Business Organization and Financial markets Some basic concepts Financial management: Lecture 2

Today’s agenda Understand the types and features of business organizations Understand the goal of corporation and agency problem Understand financial markets and their functions Understand the concept of the cost of capital and the time value of money

Organize a business Types of Business Organizations Sole Proprietorships A business owned and run by one individual Partnerships A business owned by two or more people Corporations A business organized as a separate legal entity owned by stockholders. Financial management: Lecture 2

Organize a business Financial management: Lecture 2

Organize a business Financial management: Lecture 2 Sole Proprietorships Corporations Partnerships Limited Liability Corporate tax on profits + Personal tax on dividends Unlimited Liability Personal tax on profits

1- 6 Who is The Financial Manager? Chief Financial Officer TreasurerController

Financial managers Chief Financial Officer (CFO) Oversees the treasurer and controller and sets overall financial strategy. Treasurer Responsible for financing, cash management, and relationships with banks and other financial institutions. Controller Responsible for budgeting, accounting, and taxes. Financial management: Lecture 2

The goal of corporation The financial managers are supposed to maximize shareholders’ wealth or maximize stock prices Financial management: Lecture 2

Agency problems Managers, acting as agents for stockholders, may act in their own interests rather than maximizing shareholders’ value. This conflict of interest between shareholders and managers causes the agency problem. Financial management: Lecture 2

Career In Finance Financial management: Lecture 2

Financial Manager Firm's operations Investors (1) Investors buy shares with cash (1) (2)Cash is invested (2) (3) Operations generates cash (3) (4a) Cash reinvested (4a) (4b) Cash returned to investors (4b) Financial markets and investors Real assets (timberland) (stockholders save and invest in closely held firm.)

2- 12 Corporation Investment in real assets Investors worldwide Financial markets Stock markets Fixed-income markets Money markets Markets for Commodities Foreign exchange Derivatives Financial Intermediaries Mutual Funds Pension funds Financial Institutions Banks Insurance companies Reinvestment Financial Markets

2- 13 Total U.S. Financing % Holdings of Corporate Equities (Qtr 3, 2007)

Financial management: Lecture 2 Financial markets A financial market Securities are issued and traded The classification of the financial market By seasoning of claim Primary market Secondary market By nature of market Debt market Equity market

Financial management: Lecture 2 Financial markets (continue) By maturity of claim Money market Capital market

Financial management: Lecture 2 The functions of financial markets 1. Conducting exchange 2. Providing liquidity 3. Pooling money to fund large corporations 4. Transferring money across time and distance 5. Risk management (hedge, diversify) 6. Providing information 7. Providing efficient allocation of money

Financial management: Lecture 2 Conducting exchange What does it mean ? Examples

Financial management: Lecture 2 Providing liquidity What does this mean? Examples

Financial management: Lecture 2 Pooling money to fund large corporation investments What does this mean? Examples

Financial management: Lecture 2 Transferring money across time and distance What does this mean? Examples

Financial management: Lecture 2 Risk management What does this mean? Examples

Financial management: Lecture 2 Providing information What does this mean? Examples

Financial management: Lecture 2 Providing efficient allocation of money What does this mean? Examples

Financial management: Lecture 2 The cost of capital The cost of capital is a very important concept in capital budgeting. It links investment opportunities in financial markets and investment opportunities in real assets markets.

Financial management: Lecture 2 What is the cost of capital? Cash Investment opportunity (real asset) FirmShareholder Investment opportunities (financial assets) InvestAlternative: pay dividend to shareholders Shareholders invest for themselves

Cost of capital Cost of capital sometimes is also called The opportunity cost of your money The interest rate The discount rate It is defined as the expected return required by investors for the same risky project in financial markets. Financial management: Lecture 2