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Ch.

1 - An Introduction to

Financial Management

2002, Prentice Hall, Inc.

What is Finance?
Perspective of Finance
Past Financial Statement Analyses
Present Short-Term Financial Management
Future Capital Budgeting

Goals of the Firm


Four (of Ten) Basic Principles of Finance
Three Types of Business Organizations

Learning Objectives
1. Identify the 3 primary business decisions that
financial managers make.
2. Identify the key differences between 3 major
legal forms of business.
3. Understand the role of the financial manager
within the firm and the goal for making
financial choices.
4. Memorize the 4 principles of finance that
form the basis of financial management for
both businesses and individuals.
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FIN3000, Liuren Wu

Learning Objectives
1. Identify the 3 primary business decisions that
financial managers make.
2. Identify the key differences between 3 major
legal forms of business.
3. Understand the role of the financial manager
within the firm and the goal for making
financial choices.
4. Memorize the 4 principles of finance that
form the basis of financial management for
both businesses and individuals.
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FIN3000, Liuren Wu

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

GOALS OF THE CORPORATION


1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
11.
12.
13.
14.
15.

Maximize Shareholders Wealth


Optimum Cash Flow Management
Optimum Inventory Level Management
Optimum Dividend Payout Ratio
Minimize Tax Burden
Avoiding Bankruptcy
Effective & Efficient Financial Control
Effective & Efficient Financing of Growth
Optimum Investment Management
Optimum Risk-Return Trade-Off
Optimum Debt-Equity Ratio
Minimize Interest & Capital Cost
Optimize Social & Societal Welfare
Maximize Distribution of Wealth
Maximize Distribution of Ownership

Three Types of Business


Organizations

FIN3000, Liuren Wu

Legal Forms of Business


1) Sole Proprietorship
A business owned by a single individual.
Owner maintains title to the firms assets.
Owner has unlimited liability.

2) Partnership
Similar to a sole proprietorship, except
that there are two or more owners.

Legal Forms of Business


2a) General Partnership
All partners have unlimited liability.

2b) Limited Partnership


Consists of one or more general partners,
who have unlimited liability, and
One or more limited partners (investors)
whose liability is limited to the amount of
their investment in the business.

Legal Forms of Business


3) Corporation
A business entity that legally functions
separate and apart from its owners.
Owners liability is limited to the amount
of their investment in the firm.
Owners hold common stock certificates,
and ownership can be transferred by
selling the certificates.

The Corporation and Financial


Markets

The Corporation and Financial


Markets
Corporation

The Corporation and Financial


Markets
Corporation

Investors

The Corporation and Financial


Markets
Corporation

Investors

Government

The Corporation and Financial


Markets
Corporation

cash

Government

Investors

The Corporation and Financial


Markets
Corporation

cash
securities

Government

Investors

The Corporation and Financial


Markets
Corporation

cash

Investors

securities
Secondary
markets

Government

The Corporation and Financial


Markets
Corporation

cash

Investors

securities
Secondary
markets

Government

The Corporation and Financial


Markets
Corporation

cash

Investors

securities
Secondary
markets

Government

The Corporation and Financial


Markets
Corporation

cash

Investors

securities

Cash flow

Government

Secondary
markets

The Corporation and Financial


Markets
Corporation

cash

Investors

securities

Cash flow
tax

Government

Secondary
markets

The Corporation and Financial


Markets
cash

Corporation

Investors

securities
reinvest

Cash flow
tax

Government

Secondary
markets

The Corporation and Financial


Markets
cash

Corporation

Investors

Debt & equity


securities

reinvest

Cash flow

Interest,
dividends

tax

Government

Secondary
markets

The Corporation and Financial


Markets
Primary Market

The Corporation and Financial


Markets
Primary Market
Market in which new issues of a
security are sold to initial buyers.

The Corporation and Financial


Markets
Primary Market
Market in which new issues of a
security are sold to initial buyers.

Secondary Market

The Corporation and Financial


Markets
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 Corporation and Financial


Markets
Initial Public Offering (IPO)
The first time the firms stock is
sold to the general public.

The Corporation and Financial


Markets
Initial Public Offering (IPO)
The first time the firms stock is
sold to the general public.

Seasoned New Issue

The Corporation and Financial


Markets
Initial Public Offering (IPO)
The first time the firms 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.

FINANCIAL MARKETS, INSTITUITION & INSTRUMENTS


Primary Markets
Secondary Markets
Money Markets
o
o
o
o
o
o
o
o

T-Bills
Federal Agency Discount Notes
Short Term Munis
Federal Funds
Negotiable Certificate of Deposits
Commercial Paper
Bankers Acceptance
Repos

Mortgage Markets

FINANCIAL MARKETS, INSTITUITION & INSTRUMENTS


Capital Markets
o Debt
o Equity

o Common Shares
o Preferred Shares

Bond Markets
o
o
o
o

T-Bonds
Agency Debt
Munis Bonds
Corporate Bonds

Futures Market, i.e., real or financial assets


o Options
o Forwards
o Derivatives

The Four Basic Principles of


Finance
1. Money has a time value.

A dollar received today is more valuable than a dollar received in the


future (due to interests, investment returns,)

2. There is a risk-return trade-off.

One shall take extra risk only if one expects to be compensated for
extra return.

3. Cash flows are the source of value.

Profit is an accounting concept designed to measure a businesss


performance over an interval of time.
Cash flow is the amount of cash that can actually be taken out of the
business over this same interval.

4. Market prices reflect information.

Investors respond to new information by buying and selling their


investments.
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FIN3000, Liuren Wu

Financial Management Axioms

1) Risk - return trade-off


2) Time value of money
3) Cash - not profits - is king
4) Incremental cash flows count
5) The curse of competitive markets
6) Efficient capital markets
7) The agency problem
8) Taxes bias business decisions
9) All risk is not equal
10) Ethical dilemmas are everywhere in finance

BUSINESS
INVESTMENT

ASSETS

FINANCE

S/T INV + L/T INV S/T FINANCE + L/T FINANCE

C A +

F A

C L

+ LTD + EQUITY

Cash
Plant & Equipment
Short Term Loan
Long Term Preferred
Marketable Securities
Current Maturities
Debt
Share
Machinery
Accounts Payable
Bank Loans Ordinary Share
Accounts Receivables
Capital WIP
Notes
Share Premium
Notes
Treasury Stock
Inventory
Land
Accrued Expenses
Bonds
Retained Earnings
Others
Investments (Land)
Proposed Dividend
Reserves

S/T= SHORT TERM, L/T=LONG TERM, INV= INVESTMENT


CA= CURRENT ASSETS, FA= FIXED ASSETS, CL= CURRENT LIABILITY
CM= CURRENT MATURITY, WIP= WORK IN PROGRESS

What is Finance?
Finance is the study of how people and businesses
evaluate investments and raise capital to fund them.
(-- How to get and use money)
Three questions addressed by the study of finance
1. What long-term investments should the firm undertake?
(capital budgeting decisions how to spend the money?)
2. How should the firm fund these investments? (capital
structure decisions -- How to get the money?)
3. How can the firm best manage its cash flows as they arise
in its day-to-day operations? (working capital management
decisions how to manage cash (liquid) money?)
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FIN3000, Liuren Wu

Sole Proprietorship
It is a business owned by a single individual that is
entitled to all the firms profits and is responsible for all
the firms debt.
There is no separation between the business and the
owner when it comes to debts or being sued.
Sole proprietorships are generally financed by personal
loans from family and friends and business loans from
banks.
Advantages:
Easy to start
No need to consult others while making decisions
Taxed at the personal tax rate

Disadvantages:

Personally liable for the business debts


Ceases on the death of the proprietor
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FIN3000, Liuren Wu

Partnership
A general partnership is an association of two or
more persons who come together as co-owners for the
purpose of operating a business for profit.
There is no separation between the partnership and
the owners with respect to debts or being sued.

Advantages:

Relatively easy to start


Taxed at the personal tax rate
Access to funds from multiple sources or partners

Disadvantages:

Partners jointly share unlimited liability


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FIN3000, Liuren Wu

Limited Partnership
In limited partnerships, there are two classes of
partners: general and limited.
The general partners runs the business and face
unlimited liability for the firms debts, while the
limited partners are only liable on the amount
invested.
One of the drawback of this form is that it is
difficult to transfer the ownership of the general
partner.
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FIN3000, Liuren Wu

Corporation
Corporation is an artificial being, invisible, intangible,
and existing only in the contemplation of the law.
Corporation can individually sue and be sued, purchase,
sell or own property, and its personnel are subject to
criminal punishment for crimes committed in the name
of the corporation.
Corporation is legally owned by its current stockholders.
The Board of directors are elected by the firms
shareholders. One responsibility of the board of directors
is to appoint the senior management of the firm.
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FIN3000, Liuren Wu

Corporation Pros & Cons


Advantages

Liability of owners limited to invested funds


Life of corporation is not tied to the owner
Easier to transfer ownership
Easier to raise Capital

Disadvantages
Greater regulation
Double taxation of dividends
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FIN3000, Liuren Wu

Hybrid Organizations
These organizational forms provide a cross between a
partnership and a corporation.
Limited liability company (LLC) combines the tax benefits
of a partnership (no double taxation of earnings) and limited
liability benefit of corporation (the owners liability is
limited to what they invest).
S-type corporation provides limited liability while allowing
the business owners to be taxed as if they were a partnership
that is, distributions back to the owners are not taxed twice
as is the case with dividends in the standard corporate form.
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FIN3000, Liuren Wu

The Goal of the Financial


Manager

The goal of the financial manager must be consistent


with the mission of the corporation.

To maximize firm value shareholders wealth (as measured by


share prices).

While managers have to cater to all the stakeholders


(such as consumers, employees, suppliers etc.), they
need to pay particular attention to the owners of the
corporation, i.e., shareholders.
If managers fail to pursue shareholder wealth
maximization, they will lose the support of investors
and lenders. The business may cease to exist and
ultimately, the managers will lose their jobs!
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FIN3000, Liuren Wu

Corporate Mission Statements:


Examples
To achieve sustainable growth, we have established a
vision with clear goals: Maximizing return to
shareholders while being mindful of our overall
responsibilities (part of Coca-Colas mission statement)
Our final responsibility is to our stockholders when
we operate according to these principles, the stockholders
should realize a fair return (part of Johnson & Johnsons
credo)
Optimize for the long-term rather than trying to produce
smooth earnings for each quarter -- Google.
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FIN3000, Liuren Wu