Chapter (1)
An Overview of Financial
Management
What Is Finance?
• Finance is defined as “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 is generally divided into three areas: (1) financial management, (2)
capital markets, and (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.
• Investments relate to decisions concerning stocks and bonds and include a
number of activities: (1) Security analysis deals with finding the proper values of
individual securities (i.e., stocks and bonds). (2) Portfolio theory deals with the
best way to structure portfolios, or “baskets,” of stocks and bonds.
Finance within an Organization
Forms of Business Organization
• There are four main forms of business organizations:
• (1) proprietorships,
• (2) partnerships,
• (3) corporations, and
• (4) limited liability companies (LLCs) and limited liability partnerships (LLPs).
• A proprietorship is an unincorporated business owned by one individual.
• Proprietorships have three important advantages:
• (1) They are easy and inexpensive to form,
• (2) they are subject to few government regulations, and
• (3) they are subject to lower income taxes than are corporations.
Cont.
• However, proprietorships also have three important limitations:
• (1) Proprietors have unlimited personal liability for the business’ debts, so they can lose more
than the amount of money they invested in the company.
• (2) The life of the business is limited to the life of the individual who created it, and to bring
in new equity, investors require a change in the structure of the business.
• (3) Because of the first two points, proprietorships have difficulty obtaining large sums of
capital; hence, proprietorships are used primarily for small businesses.
• A partnership is a legal arrangement between two or more people who decide to do business
together.
• Partnerships are similar to proprietorships in that they can be established relatively easily and
inexpensively.
• Moreover, the firm’s income is allocated on a pro rata basis to the partners and is taxed on an
individual basis. This allows the firm to avoid the corporate income tax
Cont.
• A corporation is a legal entity created by a state, and it is separate and distinct
from its owners and managers.
• It is this separation that limits stockholders’ losses to the amount they invested in
the firm.
• Corporations also have unlimited lives, and it is easier to transfer shares of stock
in a corporation than one’s interest in an unincorporated business.
• A major drawback to corporations is taxes. Most corporations’ earnings are
subject to double taxation.
Cont.
• A limited liability company (LLC) is a popular type of organization that is a hybrid
between a partnership and a corporation.
• A limited liability partnership (LLP) is similar to an LLC. LLPs are used for
professional firms in the fields of accounting, law, and architecture.
• LLCs and LLPs provide limited liability protection, but they are taxed as
partnerships.
• Firm must trade off the advantages of incorporation against double taxation.
However, for the following reasons, the value of any business other than a
relatively small one will probably be maximized if it is organized as a corporation:
1. Limited liability reduces the risks borne by investors, and, other things held constant,
the lower the firm’s risk, the higher its value.
2. A firm’s value is dependent on its growth opportunities, which are dependent on
its ability to attract capital.
3.The value of an asset also depends on its liquidity.
The Main Financial Goal: Creating Value for Investors
• In public corporations, managers and employees work on behalf of the
shareholders who own the business, and therefore they have an obligation to
pursue policies that promote stockholder value.
• While many companies focus on maximizing a broad range of financial objectives,
such as growth, earnings per share, and market share, these goals should not
take precedence over the main financial goal, which is to create value for
investors.
Determinants of Value
Cont.
• Intrinsic Value is an estimate of a stock’s “true” value based on accurate risk and
return data. The intrinsic value can be estimated, but not measured precisely.
• Market Price is the stock value based on perceived but possibly incorrect
information as seen by the marginal investor.
• Marginal Investor is an investor whose views determine the actual stock price.
• Equilibrium is the situation in which the actual market price equals the intrinsic
value, so investors are indifferent between buying and selling a stock.
Intrinsic Value
• Actual stock prices are easy to determine—they can be found on the Internet and
are published in newspapers every day.
• However, intrinsic values are estimates, and different analysts with different data
and different views about the future form different estimates of a stock’s intrinsic
value.
• Investing would be easy, profitable, and essentially riskless if we knew all stocks’
intrinsic values—but, of course, we don’t.
• We can estimate intrinsic values, but we can’t be sure that we are right.
Consequences of having a short-run focus
• Corporate Governance is establishment of rules and practices by Board of
Directors to ensure that managers act in shareholders‘ interests while balancing
the needs of other key constituencies.
• This involves putting in place a set of rules and practices to ensure that managers
act in shareholders’ interests while also balancing the needs of other key
constituencies such as customers, employees, and affected citizens.
Stockholder–Manager Conflicts
• Managers might be more interested in maximizing their own wealth than their
stockholders’ wealth; therefore, managers might pay themselves excessive
salaries.
• Effective executive compensation plans motivate managers to act in their
stockholders’ best interests.
• Useful motivational tools include
• (1) reasonable compensation packages,
• (2) firing of managers who don’t perform well, and
• (3) the threat of hostile takeovers.
Stockholder–Debtholder Conflicts
• Conflicts can also arise between stockholders and debtholders.
• 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.
• This situation leads to conflicts between these two groups, to the extent that
stockholders are typically more willing to take on risky projects.
Balancing Shareholder Interests and the Interests of
Society
• Management’s primary financial goal is shareholder wealth maximization.
• Shareholder wealth maximization is the primary financial goal for managers of
publicly owned companies implies that decisions should be made to maximize
the long-run value of the firm’s common stock.
• Managers have an obligation to behave ethically, and they must follow the laws
and other society imposed constraints.
• Most managers understand that maximizing shareholder value does not mean
that they are free to ignore the larger interests of society.
Business Ethics
• Ethics is defined as “standards of conduct or moral behavior.”
• Business ethics can be thought of as a company’s attitude and conduct toward its
employees, customers, community, and stockholders.
• A firm’s commitment to business ethics can be measured by the tendency of its
employees, from the top down, to adhere to laws, regulations, and moral
standards relating to product safety and quality, fair employment practices, fair
marketing and selling practices, the use of confidential information for personal
gain, community involvement, and the use of illegal payments to obtain business.
