Fundamentals of Financial Management

FUNDAMENTALS OF FINANCIAL
MANAGEMENT
CHAPTER 1
What Is Finance?
• the system that includes the circulation of
money, the granting of credit, the making of
investments, and the provision of banking
facilities
AREAS OF FINANCE
• Finance as taught in universities is generally
divided into three areas:
(1) financial management,
(2) capital markets,
(3) investments
Financial management
• also called corporate finance, focuses on
decisions relating to how much and what
types of assets to acquire, how to raise the
capital needed to purchase assets, and how to
run the firm so as to maximize its value.
Capital markets
• relate to the markets where interest rates,
along with stock and bond prices, are
determined. Also studied here are the
financial institutions that supply capital to
businesses
Investments
• relate to decisions concerning stocks and
bonds and include a number of activities:
a) Security Analysis
b) Portfolio Theory
c) Market Analysis
Security Analysis
• deals with finding the proper values of
individual securities (i.e., stocks and bonds)
Portfolio theory
• deals with the best way to structure
portfolios, or “baskets,” of stocks and bonds.
Rational investors want to hold diversified
portfolios in order to limit risks, so choosing a
properly balanced portfolio is an important
issue for any investor.
Market analysis
• deals with the issue of whether stock and
bond markets at any given time are “too high,”
“too low,” or “about right.” Included in market
analysis is behavioral finance, where investor
psychology is examined in an effort to
determine whether 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
Forms of Business Organization
• Proprietorship
• Partnership
• Corporation
Proprietorship
• An unincorporated business owned by
one individual.
Advantages:
1. They are easy and inexpensive to form.
2. They are subject to few government regulations
3. They are subject to lower income taxes than are
corporations
Proprietorship
Limitations:
1. unlimited personal liability for the business’
debts
2. The life of the business is limited to the life of
the proprietor
3. Difficulty obtaining large sums of capital
Partnership
• business owned by two or more persons.
Advantages:
1. They are easy and inexpensive to form.
2. They are subject to few government regulations
Disadvatages
1. They are subject to lower income taxes than are
corporationsThe life of the business is limited to
the life of the proprietor
2. Difficulty obtaining large sums of capital
Corporation
• A legal entity created by a state, separate and
distinct from its owners and managers, having
unlimited life, easy transferability of
ownership, and limited liability.
Advantages:
1. Safer for investors
2. Unlimited lives
3. Easier to raise capital
Corporation
Disadvantage:
1. Corporate Taxes
2. Decision Making
The Main Financial Goal: Creating Value for
Investors
Intrinsic Value - An estimate of a stock’s “true” value based on
accurate risk and return data. The intrinsic value can be
estimated, but not measured precise
Market Price - The stock value based on perceived but possibly

incorrect information as seen by the marginal investor.
Marginal Investor - An investor whose views determine the

actual stock price.
Equilibrium - The situation in which the actual market price

equals the intrinsic value, so investors are indifferent between
buying and selling a stock.
Stockholder–Debtholder Conflicts
Stockholder - one who owns shares of stock in
a corporation
Debtholder - an owner of a financial obligation
of another party.
* Debtholders, which include the company’s

bankers and its bondholders, generally receive
fixed payments regardless of how well the
company does, while stockholders do better
when the company does better.
A company has raised $2,000 in capital, $1,000 from bondholders,
and $1,000 from stockholders. To keep things simple, we assume
that the bonds have a 1-year maturity and pay an 8% annual
interest rate. The company’s current plan is to invest its $2,000 in
Project L, a relatively low-risk project that is expected to be worth
$2,400 one year from now if the market is good and $2,000 if the
market is bad. There is a 50% chance that the market will be good
and a 50% chance the market will be bad. In either case, there will
be enough cash to pay the bondholders their money back plus the
8% annual interest rate that they were promised. The stockholders
will receive whatever is left over after the bondholders have been
paid. As expected, because they are paid last, the stockholders are
bearing more risk (their payoff depends on the market), but they
are also earning a higher expected return.
Now assume that the company discovers another project (Project
H) that has considerably more risk. Project H has the same
expected cash flow as Project L, but it will produce cash flows of
$4,400 if the market is good but $0 if the market is bad.
FINANCIAL MARKETS AND
INSTITUTIONS
CHAPTER 2
The Capital Allocation Process
Financial Markets
• a broad term describing any marketplace
where trading of securities including equities,
bonds, currencies, and derivatives occur.
Types of Financial Markets
1. Physical asset markets (also called “tangible” or
“real” asset markets) are for products such as wheat,
autos, real estate, computers, and machinery.
2. Financial asset markets - deal with stocks, bonds,

notes, and mortgages. Financial markets also deal
with derivative securities whose values are derived
from changes in the prices of other assets
3. Spot markets - markets in which assets are bought

or sold for “on-the-spot” delivery (literally, within a
few days).
4. Futures markets - markets in which participants
agree today to buy or sell an asset at some future
date.
5. Money markets - markets for short-term, highly
liquid debt securities
6. Capital markets - the markets for intermediate- or
long-term debt and corporate stocks
7. Primary markets - the markets in which
corporations raise new capital.
8. Secondary markets - markets in which existing,
already outstanding securities are traded among
investors
9. Private markets - where transactions are
negotiated directly between two or more parties
10. Public markets - where standardized contracts
are traded on organized exchanges
Financial Institutions
• a company engaged in the business of dealing
with financial and monetary transactions such
as deposits, loans, investments, and currency
exchange.
Categories of Financial Institutions
1. Investment Bank - an organization that underwrites and distributes new investment
securities and helps businesses obtain financing.
2. Commercial Bank - The traditional department store of finance serving a variety of

savers and borrowers.
3. Financial Services Corporation - A firm that offers a wide range of financial services,
including investment banking, brokerage operations, insurance, and commercial
banking
4. Credit unions - cooperative associations whose members are supposed to have a

common bond, such as being employees of the same firm. Members’ savings are
loaned only to other members, generally for auto purchases, home improvement
loans, and home mortgages. Credit unions are often the cheapest source of funds
available to individual borrowers.
Categories of Financial Institutions
5. Pension funds - retirement plans funded by corporations or government agencies for
their workers and administered primarily by the trust departments of commercial
banks or by life insurance companies.
6. Life insurance companies - take savings in the form of annual premiums; invest
these funds in stocks, bonds, real estate, and mortgages; and make payments to the
beneficiaries of the insured parties
7. Mutual Funds - Organizations that pool investor funds to purchase financial

instruments and thus reduce risks through diversification.
8. Money Market Funds - Organizations that pool investor funds to purchase financial
instruments and thus reduce risks through diversification.
9. Exchange Traded Funds (ETFs) - similar to regular mutual funds and are often
operated by mutual fund companies
10. Hedge funds - are also similar to mutual funds because they accept money from
savers and use the funds to buy various securities, but there are some important
differences
Physical Location Exchanges
• Formal organizations having tangible physical
locations that conduct auction markets in
designated (“listed”) securities.
Financial
Statements and
Reports
Annual Report
• A report issued annually by a corporation to
its stockholders. It contains basic financial
statements as well as management’s analysis
of the firm’s past operations and future
prospects.
FINANCIAL STATEMENTS
• Balance Sheet
• Income Statement
• Statement of Cash Flows
• Statement of Stockholder’s Equity
BALANCE SHEET
• shows what assets the company owns and
who has claims on those assets as of a given
date—for example, December 31, 2018.
• a “snapshot” of a firm’s position at a specific
point in time.
INCOME STATEMENT
• which shows the firm’s sales and costs (and
thus profits) during some past period—for
example, 2018.
STATEMENT OF CASHFLOWS
• which shows how much cash the firm began
the year with, how much cash it ended up
with, and what it did to increase or decrease
its cash.
STATEMENT OF STOCKHOLDER’S
EQUITY
• which shows the amount of equity the
stockholders had at the start of the year, the
items that increased or decreased equity, and
the equity at the end of the year

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FUNDAMENTALS OF FINANCIAL

Market Price - The stock value based on perceived but possibly

Marginal Investor - An investor whose views determine the

Equilibrium - The situation in which the actual market price

* Debtholders, which include the company’s

2. Financial asset markets - deal with stocks, bonds,

3. Spot markets - markets in which assets are bought

2. Commercial Bank - The traditional department store of finance serving a variety of

4. Credit unions - cooperative associations whose members are supposed to have a

7. Mutual Funds - Organizations that pool investor funds to purchase financial

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