1. An Overview of Financial Management and the Financial Environment
Chapter 1
An Overview of Financial Management and the Financial Environment

2. The operation of a firm

3. Forms of Business Organization
Proprietorship
Advantages
Easy formation with low organizational costs
Affected by few government regulations
Income included and taxed only on proprietor’s personal tax return (i.e. only one)

4. Forms of Business Organization
Proprietorship
Drawbacks
Owner has unlimited liability (i.e. total wealth can be taken to satisfy debts)
Lacks continuity when proprietor dies
Transferring of ownership is difficult
Limited fund-raising power tends to inhibit growth

5. Forms of Business Organization
Partnership
Advantages
Fairly easy and inexpensive formation
Affected by few government regulations
Income included and taxed only on partner’s tax return

6. Forms of Business Organization
Partnership
Drawbacks
Owners have unlimited liability and may have to cover debts of other partners
Partnership is dissolved when a partner dies
Difficulty to liquidate or transfer partnership
Difficulty of raising large amounts of capital

7. Forms of Business Organization
Corporation
Advantages
Long life of firm even if owners do not have a relationship with the business
Ownership (stock) is readily transferable
Owners have limited liability which guarantees that they cannot lose more than they invested
Better access to financing

8. Forms of Business Organization
Corporation
Drawbacks
More expensive to organize than other business forms and subject to greater government regulation
Taxes are higher because of double taxation: corporate income is taxed and also dividends paid to owners are taxed

9. Growing and Managing a Corporation
In addition to having products/services that attract customers, a corporation must attract investors.
Founder’s own resources and from friends, family, other private investors
Initial public offering (IPO)
Borrowing from banks, issuing bonds and additional shares
Separation of ownership and management
Agency problem
Corporate governance

10. Value maximized for corporations
Why?
Limited Liability reduces the risk borne by investors
A firm’s current value is related to its future growth opportunities
Corporate ownership can be transferred easier than the ownership of either a proprietorship or a partnership

11. Role of Finance in a Business Organization

12. The Goals of the Corporation
Stockholder wealth maximization
This should be the primary goal of a financial manager Incentives against are to keep stockholder returns “at reasonable level” and work for other goals such as:
pursue goals of public service activities
target employee benefits
pursue higher executive salaries
But…
Competitive forces require financial managers to opt for stockholder wealth maximization, to avoid losing their jobs

13. The Goals of the Corporation
Social Responsibility
Firms should provide a safe environment, avoid air pollution and produce safe products. Incentives against for firms to act in a socially responsible manner are:
Disadvantage in attracting funds due to extra costs incurred
Inability to compete due to higher prices of products
Constraints by capital market factors
Therefore…
Social Responsibility actions should be enforced on a mandatory rather than a voluntary basis

14. The Goals of the Corporation
Stock Price Maximization and Social Welfare
Shareholder Wealth Maximization is beneficial for the society:
Stock price maximization requires efficient, low cost plants that produce high-quality goods and services at a low cost
Stock price maximization requires the development of products that customers want and need, leading to new technology, new products and new jobs
Stock price maximization necessitates efficient service, adequate stocks and well located business establishments

15. The Goals of the Corporation
Therefore primary goal is to Maximize Shareholder Wealth

16. Should Earnings Per Share Be Maximized?
Beware: Wealth is NOT profit!
Profit maximization fails to account for differences in the level of cash flows (as opposed to profits), the timing of these cash flows, and the risk of these cash flows.

17. Make decisions about the cash flow
Beware: Accounting is NOT an economic profit!
Cash flow is the actual cash generated by the firm. CF = Net Income + Depreciation or (CF = NI + DEP )

18. Free Cash Flows (FCF)
FCF are cash flows available (or free) for distribution to all investors (stockholders and creditors).
FCF = sales revenues – operating costs – operating taxes – required investments in operating capital.
There are many ways firms can increase free cash flows.
Copyright © 2014 by Nelson Education Ltd.

19. Weighted Average Cost of Capital (WACC)
In addition to FCF, another factor of determining a firm’s value and its long-term stock price is WACC.
WACC is the average rate of return required by all of the company’s investors.
WACC is affected by:
capital structure (the firm’s relative amounts of debt and equity)
interest rates
risk of the firm
investors’ overall attitude toward risk
Copyright © 2014 by Nelson Education Ltd.

20. Copyright © 2014 by Nelson Education Ltd.

21. The capital formation process
Transfer of funds
Direct Transfers
Securities (stocks or bonds)
Borrower
(Business)
Saver
(Investor)
Euros €
Indirect Transfers through an Investment Banker
Securities
Securities
Borrower
(Business)
Investment Banker
Saver
(Investor)
Euros €
Euros €
Indirect Transfers through a Financial Intermediary
Borrower
(Business)
Business
Securities
Intermediary
Securities
Financial
Intermediary
Saver
(Investor)
Euros €
(Loans)
Euros €
(Deposits)

22. Stockholders versus Managers – The problem
Agency Relationships
Stockholders versus Managers – The problem
Whenever a manager owns less than 100% of the firm’s equity, a potential agency problem exists.
In theory, managers would agree with shareholder wealth maximization.
However, managers are also concerned with their personal wealth, job security, fringe benefits, and lifestyle.
This would cause managers to act in ways that do not always benefit the firm’s shareholders.

23. The Cost of Money
Supply and demand of funds determine the cost or price of money.
What do we call the price (or cost) of debt capital? Of equity capital?
Interest rate
Cost of equity = required return = dividend yield + capital gain
Both are the rate fund users pay to fund providers.
Copyright © 2014 by Nelson Education Ltd.

24. Fundamental Factors That Affect the Cost of Money
Production opportunities
Time preferences for consumption
Risk
Expected inflation
Copyright © 2014 by Nelson Education Ltd.

25. Economic Conditions and Policies That Affect the Cost of Money
Fed policies
Budget deficits/surpluses
Business activity (recession or boom)
International trade deficits/surpluses
Country risk depending on its economic, political, and social environment
Exchange rate risk
Copyright © 2014 by Nelson Education Ltd.

26. What are the Financial Markets
Mechanism by which those who have excess funds (investors / lenders) are brought together with those that require funds (borrowers)
Financial markets are important throughout our lives
Youngsters spend more than they earn
Working adults earn more than they consume
People on retirement use accumulated funds to compensate for their declining income

27. Types of financial markets
Debt markets versus equity markets
Loans are traded in debt markets
Stocks are traded in equity markets

28. Types of financial markets
Money markets versus capital markets
Securities with maturities of 1 year or less are traded in money markets
Securities with maturities of 1 year or more are traded in capital markets

29. Types of financial markets
Mortgage markets versus credit markets
Debt associated with real estate is traded in mortgage markets
Consumer loans (i.e. automobiles, education, consumer appliances) are traded in consumer credit markets

30. Types of financial markets
Financial markets can be…
Local, Regional, National and Global
Depending on…
Coverage of securities traded
Nature of markets

31. Types of financial markets
Primary markets versus secondary markets
New issues of stocks and bonds are traded in the primary markets
Previously issued securities are traded in the secondary markets

32. Types of financial markets
Spot versus futures markets
Items that traded for immediate delivery
Contracts that give details about the delivery of products at some date in the future

33. Physical Stock Exchanges
The Stock Markets
Physical Stock Exchanges
Characteristics
Physical locations where stock is traded (i.e. New York Stock Exchange)
Members have “seats” on the Exchanges

34. Organized Investment Networks – (Over the counter - market)
The Stock Markets
Organized Investment Networks – (Over the counter - market)
Characteristics
Networks of brokers and dealers around the country linked electronically (i.e. National Association of Security Dealers Automated Quotation System)
Electronic Communications Networks (ECN), i.e. systems that transfer information to facilitate securities transactions – buy and sell orders are automatically matched