CHAPTER 1 Introduction to Financial Management

1. CHAPTER 1Introduction to Financial Management Forms of Businesses Goals of the Corporation Stock Prices and Intrinsic Value Some Recent Trends Conflicts Between Managers and Shareholders 1-1

2. Financial Management • Financial management is concerned with the acquisition, financing and the management of assets with goal in mind 1-2

3. Decision function of financial management can be broken down into three major areas: • Investment • Financing • Asset Management 1-3

4. Investment decision • Investment decision begins with a determination of the total amount of assets needed to be held by the firm-size of the firm –composition of the assets 1-4

5. Financing decisions • Capital structure of the firm- mix of funds i.e. debt financing or equity financing • How to acquire the needed funds e.g. short term loan, long term lease agreements, negotiating a sale of bond or stock etc. • Matching rule 1-5

6. Asset management Decision • The financial manager is charged with varying degrees of operating responsibility over existing assets • Management of current assets • The optimal level of a current assets depends on the profitability and flexibility associated with that level in relation to the cost involved in maintaining it • Decisions regarding the management of assets must be made in accordance with the underlying objective of the firm: maximize profits 1-6

7. The decisions to acquire an asset necessitates the financing and management of that asset, whereas financing and management costs affect the decision to invest 1-7

8. The Business Environment • Need to understand environment in which financial managers operate. • The form of business organization that a firm chooses is one aspect of the business setting in which it must function 1-8

9. Alternative Forms of Business Organization Proprietorship Partnership Corporation 1-9

10. Proprietorships • An unincorporated business owned by one individual. • Advantages • Ease of formation • Subject to few regulations • No corporate income taxes-only as a part of personal income • Disadvantages • Difficult to raise capital • Unlimited liability-personal wealth at stake • Limited life-to the life of the founder 1-10 1-10

11. Partnerships A partnership exists whenever two or more persons or entities associate to conduct a non corporate business for profit Partnership may operate under different degrees of formality, ranging from informal to formal agreeements: %age of share, %age of NI 1-11 1-11

12. Partnerships • Advantages • Ease of formation • Subject to few regulations • No corporate income taxes • Disadvantages • Difficult to raise capital • Unlimited liability • Limited life • Difficulty of transferring ownership 1-12 1-12

13. Corporation • A corporation is a legal entity, having an existence separate and distinct from that of its owner and managers. • Owners of a corporation are called stockholders and their ownership is determined by the numbers of stocks owned in that corporation. • Types of corporations: • Publicly owned • Closely held 1-13 1-13

14. Corporation • Advantages • Unlimited life • Easy transfer of ownership • Limited liability • Ease of raising capital • Disadvantages • Double taxation • Cost of set-up and report filing 1-14 1-14

15. The Financial Environment • All businesses operate within financial systems: markets, institutions • Suppliers and users • Suppliers of financial resources are savers, users are investors 1-15

16. CAREER OPPORTUNITIES IN FINANCE • Money & Capital Markets: It deals with securities markets and financial Institutions. Knowledge of valuation techniques, factors effecting interest rates and its effect on securities prices, various financial instruments and financial regulations is required. 1-16

17. Primary and secondary market Primary market is a new issue market Secondary market, where existing securities are bought and sold 1-17

18. Financial Institutions • Depositary institutions • Contractual saving institutions • Investment intermediaries 1-18

19. CAREER OPPORTUNITIES IN FINANCE • Investments: Three main functions of investments are • Sales • Analyzing securities • Determining optimal mix of securities for an investor. • Financial Management 1-19

20. Financial Goals of the Corporation • The primary financial goal is shareholder wealth maximization, which translates to maximizing stock price. • Any financial asset is valuable only to the extent that it generates cash flows • Timing of cash flows matter • Should firms behave ethically?, investors are risk averse so they will pay more for a stock whose cash flow are relatively certain than those that are risky 1-20

21. CORPORATION • Value of a business setup as a corporation can be maximized due to following reasons: • Limited Liability • Growth Opportunities • Liquidity position 1-21

22. Financial Staff’s Responsibilities • Forecasting & planning • Major investment and financing decisions • Coordination & Control • Dealing with Financial Markets • Risk Management 1-22

23. Factors that affect stock price • Projected cash flows to shareholders • Timing of the cash flow stream • Riskiness of the cash flows 1-23

24. Stock Prices and Intrinsic Value • In equilibrium, a stock’s price should equal its “true” or intrinsic value. • 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. 1-24

25. Determinants of Intrinsic Value and Stock Prices (Figure 1-1) 1-25

26. 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. 1-26

27. Conflicts Between Managers and Stockholders • 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 plans • Direct intervention by shareholders • The threat of firing • The threat of takeover 1-27