A

Learning Objectives
1. Describe what the subject of financial
management is about.
2. Explain the goal of the firm.
Chapter 1
3. Compare the various legal forms of business
and explain why the corporate form of
An Introduction to Financial
business is the most logical choice for a firm
Management
that is large or growing.

By Keown,
Keown, Martin, Petty & Scott 4. Explain the 10 principles that form the basics
of financial management.

What is Finance? Goal of the firm

 We will designate maximization of
 Maintenance & creation of economic shareholder wealth
value or wealth i.e. maximization of the total market value of
Ex. 2 firms: Merck & GM in end 2003 the firm's common stock
– Merck, a large pharmaceutical company (price of the existing common stock)
Total market value $103 B
Investments over the life of the business $ 30 B
to be the goal of the firm.
Value creation $ 73 B  Scarce resources are directed to the most
– General Motors GM, car company productive use by businesses competing to
Total market value $ 30B create wealth
Investments over the years $ 85B
Loss in value $ 55B

Goal of the firm Profit Maximization

 We will designate maximization of shareholder
wealth
To understand this goal and its inclusive nature it is
first necessary to understand the difficulties
involved with the frequently suggested goal of
profit maximization.
Why not profit maximization?
 Stresses the efficient use of capital
resources.
It assumes away many of the complexities of
the real world.
- It assumes away uncertainty of returns,
returns,
i.e. projects are compared by examining their
expected values or weighted average profit.
- It assumes away timing differences of returns
(not specific about the time frame)
- It tends to focus on short term increase in profits
 Is unacceptable and a more realistic goal
is needed.
Profit Maximization
 Weaknesses
– Ignores uncertainty and risk
 Projects & investment alternatives compared
i.t.o.
i.t.o. expected values or weighted average
profits
 Calculations do not reflect whether one project
riskier than another
– Ignores timing of the project’
project’s returns
 Given equivalent cash flows from profits, we
want those cash flows sooner rather than later.
Maximization of Shareholder
Wealth
 We have chosen the goal of shareholder
wealth maximization
i.e. Maximize the market value of the existing
shareholders’
shareholders’ common stock
Modifying the goal of profit maximization
 Considers complexities of the operating
environment
 Includes effects of all financial decisions
Maximization of Shareholder
Wealth
– Investors react to the firm’
firm’s investment or
dividend decisions
 Poor decisions  total value of the firm’
firm’s stock
falls
 Good decisions  pushes up the price of the
stock
 Good decisions create wealth for the
shareholder
 Over the long run, price = value
Note that shareholders are the legal owners of
the firm
Profit Maximization
 Weaknesses
– Accounting profits ignores cost of funds
provided by the firm’firm’s shareholders.
 i.e. it only considers interest expense as a
cost of borrowing money
 ex. New investment will earn 8%
But could earn 12% on another
investment of similar risk
Maximization of Shareholder
Wealth
 To employ this goal we need not consider
every price change to be a market
interpretation of the worth of our
decisions.
What we do focus on is the effect that our
decision should have on the stock price if
everything were held constant.
Maximize Shareholder Wealth!!!
 Why?
 Because maximizing shareholder wealth properly
considers cash flows, the timing of these cash flows,
and the risk of these cash flows.
 This can be illustrated using the following simple
valuation equation: level & timing
of cash flows
Share Price = Future Dividends
risk of cash
Required Return
flows
Maximization of Shareholder Maximization of Shareholder
Wealth Wealth
 The agency problem Year Asset 1 Asset 2 Asset 3
1 $42,000 $15,000 $16,000
It is a result of the separation between 2 30,000 30,000 38,000
the decision makers and the owners of 3 15,000 42,000 42,000
the firm. Sum $87,000 $87,000 $96,000

As a result managers may make decisions

As a financial manager, what asset would you
that are not in line with the goal of
choose?
maximization of shareholder wealth.
 Based on profit maximization goal
 Based on shareholder wealth maximization goal

Legal Forms of Business Sole proprietorship

Organization
 Sole proprietorship is a business owned by a single
 Three most common categories:
person who operates it for his/her own profit and has a
– Sole proprietorship
minimum amount of legal structure.
– Partnership
About 75% of all business firms
– Corporation
Examples: market vendors, s-s stores
Majority found in the wholesale, retail, and
construction industries

Sole proprietorship Sole proprietorship

Typically, the proprietor with a few employees
operates the business, raises capital from personal
resources or from borrowings, and is responsible for
all business decisions.
Has unlimited liability, his/her wealth and not
merely the amount of original investment can be
taken to satisfy creditors
Termination occurs on the owner’
owner’s death, or by
choice
 Advantages
a. Easily established with few complications
b. Minimal organizational costs
c. Does not have to share profits or control with
others
 Disadvantages
a. Unlimited liability for the owner
b. Owner must absorb all losses
c. Equity capital limited to the owner's personal
investment
d. Business terminates immediately upon death of
owner
Partnership
 Partnership is an association of two or more
individuals coming together as co-
co-owners to operate a
business for profit.
Account for about 10% of all business firms
Typically larger than sole proprietorship
Most common: finance, insurance and real estate
firms; public accounting, stock brokerage and law
partnerships often have large number of partners
Partnership
Two types of partnerships
a. General partnership-
partnership- Relationship between
partners is dictated by the partnership
agreement.
b. Limited partnership
In a general (or regular) partnership, all partners
have unlimited liability, and each partner is legally
liable for all of the debts of the partnership.
Partnership
b. Limited partnership
 Advantages
a. For the limited partners, liability limited to
the amount of capital invested in the
company
b. Withdrawal or death of a limited partner
does not affect continuity of the business
c. Stronger inducement in raising capital
Partnership
Relationship among partners dictated by the
partnership agreement-
agreement- whether oral commitment
or formal document
In a general (or regular) partnership, all partners
have unlimited liability, and each partner is legally
liable for all of the debts of the partnership.
Partnership
a. General partnership.
 Advantages
a. Minimal organizational requirements
b. Negligible government regulations
 Disadvantages
a. All partners have unlimited liability
b. Difficult to raise large amounts of
capital
c. Partnership dissolved by the death or
withdrawal of general partner
Partnership
b. Limited partnership
 Disadvantages
a. There must be at least one general partner
who has unlimited liability in the partnership
b. Names of limited partners may not appear in
the name of the firm
c. Limited partners may not participate in the
management of the business
d. More expensive to organize than general
partnership, as a written agreement is
mandatory
Partnership
c. There is also a Limited Liability
Company (LLC) form of business.
 A cross between a partnership and a corporation.
 It retains limited liability for its owners, but is run
and taxed like a partnership.
Corporation
In general only about 15% of all businesses, but is
the dominant form in terms of receipts and profits,
i.e. 90% of business receipts and 80% of net profits
Manufacturing corporations account for largest
portion of corporate business receipts and net
profits.
Legal Forms of Business
Organization
Corporation
 Corporation
An artificial, “impersonal”
impersonal” being created by law
often called a “legal entity”
entity”
Has the power of an individual in that it can
purchase, sell, and own assets/ property in its own
name, incur liabilities, sue and be sued and make
and be party to contracts while existing separately
and apart from its owners
Ownership is evidenced by shares of
stock
Corporation
 Advantages
a. Limited liability of owners
b. Ease of transferability of ownership, i.e., by
the sale of one's shares of stock
c. The death of an owner does not result in the
discontinuity of the firm's life
d. Ability to raise large amounts of capital is
increased
 Disadvantages
a. Most difficult and expensive form of business
to establish
b. Control of corporation not guaranteed by
partial ownership of stock
Corporation
The owners of a corporation are its stockholders,
whose ownership is equity, is evidenced by either
common stock or preferred stock. Common
stock is the purest and most basic form of
corporate ownership.
Corporation Corporation

Stockholders expect to earn a return The board of directors is typically responsible for:
• By receiving dividends- periodic distribution of earnings • Developing strategic goals and plans
• By realizing gains through increases in share price • Setting general policy

Control of the corporation is structured as a • Guiding corporate affairs

democracy. The stockholders (owners) vote • Approving major expenditures

periodically to elect members of the board of • Hiring/ firing

directors, and to decide other issues • Compensating

• Ex. Amendments to corporate charter • Monitoring key officers and executives

Corporation Corporate Organization

The board of directors typically include:

• Inside directors, such as key corporate executives
• Outside directors, such as executives from other
companies, major shareholders, and national or
community leaders

The president or chief executive officer (CEO)

is responsible for managing day-
day-to-
to-day operations,
carrying out the policies established by the board,
and reporting periodically to the firm’
firm’s board.

Other Limited Liability

Corporation
Organizations
 Owners elect a board of directors
 Board members in turn select/ hire individuals
to serve as company officers
– Including the president, vice president, secretary
and treasurer
 Ownership is reflected in common stock
certificates-
certificates- with no. of hares owned by its
holder
 Shares are transferable, so ownership changes
by simply remitting the shares to a new
shareholder.
Corporation Corporation
 Investor’
Investor’s liability is confined to the amount  Life of the corporation is not dependent on
of investment in the company the status of the investors.
 This prevents creditors from confiscating  Death or withdrawal of an investor does not
stockholders’
stockholders’ personal assets to settle affect the continuity of the corporation.
unresolved claims.  Management continues to run the
corporation when the stock is sold or passed
on through inheritance.

The Role of the Financial

Treasurer
Manager in a Corporation
– Handles the firm’
firm’s financial activities
 Vice President for Finance/ Chief Financial
Officer (CFO)  Cash and credit management

– Serves under the Chief Executive Officer  Making capital expenditure decisions

(CEO)  Raising funds

– Responsible for overseeing the  Financial planning

 Financial planning  Managing foreign currency received by the

 Corporate strategic planning firm

 Controlling the firm’
firm’s cash flow
– Treasurer and Controller serve under the CFO

Controller Flow Of Capital Through The

Financial Markets
– Manages the firm’
firm’s accounting duties
 The popularity of the corporation
 Producing accounting statements
stems from the ease in raising capital
 Cost accounting that it provides.
 Paying taxes Among the corporation, individuals and
 Gathering and monitoring data necessary to
the government
oversee the firm’
firm’s financial well-
well-being Initially, the corporation raises funds in
the financial markets by selling securities-
securities-
stocks and debt. Receives cash in turn.
 We focus on the duties of the Treasurer and The corporation then invests this cash in
on how investment decisions are made. assets that generate returns
Flow Of Capital Through The Primary and Secondary
Financial Markets Markets
 Securities market is a place where you can
 Cash flow from those assets is: buy or sell securities
Either reinvested in the corporation – Wall Street, an actual building in New
Or given back to the investors in the York City
form of dividends or interest payments – Electronic hookup among security dealers
Or used to repurchase stock-
stock- which all over the world
should cause the stock price to rise
Or given to the government as tax
payments

Primary Market Secondary Market

 The market where securities that have
 A market where new (as opposed to
previously issued) securities are traded. previously been issued and bought are traded.
 This is the only time that the issuing firm Ex. You bought 100 shares of stock in an IPO,
actually receives money for its stock. and wanted to resell them. You resell them
Initial public offering (IPO)-
in the secondary market.
(IPO)- first time the
company’
company’s stock is sold to the general Ex. The proceeds from the sale of a share of
public IBM stock in the secondary market go to the
Seasoned new issue-
previous owner of the stock, not to IBM.
issue- stock offerings from
 The only time IBM ever receives money
companies that already have common
stock traded in the secondary market. from the sale of one of its securities is in
the primary markets.