© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part. An Overview of Financial Management Chapter 1 1-1

© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part. What Is Finance? Finance can be defined as the science and art of managing money. Personal level: finance is concerned with individuals’ decisions about how much of their earnings they spend, how much they save, and how they invest their savings. Business context: finance involves how firms raise money from investors, how firms invest money in an attempt to earn a profit, and how they decide whether to reinvest profits in the business or distribute them back to investors. 1-2

© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part. What Is Finance? (cont’d....) Finance grew out of economics and accounting. Economists developed the idea that an asset’s value is based on the future cash flows that it will provide. Accountants provided estimates regarding the likely size of those cash flows. Thus, finance lies between economics and accounting. 1-3

© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part. Why Study Finance? Because the consequences of most business decisions are measured in financial terms, the financial manager in any organization plays a key operational role. People in all areas of responsibility—accounting, information systems, management, marketing, operations, and so forth—need a basic awareness of finance so they will understand how to quantify the consequences of their actions. 1-4

© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part. The financial system is the process by which money flows from savers to users. Households, businesses, government, financial institutions, intermediaries and financial markets together form the financial system. The Financial System 1-5

© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part. SAVERS – those with excess fund because they do not spend all of their current income. USERS – their spending needs exceed their current income for which they have a deficit and need additional fund. Transfer of fund from savers to users: (i) Direct transfers: occur when a business sells its stocks or bonds directly to savers. (ii) Indirect transfer through an investment bank - The company sells its stocks or bonds to the investment bank, which then sells these same securities to savers. (iii) Indirect transfer through financial intermediary - Here the intermediary obtains funds from savers in exchange for its securities. The intermediary uses this money to buy and hold businesses’ securities, while the savers hold the intermediary’s securities. The Financial System (cont’d….) 1-6

© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part. Three areas of Finance Financial Management Corporate Finance Decisions regarding acquiring and funding for assets How to maximize firm’s value Capital Markets Markets where prices of bonds and stocks are determined Financial institutions like banks, brokers, insurance companies are studied here Also studied are government agencies relating to fiscal and monetary policies Investments Decisions to use money to generate more. Most common types of investment is bonds and stocks Includes: Security analysis, portfolio theory, market analysis, behavioral finance.

© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part. Financial Markets Financial asset Markets Spot Markets & Futures Markets Money Markets & Capital Markets Primary Markets & Secondary Markets

© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part. Financial Markets (cont’d…) Financial asset Markets deal with financial securities like stocks, bonds, notes, derivative. Spot Markets are markets in which assets are bought or sold for “on-the-spot” delivery. Spot market prices are the current prices of the asset. Futures Markets are markets in which participants agree today to buy or sell an asset at some future date at a particular price. Prices at the futures market are estimated. – Transactions in the futures market can reduce risk. This is called hedging.

© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part. Financial Markets (cont’d…) Money Markets are the markets for short-term, highly liquid debt securities. NY, London and Tokyo money markets are the largest in the world. Capital Markets are the markets for intermediate or long-term debt and equity securities. All the stock exchanges in the world are examples of Capital Market.

© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part. Financial Markets (cont’d…) Primary Markets are the markets in which corporations raise new capital. When securities are sold for the first time directly from the issuer it is a transaction in the primary market. Secondary Markets are markets in which existing, already outstanding, securities are traded among investors.

© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part. Ideally, the primary goal of any corporation should be: Maximization of Shareholder Wealth/Value! Value creation occurs when we maximize the share price for current shareholders and not necessarily the profit. Shareholder wealth is determined by: shareholder wealth = no. of shares outstanding*current stock price This does not mean maximize shareholder value “at all costs.” Managers have an obligation to behave ethically, and they must follow the laws and other society-imposed constraints STOCK PRICES AND SHAREHOLDER VALUE 1-12

© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part. STOCK PRICES AND SHAREHOLDER VALUE What determines the price of the stock? – Value of any asset is present value of cash flow stream to owners, so high dividends will increase stock price – Good decisions – Stock prices change over time as conditions change and as investors obtain new information about a company’s prospects. 1-13

© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part. Intrinsic Value and Stock Price A stock’s intrinsic value is determined by it’s ability to generate cash now and in the future. – Intrinsic value is an estimate of stock’s “true” value based on accurate risk and historical return data. This value is an estimate as future cash flows cannot be determined with certainty.

© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part. Intrinsic Value and Stock Price Stock Prices are seldom equal to it’s intrinsic value. The prices of stocks in the market are determined by it’s demand and supply. – The investors’ demand of stocks are based on their “perceived” risk and return. “Perceived” means what the investors expect of the future.

© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part. 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 1-16

© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part. 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). This is called the agency problem or the principal-agent problem. Stockholders (principals) hire managers (agents) to run the company Agency problem Conflict of interest between principal and agent But the following factors affect managerial behavior: – Managerial compensation packages – Direct intervention by shareholders – The threat of firing – The possibility of takeover 1-17

© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part. Conflicts Between Stockholders and Bondholders (i)Stockholders are more likely to prefer riskier projects, because they are benefitted more if the project succeeds. By contrast, bondholders receive fixed payments regardless of how well the company does and are more interested in limiting risk. (ii)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. 1-18