Chapter 1
An Overview of Financial Management
Anum Qureshi
An Overview of Financial Management
◦ Finance – Areas of Finance
◦ Forms of Business Organization
◦ Creating Value for Investors
◦ Stockholder-Manager Conflicts
◦ Stockholder-Debtholder Conflicts
◦ Balancing Interests of Shareholders and Society
What is finance?
◦ The system that includes the circulation of money, the granting of credit, the
making of investments, and the provision of banking facilities.
◦ Finance has many facets, which makes it difficult to provide one concise
definition.
Areas of Finance
◦ Financial management (Corporate finance)
◦ Focuses on decisions relating to how much and what types of assets to acquire, how to raise
the capital needed to purchase assets, and how to run the firm so as to maximize its value.
◦ Capital markets
◦ Are financial market where individuals, institutions, and governments trade financial securities,
such as stock or bond. It also relates to the market where interest rates, along with stock and
bond prices, are determined.
◦ Investments
◦ Investments relate to decisions concerning stocks and bonds
Corporate Finance involves three important
decision-making areas
◦ What investments should the business take on?
THE INVESTMENT DECISION
◦ How can finance be obtained to pay for the required investments?
THE FINANCE DECISION
◦ What should the firm do to operate the assets in the most efficient manner?
ASSET MANAGEMENT DECISION
Finance Within the Organization
Forms of Business Organization
Proprietorship Partnership Corporation
Forms of Business Organization
◦ Proprietorships
◦ An unincorporated business owned by one individual.
◦ Partnerships
◦ An unincorporated business owned by two or more persons.
◦ Corporation
◦ A legal entity created by a state, separate and distinct from its owners and
managers.
Proprietorships and Partnerships
◦ Advantages
• Ease of formation
• Subject to few regulations
• No corporate income taxes (single taxation)
◦ Disadvantages
• Difficult to raise capital (funds)
• Unlimited liability
• Limited life
Corporation
Advantages Disadvantages
Unlimited life Double taxation
Easy transfer of ownership Cost of setup and report filing
Limited liability Complexity
Ease of raising capital
Growth potential
Separate legal entity
Greater access to human and financial
resources
Other forms of Business Organizations
◦ S Corporations
◦ A special designation that allows small businesses that meet qualifications to be taxed as
if the were a proprietorship or a partnership rather than a corporation.
◦ To qualify for S corporation status, a firm can have no more than 100 stockholders.
◦ Taxed as if they were proprietorships or partnerships; thus, they are exempt from the
corporate income tax.
Other forms of Business Organizations
◦ Limited Liability Company (LLC)
◦ A popular type of organization that is a hybrid between a partnership and a
corporation.
◦ A limited liability partnership (LLP)
◦ Similar to an LLC. LLPs are used for professional firms in the fields of
accounting, law, architects, and consulting.
Financial Goals of Business Corporation
◦ Main Goal
◦ Creating value for investors (Maximizing shareholders wealth)
◦ Other goals to achieve main goal
◦ Survival
◦ Avoid financial distress and bankruptcy
◦ Beat the competition
◦ Maximize sales or market share
◦ Minimize costs and maximize profits
◦ Maintain steady earnings growth
Determinants of Intrinsic Values and Stock
Prices
Determinants of Intrinsic Values and Stock
Prices
◦ True cashflows and risk – investors would expect if they had all of the
information that existed about a company.
◦ Perceived cashflows and risk – what investors expect given the limited
information they have.
◦ Intrinsic value – an estimate of the stock’s “true” value as calculated by a
competent analyst who has the best available data.
◦ Market price – the actual market price based on perceived but possibly incorrect
information as seen by the marginal investor.
Stock Prices and Intrinsic Value
◦ In equilibrium, a stock’s price should equal its “true” or intrinsic value.
◦ Intrinsic value is a long-run concept.
◦ To the extent that investor perceptions are incorrect, a stock’s 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.
Actual prices vs intrinsic value
Stock undervalued = Intrinsic value > Actual stock price
Stock overvalued = Intrinsic value < Actual stock price
Equilibrium = Intrinsic value = Actual stock price
Management Long Term Goal
◦ Intrinsic value is a long-run concept. Management’s goal should be to take actions designed to
maximize the firm’s intrinsic value, not its current market price.
◦ Note, though, that maximizing the intrinsic value will maximize the average price over the
long run but not necessarily the current price at each point in time.
Stockholder-Manager Conflicts – Agency
Problem
◦ Managers are naturally inclined to act in their own best interests (which are not
always the same as the interest of stockholders).
◦ But the following factors affect managerial behavior:
• Managerial compensation packages
• Direct intervention by shareholders
• The threat of firing
• The threat of takeover
• Corporate raiders –takeover of undervalued corporation.
• Hostile takeover –takeover with opposition of management.
Stockholder-Debtholder Conflicts
◦ Stockholders are more likely to prefer riskier projects, because they receive more
of the upside if the project succeeds. By contrast, bondholders receive fixed
payments and are more interested in limiting risk.
◦ Bondholders are particularly concerned about the use of additional debt.
◦ Bondholders attempt to protect themselves by including covenants/provisions
in bond agreements that limit the use of additional debt and constrain
managers’ actions.
Balancing Shareholder Interests and Society
Interests
◦ The primary financial goal of management is shareholder wealth maximization,
but corporations should also consider:
◦ Investing in socially responsible firms.
◦ Environmental, Social, and Governance (ESG) Measures
◦ Three main factors for measuring social responsibility in a firm.
Business Ethics
◦ Business ethics –a company’s attitude and conduct toward its employees, customers,
community, and stockholders.
◦ WHAT COMPANIES ARE DOING
◦ When conflicts arise involving profits and ethics
• Firms today have strong written codes of ethical behavior
• Companies conduct training programs to ensure that employees understand proper
behavior in different situations.
◦ CONSEQUENCES OF UNETHICAL BEHAVIOR
◦ The collapses of Enron and WorldCom as well as the accounting firm Arthur Andersen
dramatically illustrate how unethical behavior can lead to a firm’s rapid decline.
◦ Moreover, Merrill Lynch and Citigroup, which were accused of facilitating these frauds,
were fined hundreds of millions of dollars.
Business Ethics
◦ How should employees deal with unethical behavior?
◦ Discussion
