Chapter Outline

The Goals and

• Introduction to Finance
Functions of
Chapter Financial
• Forms of Organizations

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• The Risk-Return Tradeoff
Management • Primary Goal of Financial Managers
• Role of Financial Managers

McGraw-Hill/Irwin Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved. 1-2

Relationship between Finance,

Evolution of the Field of Finance
Economics and Accounting
• Economics provides a broad picture of the • At the turn of the century, finance emerged
economic environment for decision making as a field separate from economics
in many important areas • By1930s, because of the Great
• Accounting, the language and tool of Depression, financial practices revolved
finance, provides financial data through: around such topics as:
– Income statements
– Preservation of capital
– Balance sheets
– Maintenance of liquidity
– Statement of cash flows
– Reorganization of financially troubled
• Finance links economic theory with the corporations
numbers of accounting
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– Bankruptcy process 1-4

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 Evolution of the Field of Finance
Meaning of Finance
(cont’d)
• By mid-1950s, finance became more • Finance is the study of money
analytical toward: • Finance means to arrange payment for
– Financial capital (money) being used to • Finance concerned with the nature
purchase real capital (long-term plant and
creation, behavior, regulation and problems
equipment)
of money.
– Cash and inventory management
– Capital structure theory • Finance focuses on how the individuals,
– Dividend policy
businessmen, investors, government and
financial institutions deal.
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Meaning of Financial
Management
• Financial management involves the • planning future operations, controlling
management of finance functions current performance and future
• Fm. Is concerned with the planning developments through financial accounting,
organizing ,directing and controlling the cost accounting ,budgeting ,statics and
financial activities of an enterprise other means .
• Fm. Deals mainly with raising funds in the • Fm. Means the entire range of managerial
most economic and suitable manner, using efforts devoted to the management of
these funds as profitable as possible finance in both its sources and uses of the
enterprise.
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 Modern Issues in Finance Modern Issues in Finance (cont’d)
• Focus has been on:
• The following are significant to financial
– Risk-return relationships (Direct relation)
managers during decision making:
– Liquidity – Return or Risk relationship (Inverse)
– Effects of inflation and disinflation on financial
– Maximization of return for a given level of risk forecasting
– Portfolio management – Required rates of return for capital budgeting
– Capital structure theory decisions
• New financial products with a focus on – Cost of capital
hedging are being widely used(Finance
became more analytical and Mathmatical.
• Inflation – a key variable in financial decisions 1-9 1-10

Risk Management and the Financial

The Impact of the Internet
Crisis
• Recent financial crisis due to: • Internet and its acceptance has enabled
– Unwarranted extension of credit acceleration of e-commerce solutions for
– Creation and sale of mortgage-backed “old economy” companies
securities • E-commerce solutions for existing companies
– Losses from credit defaults in excess of a – B2C
bank’s capital in many cases – B2B
• Creation of complicated and unregulated • Spurt in new business models and companies
financial products like Credit Default Swaps
– Amazon.com
(CDS)
– eBay
• Government action and bail–outs
• New regulations for financial institutions 1-11 1-12

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 The Impact of the Internet (cont’d) Functions of Financial Management
• For any financial manager, e-commerce  Financial management is concerned with
impacts financial management because it managing an entity’s money
affects the pattern and speed with which
cash flows through the firm  Functions:
– B2C model: – Allocate funds to current and fixed assets
• Products are bought with credit cards – Obtain the best mix of financing alternatives
• Credit card checks are performed – Develop an appropriate dividend policy within
• Selling firms get the cash flow faster the context of the firm’s objectives
– B2B model can help companies
• Lower the cost of managing inventory, accounts
receivable, and cash
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Functions of the Financial Manager Risk-Return Trade-Off

• Influences operational side (Capital vs.
Labor / Product A vs. Product B)
• Influences financial mix (Stock vs. Bonds
vs. Retained earnings)

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 Forms of Organization Sole Proprietorship
• Different forms of organizations are: • Represents single-person ownership
– Sole Proprietorship • Advantages:
– Partnership – Simplicity of decision-making
– Corporation – Low organizational and operational costs
• Drawback - Unlimited liability to the owner
• Profits and losses are taxed as though they
belong to the individual owner

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Partnership Partnership (cont’d)

• Similar to sole proprietorship except there • Limited partnership
are two or more owners – One or more partners are designated general
– Articles of partnership specifies: partners and have unlimited liability for the
• The ownership interest debts of the firm
• The methods for distributing profits – Other partners are designated limited partners
• The means of withdrawing from the partnership and are liable only for their initial contribution
• Carries unlimited liability for the owners • Not all financial institutions extend funds to
a limited partnership firm

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 Corporation Corporation (cont’d)
• Corporation • Disadvantage:
– Unique; it is a legal entity unto itself – The potential of double taxation of earnings
− Formed through Articles of Incorporation, • Subchapter S corporation
which specify the rights and limitations of the – Income is taxed as direct income to
entity stockholders and is thus taxed only once as
− Owned by shareholders who enjoy the normal income
privilege of limited liability
− Has a continual life
• Key feature – Easy divisibility of ownership
interest by issuing shares of a stock 1-21 1-22

Corporate Governance Sarbanes-Oxley Act

• Agency theory • Set up a five-member Public Company Accounting
Oversight Board (PCAOB) with responsibility for:
– Examines the relationship between owners
– Auditing standards within companies
and managers of the firm
– Controlling the quality of audits
• Institutional investors – Setting rules and standards for the independence of the
– Have more to say about the way publicly auditors
owned companies are managed • Major focus is to make sure that publicly-traded
corporations accurately present their
– Assets
– Liabilities
– Equity and income on their financial statements
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 Management and Stockholder
Goals of Financial Management
Wealth
• Primary goal – Maximization of profit • Only way to retain power in long run is by
– Drawbacks: becoming sensitive to shareholder
• A change in profit may also represent a change in concerns
risk
• Fails to consider the timing of the benefits
• Sufficient stock option incentives to
• Impossible task of accurately measuring the key motivate achievement of market value
variable “profit” maximization
• Broader goal – Maximizing Shareholder • Powerful institutional investors are making
wealth management more responsive to
– Achieving the highest possible value for the firm shareholders
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Social Responsibility and Ethical

Valuation Approach
Behavior
• The ultimate measure of performance – how the • Adopting policies that:
earnings are valued by the investor
• In analyzing the firm, the investor will consider – Maximize values in the market
the: – Attracts capital
– risk inherent in the firm’s operation
– time pattern over which the firm’s earnings increase or
– Provides employment
decrease – Offers benefits to the society
– quality and reliability of reported earnings
• A finance manager must question the impact of • Certain cost-increasing activities may have
each decision on the firm’s overall valuation to be mandatory (Pollution Control Projects)
• If a decision maintains or increases the firm’s rather than voluntary initially, to ensure
overall value, it is acceptable; otherwise, it should
be rejected burden falls equally over all business firms
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 Social Responsibility and Ethical
The Role of Financial Markets
Behavior (cont’d)
• Insider trading: • Financial markets are the meeting place for
– Using information that is not available to the corporations, institutions and investors.
public and making undue profit from trading • Financial markets are indicators to
– Unethical and illegal practice maximization of shareholder value and any
– Protected against by the Securities and ethical or unethical behavior that may
Exchange Commission (SEC) influence the value of the company
• Ethical behavior creates invaluable
reputation

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Structure and Functions

Continued
of the Financial Markets
• Participants in the financial market range • Distinct parts of financial markets:
from individuals to various Public, Private, – Domestic and international markets
and Government institutions. – Corporate and government markets
• Kinds of Markets: – Money and capital markets
– Public financial markets
– Corporate financial markets

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 Structure and Functions Structure and Functions
of the Financial Markets (cont’d) of the Financial Markets (cont’d)
• Money markets • Capital markets
− Deals with short-term securities that have a life – Deals with securities that have a life of more
of one year or less than one year
− Securities in these markets include: – Long-term markets
− Commercial paper sold by corporations to finance – Securities include:
their daily operations • Common stock
− Certificates of deposit with maturities of less than 12 • Preferred stock
months sold by banks
• Corporate and government bonds
− Banker’s Acceptance
− Treasury Bills

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Return Maximization
The Capital Market
and Risk Minimization
• Primary market • Investors can choose risk level that meets
– When a corporation uses the financial markets to raise their objective and maximizes return for
new funds, the sale of securities is made by way of a that given level of risk
new issue called an initial public offering or IPO
• Secondary market • Companies that are rewarded with high-
priced securities can raise new funds in
- This Market is the Stock Exchange Market money markets and capital markets at a
– Securities are bought and sold amongst the investors
lower cost compared to competitors
– Prices of securities keep changing continually
– Financial managers are given a feedback about their • Firms pay a penalty for failing to perform
firms’ performance competitively
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 Internationalization
Restructuring
of Financial Markets
• Restructuring can result in: • Allocation of capital and a search for lower-
– Changes in the capital structure (liabilities and cost sources of financing in global market
equity on the balance sheet) • The impact of international affairs and
– Selling of low-profit-margin divisions with the technology has resulted in the need for
proceeds from the sale reinvested in better future financial managers to understand
investment opportunities
− International capital flows
– Removal of the current management team or
large reductions in the workforce − Computerized electronic funds transfer
systems
• Also includes mergers and acquisitions − Foreign currency hedging strategies
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Technological Impact
on Capital Markets Chapter One
• Cost reduction in trading securities
• Consolidation among major stock markets
and mergers of brokerage firms with
domestic and international partners
• Creation of electronic communication The End
networks (ECNs)
• Electronic markets like NASDAQ have
gained popularity as against traditional
organized exchanges such as NYSE
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