CHAPTER 1 Introduction to Financial Management Forms of Businesses Goals of the Corporation Stock Prices and Intrinsic Value Some Recent Trends Conflicts Between Managers and Shareholders 1-1

Financial Management Financial management is concerned with the acquisition, financing and the management of assets with goal in mind 1-2

Decision function of financial management can be broken down into three major areas: Investment Financing Asset Management 1-3

Investment decision Investment decision begins with a determination of the total amount of assets needed to be held by the firm-size of the firm –composition of the assets 1-4

Financing decisions Capital structure of the firm- mix of funds i.e. debt financing or equity financing How to acquire the needed funds e.g. short term loan, long term lease agreements, negotiating a sale of bond or stock etc. Matching rule 1-5

Asset management Decision The financial manager is charged with varying degrees of operating responsibility over existing assets Management of current assets The optimal level of a current assets depends on the profitability and flexibility associated with that level in relation to the cost involved in maintaining it Decisions regarding the management of assets must be made in accordance with the underlying objective of the firm: maximize profits 1-6

The decisions to acquire an asset necessitates the financing and management of that asset, whereas financing and management costs affect the decision to invest 1-7

The Business Environment Need to understand environment in which financial managers operate. The form of business organization that a firm chooses is one aspect of the business setting in which it must function 1-8

Alternative Forms of Business Organization Proprietorship Partnership Corporation 1-9

Proprietorships An unincorporated business owned by one individual. Advantages Ease of formation Subject to few regulations No corporate income taxes-only as a part of personal income Disadvantages Difficult to raise capital Unlimited liability-personal wealth at stake Limited life-to the life of the founder 1-10 1-10

Partnerships A partnership exists whenever two or more persons or entities associate to conduct a non corporate business for profit Partnership may operate under different degrees of formality, ranging from informal to formal agreeements: %age of share, %age of NI 1-11 1-11

Partnerships Advantages Disadvantages Ease of formation Subject to few regulations No corporate income taxes Disadvantages Difficult to raise capital Unlimited liability Limited life Difficulty of transferring ownership 1-12 1-12

Corporation Types of corporations: A corporation is a legal entity, having an existence separate and distinct from that of its owner and managers. Owners of a corporation are called stockholders and their ownership is determined by the numbers of stocks owned in that corporation. Types of corporations: Publicly owned Closely held 1-13 1-13

Corporation Advantages Disadvantages Unlimited life Easy transfer of ownership Limited liability Ease of raising capital Disadvantages Double taxation Cost of set-up and report filing 1-14 1-14

The Financial Environment All businesses operate within financial systems: markets, institutions Suppliers and users Suppliers of financial resources are savers, users are investors 1-15

CAREER OPPORTUNITIES IN FINANCE Money & Capital Markets: It deals with securities markets and financial Institutions. Knowledge of valuation techniques, factors effecting interest rates and its effect on securities prices, various financial instruments and financial regulations is required. 1-16

Primary and secondary market Primary market is a new issue market Secondary market, where existing securities are bought and sold 1-17

Financial Institutions Depositary institutions Contractual saving institutions Investment intermediaries 1-18

CAREER OPPORTUNITIES IN FINANCE Investments: Three main functions of investments are Sales Analyzing securities Determining optimal mix of securities for an investor. Financial Management 1-19

Financial Goals of the Corporation The primary financial goal is shareholder wealth maximization, which translates to maximizing stock price. Any financial asset is valuable only to the extent that it generates cash flows Timing of cash flows matter Should firms behave ethically?, investors are risk averse so they will pay more for a stock whose cash flow are relatively certain than those that are risky 1-20

CORPORATION Value of a business setup as a corporation can be maximized due to following reasons: Limited Liability Growth Opportunities Liquidity position 1-21

Financial Staff’s Responsibilities Forecasting & planning Major investment and financing decisions Coordination & Control Dealing with Financial Markets Risk Management 1-22

Factors that affect stock price Projected cash flows to shareholders Timing of the cash flow stream Riskiness of the cash flows 1-23

Stock Prices and Intrinsic Value In equilibrium, a stock’s price should equal its “true” or intrinsic value. 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. 1-24

Determinants of Intrinsic Value and Stock Prices (Figure 1-1) 1-25

Some Important Trends Recent corporate scandals have reinforced the importance of business ethics, and have spurred additional regulations and corporate oversight. The effects of changing information technology have had a profound effect on all aspects of business finance. The continued globalization of business. 1-26

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 plans Direct intervention by shareholders The threat of firing The threat of takeover 1-27