Chapter 1 - An Introduction to Financial Management Chapter 1 - An Introduction to Financial Management  2005, Pearson Prentice Hall

Finance  The art and science of managing money

Financial Management  Is concerned with the maintenance and creation of economic value or wealth

Goal of the Firm 1) Profit Maximization? this goal ignores: a) TIMING of Returns (Time Value of Money - Ch. 5) b) UNCERTAINTY of Returns (Risk - Ch. 6)

Goal of the Firm 2) Shareholder Wealth Maximization? this is the same as: a) Maximizing Firm Value b) Maximizing Stock Price

Legal Forms of Business 1) Sole Proprietorship  A business owned by a single individual and that has a minimum amount of legal structure  Advantages:  Easily established with few complications  Minimal organizational costs  Does not have to share profits or control with others  Disadvantages:  Unlimited liability of the owner  Owner must absorb all losses  Equity capital limited to the owner’s personal investment  Business terminates immediately upon death of owner

Legal Forms of Business 2) Partnership  An association of two or more individuals joining together as co- owners to operate a business for profit.

2a) General Partnership  Relationship between partners I dictated by the partnership agreement  Advantages:  Minimal organizational requirements  Disadvantages  All partners have unlimited liability  Difficult to raise large amounts of capital  Partnership dissolved by the death or withdrawal of general partner Legal Forms of Business

2b) Limited Partnership  Consists of at least one general partner and one or more limited partners (investors)  Advantages:  For limited partners, liability limited to the amount of capital invested in the company  Withdrawal or death of a limited partner does not affect continuity of the business  Stronger inducement in raising capital  Disadvantages:  For general partners, they have unlimited liability in the partnership  Names of limited partners may not appear in the name of the firm  Limited partners may not participate in the management of the business  More expensive to organize than general partnership, as written agreement is mandatory Legal Forms of Business

2c) Limited Liability Company (LLC)  Cross between a partnership and a corporation.  Owners have limited liability, but the firm runs and is taxed like a partnership. Legal Forms of Business

3) Corporation  A business entity having the power to purchase, sell, and own assets and to incur liabilities while existing separately and apart from its owners.  Advantages:  Limited liability of owners  Ease of transferability, i.e., by the sale of one’s shares of stock  Death of an owner does not result in the discontinuity of the firm’s life  Ability to raise large amounts of capital is increased  Disadvantages:  Most difficult and expensive form of business to establish  Control of corporation not guaranteed by partial ownership of stock. Legal Forms of Business

Vice President for Finance, also called th Chief Financial Officer (CFO)  Serves under the corporation’s CEO and is responsible for overseeing financial planning, corporate strategic planning, and controlling the firm’s cash flow  Treasurer and controller serve under the CFO. Role of the Financial Manager in a Corporation

Treasurer  Handles the firm’s financial activities, including cash and credit management, making capital expenditure decisions, raising funds, financial planning, and managing any foreign currency received by the firm Role of the Financial Manager in a Corporation

Controller  Responsible for managing the firm’s accounting duties, including producing financial statements, cost accounting, paying taxes, and gathering and monitoring the data necessary to oversee Role of the Financial Manager in a Corporation

The Corporation and Financial Markets Government CorporationInvestors

The Corporation and Financial Markets cash Government securities CorporationInvestors Raising capital

The Corporation and Financial Markets Government cash securities CorporationInvestors Secondary markets Raising capital

The Corporation and Financial Markets cash Investors Secondary markets Government securities Cash flow reinvest tax Corporation dividends, int., etc. Raising capital

 Primary Market  Market in which new issues of a security are sold to initial buyers.  Secondary Market  Market in which previously issued securities are traded. The Corporation and Financial Markets

 Initial Public Offering (IPO)  The first time the firm’s stock is sold to the general public.  Seasoned New Issue  A new stock offering by a firm that already has stock that is traded in the secondary market. The Corporation and Financial Markets

Ten Principles of Financial Management Principle 1: Risk-return tradeoff - we won't take additional risk unless we expect to be compensated with additional return.

Ten Principles of Financial Management Principle 2: Time value of money - a dollar received today is worth more than a dollar received in the future.

Ten Principles of Financial Management Principle 3: Cash -- Not Profits -- is King -In measuring value we will use cash flows rather than accounting profits because it is only cash flows that the firm receives and is able to reinvest. -In measuring value we will use cash flows rather than accounting profits because it is only cash flows that the firm receives and is able to reinvest.

Ten Principles of Financial Management Principle 4: Incremental cash flows count - In making business decisions we will only concern ourselves with what happens as a result of that decision.

Ten Principles of Financial Management Principle 5: The curse of competitive markets - In competitive markets, extremely large profits cannot exist for very long because of competition moving in to exploit those large profits. As a result, profitable projects can only be found if the market is made less competitive, either through product differentiation or by achieving a cost advantage. - In competitive markets, extremely large profits cannot exist for very long because of competition moving in to exploit those large profits. As a result, profitable projects can only be found if the market is made less competitive, either through product differentiation or by achieving a cost advantage.

Ten Principles of Financial Management Principle 6: Efficient Capital Markets - The markets are quick and the prices are right.

Ten Principles of Financial Management Principle 7: The agency problem - managers won't work for the owners unless it's in their best interest. The agency problem is a result of the separation between the decision makers and the owners of the firm. As a result managers may make decisions that are not in line with the goal of maximization of shareholder wealth.

Ten Principles of Financial Management Principle 8: Taxes bias business decisions.

Ten Principles of Financial Management Principle 9: All risk is not equal - since some risk can be diversified away and some cannot. The process of diversification can reduce risk, and as a result, measuring a project’s or an asset's risk is very difficult.

Ten Principles of Financial Management Principle 10: Ethical dilemmas are everywhere in finance.  Ethical behavior is doing the right thing, and it is important in financial management, just as it is important in everything we do. Unfortunately, precisely how we define what is and what is not ethical behavior is sometimes difficult. Nevertheless, we should not give up the quest.