Financial Management: Core Concepts

Fourth Edition, Global Edition

Chapter 1
Financial Management

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Learning Objectives (1 of 2)
1.1 Describe the cycle of money, the participants in the cycle,
and the common objective of borrowing and lending.
1.2 Distinguish the four main areas of finance and briefly
explain the financial activities that each encompasses.
1.3 Explain the different ways of classifying financial
markets.
1.4 Discuss the three main categories of financial
management.
1.5 Identify the main objective of the financial manager

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Learning Objectives (2 of 2)
1.6 Explain how the finance manager interacts with both
internal and external players.
1.7 Delineate the main types of business organizations and
their respective advantages and disadvantages.
1.8 Illustrate agency theory and the principal-agent problem.
1.9 Define issues in corporate governance and business
ethics.
1.10 Explain why studying finance improves your
employability.

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Definition of Finance and Financial
Management
• Finance is the art and science of managing wealth.
– It is about making decisions regarding what assets to buy/sell and
when to buy/sell these assets.

• Financial management is defined as those activities that

create or preserve the economic value of the assets of an
individual, small business, or corporation.

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1.1 The Cycle of Money
• Financial intermediaries assist in the movement of money,
from lenders to borrowers and back again.
– This process is termed the cycle of money, and its main objective
is to make all the participants better off.
– In the business world, most lenders are not in direct contact with
their borrowers. Most lenders invest their money with a financial
institution such as a bank, which, in turn, loans these funds to
another party. Then The borrower makes payments back to the
bank, and the bank, in turn, pays back the lender.
The bank in this instance is called a financial intermediary.
– Financial intermediary: an institution that acts as a “middleman”
between borrowers and lenders.
– Figure 1.1 depicts these roles in the cycle of money.

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Figure 1.1 The Money Cycle

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Example 1: The Money Cycle
Example:
Paula decides to deposit $500 in the bank by purchasing a certificate of
deposit (CD). The CD is a promise by the bank that it will return the $500
and pay Paula $25 (5% interest) if she keeps the entire deposit in the
bank for one year.
Scott comes to the bank in need of $500 for a tuition payment. The bank
agrees to loan Scott $500 if he will repay the loan principal of $500 and an
additional $40 (8% interest) at the end of the year.
These transactions benefit all three parties—Scott, the bank, and Paula.
Scott is able to pay his tuition on time. If he then pays back $540 to the
bank, the bank can redeem Paula’s CD for $525 and keep $15 for the
services it provided:
(1) matching the borrower and lender and (2) bearing the risk that Scott
would not be able to pay back the loan with interest at the end of the year.

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1.2 Overview of Finance Areas
We often partition finance into four main areas:
• Corporate Finance
• Investments
• Financial Institutions and Markets
• International Finance

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1.2 Overview of Finance Areas
We often partition finance into four main areas:
• Corporate Finance: the set of financial activities that support the operations of
a corporation or business, such as borrowing funds to finance projects and
repaying these borrowed funds
• Investments: the activities centering on the buying and selling of assets, both
real and financial.

- Real assets are physical assets such as property, buildings, and

commodities, including corn, oil, and gold.

- Financial assets are intangible assets such as stocks and bonds.

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1.2 Overview of Finance Areas
We often partition finance into four main areas:
• Financial Institutions and Markets: the organized financial intermediaries
and the forums that promote the cycle of money. The institutions take the form
of commercial banks, investment banks, insurance companies, pension
companies, and foreign exchanges.
• International Finance: deals with the multinational aspects of the finance
activities

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1.3 Financial Markets
• Forums where buyers and sellers of financial assets and commodities
meet.
• Financial markets are the locations, both physical and virtual, where
transactions take place.
• Financial markets can be classified by:
– Type of asset traded
– Maturity of the financial asset
– Owner of the financial asset

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1.3 Financial Markets
• Financial markets can be classified by:
1- Type of asset traded
 Equity markets, where stocks are bought and sold
 Debt markets, where bonds are bought and sold
 Derivatives markets, where futures contracts and options are bought and sold
 Foreign exchange markets, where currencies are bought and sold

2- Maturity of the financial asset

Maturity means the length of time the borrower has to pay back the borrowed funds.
 money market: Investors buy and sell financial assets that will mature within
the year in money markets. These assets are short-term loans.
 capital market: Financial assets that have maturities over a year transact in the
capital markets. These assets are long-term loans and may include bonds or
stocks.

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1.3 Financial Markets
• Financial markets can be classified by:
3- Owner of the financial asset
 primary market: When a company offers stock for sale for the first time, the
sale takes place in the primary (first) market

 secondary market: After the initial public sale of stocks or bonds, the initial
buyer of the stock or bond may choose to resell the asset to another party.
When that happens, the sale takes place in the secondary market

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1.4 The Finance Manager and Financial
Management (1 of 2)
Financial manager Responsibilities:
• Has to determine the best repayment structure for
borrowed funds.
• Makes sure that debt obligations are met on time.
• Ensures that sufficient funds are available for carrying out
daily operations.

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1.4 The Finance Manager and Financial
Management (2 of 2)
Financial management involves three main functions:
• Capital Budgeting: the process of planning, evaluating, comparing,
and selecting the long-term operating projects of the company.
• Capital Structure: how a company finances its business activities; for
public companies, usually a mix of bonds (debt) and stocks (equity)
sold to investors and owners.
• Working Capital Management: the process of managing the day-to-
day operating needs of the company through its current assets and
current liabilities.

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1.5 Objective of the Finance Manager
To make investment and financing decisions that increase
the cash flow of the firm, thereby maximizing the current
stock price.

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1.6 Internal and External Players
• Financial managers have to interact with various internal
and external stakeholders.
– Internal players include all the departmental managers and other
employees.
– External parties include:
 Customers
 Suppliers
 Government
 Creditors

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Figure 1.2 A Basic Organizational Chart for
a Company

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1.7 The Legal Forms of Business (1 of 6)
• There are three main legal categories of business
organizations:
– Sole proprietorship
– Partnership
– Corporation

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1.7 The Legal Forms of Business (2 of 6)
Sole Proprietorship: is a business owned entirely by an individual.
With this form of business, a person does business in his or her own
name.
• Advantages
1. Simplest and easiest form of business.
2. Least amount of legal documentation.
3. Least regulated.
4. Owner keeps all profits.
• Disadvantages
1. Owner pays personal tax rate on profits.
2. Obligations of the business are sole responsibility of owner, and personal
assets may be necessary to pay obligations (personal and business
assets are commingled).
3. Business entity limited to life of owner.
4. Can have limited access to outside funding for the business.
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1.7 The Legal Forms of Business (3 of 6)
Partnership:
is a business owned jointly by two or more individuals. The partnership
agreement spells out the partners’ percentages of ownership and levels
of participation.
Partners can be:
1- general partners, who operate the daily business
2- limited partners, who participate only in certain aspects of the
business
3- silent partners, who participate in the business only as investors

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1.7 The Legal Forms of Business (4 of 6)
Partnership:
• Advantages
1. Agreements between partners may be easily formed.
2. Involves more individuals as owners and therefore usually more
expertise.
3. Larger amount of capital usually available to the business
(compared to proprietorship).

• Disadvantages
1. Assets of general partners are commingled with assets of the
business.
2. Profits treated as personal income for tax purposes.
3. Difficult to transfer ownership.

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1.7 The Legal Forms of Business (5 of 6)

Corporation:
is a legal entity separate from its owners, meaning that it can enter
into contracts, can sue or be sued, and pays taxes.

The structure of a corporation separates the owners and managers

of the firm.

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1.7 The Legal Forms of Business (5 of 6)
Corporation
• Advantages
1. Business is legal, separate entity from owners.
2. Owners have limited liability to obligations of the business.
3. Easy to transfer ownership.
4. Usually, greater access to capital for business.
5. Owners do not have any personal liability for default.

• Disadvantages
1. Most difficult business operation to form.
2. Double taxation of company profits.
3. Most regulated.

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1.8 The Agency Conflict (1 of 3)
Why does it arise?

The owners of the business, hire the managers to act in the

owners’ best interests and maximize the current stock price.

The managers want to earn high wages and receive

benefits from the performance of their jobs.

Are these interests always aligned? No

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1.8 The Agency Conflict (2 of 3)
Why does it arise?

A natural conflict arises because The managers cannot maximize the

current stock price without forgoing some of their personal compensation
or bonus.

This conflict raises a potential problem in the relationship between

owners and managers. Because Managers want to maximize their own
compensation, which may be costly to the owners.

The costs incurred to align managers’ interests with those of the owners
and the associated costs for which the owners pay, are agency costs.

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 1.8 The Agency Conflict (3 of 3)
How it can be minimized?

The owners of the company want the managers to make the right choice
that is, to choose those actions that most benefit the owners and are most
consistent with their values. If the owner is present and can observe a
manager’s choice, the owner can then reward the right choice and punish
the wrong one.

However, shareholders (the owners) are spread out around the world and
cannot observe a manager’s actions. They will need to:

1- hire auditors to confirm that they have made the right choice
2- or construct compensation contracts that help managers make the
right choice. Shareholders can provide the appropriate bonus incentive to
top managers by tying part of their compensation to the performance of the
company’s stock.
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1.9 Corporate Governance
• Corporate governance deals with….
– how a company conducts its business and implements controls to
ensure proper procedures and ethical behavior.

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1.10 Why Study Finance?
• Understand how and why financial decisions are made in
large and small companies.
• Helps individuals increase their own compensations.
• Improves contributions to the success of the companies
that people work for.
• Understand the trade-offs we face in making personal
financial choices and help us to select the most
appropriate action.

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