securities are sold to the public
(institutions and individuals).
1-40
Financial managers are given a feedback about
their firms performance.
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Financial Markets
Primary Market
When a corporation issues securities, cash flows
from investors to the firm.
Usually an underwriter is involved

Secondary Markets
Involve the sale of used securities from one
investor to another.
1-41
Securities may be exchange traded or trade
over-the-counter in a dealer market.
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Financial Markets

Firms

Investors

Stocks and
Bonds

securities

Money

Bob

Sue
money

Primary Market
1-42

Secondary Market

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Exchange Trading of Listed Stocks

Auction markets are different from dealer
markets in two ways:
Trading in a given auction exchange takes place
at a single site on the floor of the exchange.
Transaction prices of shares are communicated
almost immediately to the public.
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Internationalization of Financial Markets

Allocation of capital and the search for low
cost sources of financing on the rise in
global market.
The impact of international affairs and
technology has resulted in the need for
future financial managers to understand
International capital flows.
1-44
Computerized electronic funds transfer systems.
Foreign currency hedging strategies.
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Thanks
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