McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 1.0 Introduction to Financial Management Chapter 1

McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 1.1 Chapter Outline 1. Basic Areas of Finance 2. Financial Management Decisions 3. Forms of Organization 4. Goal of Financial Management 5. The Agency Problem 6. Financial Markets

McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Basic Areas Of Finance Corporate finance (Business finance) Investments Financial institutions International finance

McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 1.3 Investments Work with financial assets such as stocks and bonds Evaluate stocks and bonds and decide when to buy or sell Job opportunities Stockbroker or financial advisor Portfolio manager Security analyst

McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 1.4 Financial Institutions Companies that specialize in financial matters Banks – commercial and investment, credit unions, savings and loans Insurance companies Brokerage firms Job opportunities

McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 1.5 International Finance This is an area of specialization among all of the areas discussed so far It may allow you to work in other countries or at least travel on a regular basis Need to be familiar with exchange rates and political risk Need to understand the customs of other countries and speaking a foreign language fluently is also helpful

McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 1.6 Corporate Finance The study of financial decision making in business organizations. The study of basic techniques a financial manager should have.

McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Financial Management Decisions Capital budgeting What long-term investments or projects should we take on? About size, timing and riskiness of future cash flows. Capital structure How should we raise fund? Should we use debt or equity? Concerns about the mix of sources of funds, such as debt (borrowing) and equity (ownership interest), used. Working capital management How do we manage the day-to-day finances of the firm? Concerns about management of short-term assets and liabilities

McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 1.8 Financial Manager The top financial manager within a firm is usually the Chief Financial Officer (CFO) Treasurer – oversees cash management, credit management, capital expenditures and financial planning Controller – oversees taxes, cost accounting, financial accounting and data processing

McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Forms of Organization Three major forms in the united states Sole proprietorship: A business owned by a single individual. Partnership: A business formed by two or more individuals or entities. General: unlimited liability for all partners Limited: general partners vs. limited partners Corporation: A business created as a distinct legal entity owned by one or more individuals or entities. Limited liability company: operate and taxed like a partnership but retain limited liability for owners

McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 1.10 Sole Proprietorship Advantages Easiest to start Least regulated Single owner keeps all the profits Taxed once as personal income Disadvantages Limited to life of owner Equity capital limited to owner’s personal wealth Unlimited liability Difficult to sell ownership interest

McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 1.11 Partnership Advantages Two or more owners More capital available Relatively easy to start Income taxed once as personal income Disadvantages Unlimited liability General partnership Limited partnership Partnership dissolves when one partner dies or wishes to sell Difficult to transfer ownership

McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 1.12 Corporation Advantages Limited liability Unlimited life Separation of ownership and management Transfer of ownership is easy Easier to raise capital Disadvantages Separation of ownership and management Double taxation (income taxed at the corporate rate and then dividends taxed at personal rate)

McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Goal Of Financial Management What should be the goal of a corporation? Maximize profit? Minimize costs? Maximize market share? Maximize the current value of the company’s stock?

McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin The Agency Problem Agency relationship Principal hires an agent to represent their interest Stockholders (principals) hire managers (agents) to run the company Agency problem Conflict of interest between principal and agent Management goals and agency costs

McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 1.15 Managing Managers Managerial compensation Incentives can be used to align management and stockholder interests The incentives need to be structured carefully to make sure that they achieve their goal Corporate control The threat of a takeover may result in better management Other stakeholders

McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Financial Markets Cash flows to the firm (Figure 1.2) Primary markets: original sale by governments and corporations Public offerings vs. private placement Secondary markets: securities bought and sold after the original sale Auction vs. dealer markets Listed (stocks that trade on an exchange are said to be listed) vs. over the counter securities NYSE (New York Stock Exchange) NYSE NASDAQ (National Association of Security Dealers Automated Quotations system) NASDAQ

McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 1.17 Figure 1.2

McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 1.18 Review Questions 1. What are the four basic areas of finance? 2. What are the three types of financial management decisions and what questions are they designed to answer? 3. What are the three major forms of business organization? 4. What is the goal of financial management? 5. What are agency problems and why do they exist within a corporation? 6. What are primary and secondary markets? What types of market are NYSE and NASDAQ respectively?

McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 1.19 Sample Question The Board of Directors of Beeline, Inc. have decided to base the salary of its financial manager entirely upon the market share of the firm. Accordingly, 1. the firm may incur some agency costs since the manager will be focused on the market share of the firm rather than acting to maximize earnings. 2. the financial manager will always act in the best interest of the shareholders since all agency costs have been eliminated through salary incentives. 3. the manager may not act to maximize the current value of the firm's stock, resulting in agency costs for the firm's stockholders.