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Introduction to Financial
Management
Goals of the Corporation
The Agency Problem
Corporate Governance
Stock Prices and Intrinsic Value
Financial Markets
Are Markets Efficient?
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Goal of the Firm
What is the
goal of the
firm?
Maximize
profit?
Maximize
EPS?
Minimize
operating
costs?
Maximize
firm
value?
Maximize
stock
price?
Maximize
shareholder
wealth?
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What is Financial Management?
Financial Management is an area of finance dealing
with the financial decisions corporations make and the
tools and analysis used to make these decisions. The
primary goal of corporate finance is to enhance
corporate value while reducing the firm's financial risks.
Equivalently, the goal is to maximize the corporations'
return on capital.
Examples
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Role of Finance in a Typical Business
Organization
Board of Directors
President
VP: Sales VP: Finance VP: Operations
Treasurer Controller
Credit Manager
Inventory Manager
Capital Budgeting Director
Cost Accounting
Financial Accounting
Tax Department
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Alternative Forms of Business
Organization
Sole proprietorship
Partnership
Corporation
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Sole Proprietorships & Partnerships
Advantages
Ease of formation
Subject to few regulations
No corporate income taxes
Disadvantages
Difficult to raise capital
Unlimited liability
Limited life
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Corporation
Advantages
Unlimited life
Easy transfer of ownership
Limited liability
Ease of raising capital
Disadvantages
Double taxation
Cost of set-up and report filing
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Goals of The Corporation
Shareholders desire wealth maximization
The primary financial goal is to maximize stock price
Do managers maximize shareholder wealth?
Is stock price maximization good or bad for society?
Do firms have any responsibilities to society at large?
Should firms behave ethically?
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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.
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Firms Have Many Stakeholders
Value Maximization and Stakeholder Theory,
Harvard Business School, April 2000. Published
in J ensen, Michael, Value Maximization,
Stakeholder Theory, and the Corporate
Objective Function, Journal of Applied Corporate
Finance, Fall 2001, pp. 8-21.
Who are the stakeholders?
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The Agency Problem
Conflicts Between Managers and Stockholders
Conflict of interest between management and owners
Managers are naturally inclined to act in their own best
interests (which are not always the same as the interest
of stockholders).
Conflict Between Shareholders and Creditors
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Agency Problem Solutions
Tools to Ensure Management Pays Attention to the
Value of the Firm
Compensation plans
Financial incentives such as stock options
Board of Directors
Managers actions are subject to the scrutiny of the
board of directors
Takeovers
Shirkers are likely to find they are ousted by more
energetic managers
Specialist Monitoring
Auditors
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Factors that Affect Stock Price
Projected cash flows
to shareholders
Timing of the cash
flow stream
Riskiness of the cash
flows
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Stock Prices and Intrinsic Value
In equilibrium, a stocks price should equal its
true or intrinsic value.
To the extent that investor perceptions are
incorrect, a stocks 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.
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Determinants of Intrinsic Value and Stock
Prices
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Responsibility of the Financial Staff
Maximize stock value by:
Forecasting and planning
Investment and financing decisions
Coordination and control
Transactions in the financial markets
Managing risk
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What is a Market?
A market is a venue where goods and services
are exchanged.
A financial market is a place where individuals
and organizations wanting to borrow funds are
brought together with those having a surplus of
funds.
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Types of Financial Markets
Physical assets vs. Financial assets
Money vs. Capital
Primary vs. Secondary
Spot vs. Futures
Public vs. Private
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Importance of Financial Markets
Well-functioning financial markets facilitate the flow of
capital from investors to the users of capital.
Markets provide savers with returns on their money
saved/invested, which provides them money in the future.
Markets provide users of capital with the necessary funds
to finance their investment projects.
Well-functioning markets promote economic growth.
Economies with well-developed markets perform better
than economies with poorly-functioning markets.
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Derivative Markets
A derivative securitys value is derived from the price of
another security (e.g., options and futures).
Can be used to hedge or reduce risk. For example, an
importer, whose profit falls when the dollar loses value,
could purchase currency futures that do well when the
dollar weakens.
Speculators use derivatives to bet on the direction of
future stock prices, interest rates, exchange rates, and
commodity prices.
In many cases, these transactions produce high returns
if you guess right, but large losses if you guess wrong.
Here, derivatives can increase risk.
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Historical Stock Market Performance:
S&P 500 (1968-2004)
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Where can you find a stock quote, and
what does one look like?
Stock quotes can be found in a variety of print sources (Wall Street
Journal or the local newspaper) and online sources (Yahoo!Finance,
CNNMoney, or MSN MoneyCentral).
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Are Markets Efficient?
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How Investors Interpret Changes in
Corporate Financial Policy
In May 1987, Apple Computer announced that it would
pay $5 million in cash dividends on its common stock for
the first time in its history. On the day of the
announcement, the market value of Apple's equity rose
by $219 million.
In May 1986, Emhart announced that it intended to issue
2.75 million shares to raise $102 million in new equity.
Following the announcement, the market value of its
existing equity fell by $23 million.
In February 1989, General Motors declared a 2-for-1
stock split for the first time since 1955, and increased its
dividends. The announcement led the market value of
GM's equity to increase by $1.3 billion.
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Efficient Market Hypothesis (EMH)
Securities are normally in equilibrium and are
fairly priced.
Investors cannot beat the market except
through good luck or better information.
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Random Walk Theory
The movement of stock prices from day to day
DO NOT reflect any pattern.
Statistically speaking, the movement of stock
prices is random (but skewed positive over the long term).
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Random Walk Theory
$103.00
$100.00
$106.09
$100.43
$97.50
$100.43
$95.06
Coin Toss Game
Heads
Heads
Heads
Tails
Tails
Tails
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Random Walk Theory
S&P 500 Fi ve Year Trend?
or
5 yrs of the Coi n Toss Game?
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130
180
230
Month
L
e
v
e
l
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Levels of Market Efficiency
Weak Form Efficiency
Market prices reflect all historical information
Semi-Strong Form Efficiency
Market prices reflect all publicly available information
Strong Form Efficiency
Market prices reflect all information, both public and
private
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Weak-Form Efficiency
Cant profit by looking at past trends. A recent
decline is no reason to think stocks will go up
(or down) in the future.
Evidence supports weak-form EMH, but
technical analysis is still used.
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Semistrong-Form Efficiency
All publicly available information is reflected in
stock prices, so it doesnt pay to over analyze
annual reports looking for undervalued
stocks.
Largely true, but superior analysts can still
profit by finding and using new information.
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Strong-Form Efficiency
All information, even inside information, is
embedded in stock prices.
Not true--insiders can gain by trading on the
basis of insider information, but thats illegal.
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Implications of Market Efficiency
You hear in the news that a medical research company
received FDA approval for one of its products. If the
market is semi-strong efficient, can you expect to take
advantage of this information by purchasing the stock?
A small investor has been reading about a hot IPO that
is scheduled to go public later this week. She wants to
buy as many shares as she can get her hands on, and is
planning on buying a lot of shares the first day once the
stock begins trading. Would you advise her to do this?
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A T y p i c a l C A A R P l o t
F I G U R E 2 : C A A R O F T A R G E T F I R M S
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0
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1 0
1 2
1 4
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- 6 5 - 6 0 - 5 5 - 5 0 - 4 5 - 4 0 - 3 5 - 3 0 - 2 5 - 2 0 - 1 5 - 1 0 - 5 0 5 1 0 1 5 2 0 2 5
D A Y
P
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T
A
G
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D. Ding, Acquisition Announcements and Shareholder Wealth: Evidence from
an Emerging Market, Journal of Emerging Markets, U.S.A., Spring 1999, pp. 5-26.
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Regulator's remark on foreign investment
spurs Asian markets
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A remark by a Chinese regulator indicating that the
country's future quotas for foreign investment could be
increased as much as tenfold lifted shares across Asia
on Monday. The Nikkei jumped 1.40% to 10,801.57,
the Hang Seng rose 0.64% to 23,413.26, the Kospi
added 0.52% to 2,007.04 and the ASX was up 0.22%
at 4,719.70. Bloomberg (14/1/13)
Why?
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Conclusions About Market Efficiency
Empirical studies suggest the stock market is:
Highly efficient in the weak form.
Reasonably efficient in the semistrong form.
Not efficient in the strong form. Insiders have made abnormal
(and sometimes illegal) profits.
Behavioral finance
Incorporates elements of cognitive psychology to better
understand how individuals and markets respond to different
situations.
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Summary
Questions and Answers