An Overview of Financial Management Chapter 1 An Overview of Financial Management

What is finance? Definitions of finance: 1. VERB When someone finances something such as a project or a purchase, they provide the money that is needed to pay for them. Finance is also a noun. N-UNCOUNT A United States delegation is in Japan seeking finance for a major scientific project. 2. N-UNCOUNT : also N in pl Finance is the commercial or government activity of managing money, debt, credit, and investment. 3. N-UNCOUNT : also N in pl Finance is usually the biggest problem for students.

Finance versus Economics and Accounting Finance as we know it today grew out of economics and accounting. Economists developed the notion that an asset’s value is based on the future cash flows the asset will provide. Accountants provided information regarding the likely size of those cash flows. Finance then grew out of and lies between economics and accounting, so people who work in finance need knowledge of those two fields. As discussed next, in the modern corporation, the accounting department falls under the control of the chief financial officer (CFO).

Forms of Business Organization A proprietorship is an unincorporated business owned by one individual. A partnership is a legal arrangement between two or more people who decide to do business together. A corporation is a legal entity created by a state, and it is separate and distinct from its owners and managers. A limited liability company (LLC) or a limited liability partnership (LLP) are relatively new types of organization that are hybrids between a partnership and a corporation.

Proprietorships and Partnerships Advantages Ease of formation Subject to few regulations Lower income taxes than corporations Disadvantages Unlimited liability Limited life Difficult to raise capital Often set up through LLCs/LLPs.

Corporation Advantages Disadvantages Unlimited life Easy transfer of ownership Limited liability Ease of raising capital Disadvantages Double taxation Cost of setup and report filing

Balancing Shareholder Value and Society Interests The primary financial goal of management is shareholder wealth maximization, which translates to maximizing stock price. Value of any asset is present value of cash flow stream to owners. Most significant decisions are evaluated in terms of their financial consequences. Stock prices change over time as conditions change and as investors obtain new information about a company’s prospects. Managers recognize that being socially responsible is not inconsistent with maximizing shareholder value.

Stock Prices and Intrinsic Value In equilibrium, a stock’s price should equal its “true” or intrinsic value. Intrinsic value is a long-run concept. To the extent that investor perceptions are incorrect, a stock’s price in the short run may deviate from its intrinsic value. Ideally, managers should avoid actions that reduce intrinsic value, even if those decisions increase the stock price in the short run.

Some Important Business Trends Corporate scandals have reinforced the importance of business ethics, and have spurred additional regulations and corporate oversight. Increased globalization of business. The effects of ever-improving information technology have had a profound effect on all aspects of business finance. Stockholders now have more control of corporate governance.

Conflicts Between Managers and Stockholders Managers are naturally inclined to act in their own best interests (which are not always the same as the interest of stockholders). But the following factors affect managerial behavior: Managerial compensation packages Direct intervention by shareholders The threat of firing The threat of takeover

Conflicts Between Stockholders and Bondholders Stockholders are more likely to prefer riskier projects, because they receive more of the upside if the project succeeds. By contrast, bondholders receive fixed payments and are more interested in limiting risk. Bondholders are particularly concerned about the use of additional debt. Bondholders attempt to protect themselves by including covenants in bond agreements that limit the use of additional debt and constrain managers’ actions.

Classical Finance This course will focus on the basic theory of classical finance. It views the firm as a simple flow of financial streams from investments. It assumes that managers and investors have no conflicting interests. The capital markets are perfect. And so on…. The resulting theory is simple and practical, and thus used widely in actual business.