1 Chapter 01 Introduction to Financial Management McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.

What is Finance? Finance applies specific value to – things owned – services used – decisions made Financial management – organization’s approach to valuation 1-2

Economic Participants Two dimensions – Participants with “extra” investment money – Participants with economically viable ideas 1-3

Type 1 Participants – Do not lend or spend in business context – No direct role in financial markets – Indirect role: to provide labor and consume products Economic Participants 1-4

Type 4 Participants – Use financial tools evaluate own businesses choose highest-potential ideas – Are self-funded, so no need for financial markets Economic Participants 1-5

Types 2 and 3 Participants – use financial institutions and financial markets for mutually beneficial exchange Type 2: makes temporary loans to Type 3 Type 3: typically consists of companies engaging in R & D Economic Participants 1-6

Where Does the Cash Go? Economically successful projects repay money (plus profit) to investors Friction occurs when not all cash is returned to investors - Retained Earnings - Taxes 1-7

Figure 1.4 Complete Cash Flows of Finance 1-8

Subareas of Finance Investments – involves methods and techniques for making decisions about what kinds of securities to own 1-9

Subareas of Finance Financial management – Decisions about acquiring and using cash – Examples include Organizing and raising capital Tax decisions Projects to fund 1-10

Subareas of Finance Financial institutions and markets – Facilitate flow of capital between investors and companies International finance – Finance theory used in global business environment 1-11

Financial Decision Application & Theory Risk – Uncertainty of future cash flows due to timing and size Financial Asset – Ownership in cash flow represented by securities like stocks, bonds, and other assets 1-12

Real Assets – Physical property like gold, machinery, equipment, real estate Real Markets – Places/processes that facilitate real asset trading Time Value of Money (TVM) – Theory and application of valuing cash flows at various points in time Financial Decision Application & Theory 1-13

Finance vs. Accounting Accounting – tracks what happened to firm’s money in the past Financial Management – combines historical figures and current information – determines what should happen with firm’s money now and in the future 1-14

The Financial Manager Chief Financial Officer – Highest level financial officer Controller – Oversees accounting function Treasurer – Responsible for managing cash, credit, financing, capital budgeting, risk management CFOControllerTreasurer 1-15

Finance in Other Business Functions CFO and Treasurer – most visible finance-related positions Finance permeates the organization Used to develop and manage strategy Used in day-to-day business operations – Operations – Marketing – Human Resources 1-16

Finance in Your Personal Life Help you make good personal financial decisions – Borrowing money for a new car – Refinancing home mortgage at lower rate – Making credit card or student loan payments – Saving for retirement 1-17

Business Organization Single owners, partners, and corporations operate businesses Advantages and disadvantages related to Controls and ownership of firm Owners’ risks Access to capital and tax ramifications 1-18

Business Form Types Sole Proprietorships General Partnerships Corporations Hybrids 1-19

Sole Proprietorships Not legally separate from the owner – Advantages Easy to start Light regulatory and paperwork burden Single taxation at the personal tax rate – Disadvantages Unlimited liability Limited access to capital 1-20

General Partnerships Partners own the business together – Advantages Relatively easy to start Single taxation – Disadvantages Partners jointly share unlimited liability Personally liable for legal actions and debts of firm Difficult to raise large amounts of capital 1-21

Public Corporations Legally independent entity entirely separate from its owners – Advantages Limited liability for owners Can raise large amounts of capital Easy to transfer ownership – Disadvantages Double taxation (corporate level and personal level) 1-22

Hybrid Organizations Combine attributes of several forms – Advantages Offer single taxation and limited liability to all owners – S Corporations – Limited Liability Partnerships (LLPs) – Limited Liability Companies (LLCs) 1-23

Firm Goals Owner seeks to maximize shareholder wealth and company’s value through – Maximizing present value of future cash flows – Maximizing owners’ equity – Decisions about attracting additional funds projects in which to invest returning profits to owners over time 1-24

Maximize value of owners’ equity – Increase current value per share (stock price) of existing shares Common methods – Maximize net income or profit – Minimize costs – Maximize market share Corporate Goals 1-25

Agency Theory Problems arise when principal (shareholder) hires agent (manager) to operate firm but cannot monitor the agent’s actions Manager’s interest may not be aligned with shareholder goals 1-26

Three approaches to minimizing this conflict of interest – Ignore if effect is minimal – Use accountants, debt holders to monitor managers – Provide incentives to managers Equity stakes Stock options Employee Stock Option Plan (ESOP) Agency Theory 1-27

Corporate Governance Set of laws, policies, incentives, and monitors designed to handle issues arising from the separation of ownership and control Current CG Issues – may-raise-corporate-governance-issues-at-infy _1.html may-raise-corporate-governance-issues-at-infy _1.html 1-28

Inside monitors – Board of Directors Hires the CEO Evaluates management Designs compensation plans Corporate Governance 1-29

Outside monitors Auditors Analysts Banks Credit rating agencies Corporate Governance 1-30

Corporate Governance Monitors 1-31

Ethics Financial professionals manage other people’s money – Corporate managers – Bankers – Investment advisors Ethical dilemmas of corporate agency relationship – Stealing from firms = stealing from shareholders 1-32

Financial Markets and Intermediaries Financial markets and financial intermediaries – Facilitate flow of capital from investors to firms and back to investors – Earn very high profits because of specialized expertise and assets 1-33

Financial Institution Cash Flows 1-34

The Financial Crisis Subprime Mortgage Borrowers – Higher-risk borrowers charged higher interest rates due to higher risk of default Securitization – Loan originators sell the loan repayment rights to other financial institutions or investors 1-35

ml?pagewanted=all ml?pagewanted=all Sparked by collapse of U.S. home prices in late 2006 and 2007 Spread to other financial institutions via affected mortgage-backed securities Resulted in credit tightening by financial institutions; loss of confidence by consumers The Financial Crisis 1-36

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