Introduction to Financial Management

Contents
 Learning Objectives

 Finance : An Overview

 Three Types of Business Organizations

 The Goal of the Financial Manager

 Ethics in Finance

 The Five Basic Principles of Finance 1

 Learning Objectives

1. Understand the importance of finance in

your personal and professional lives and
identify the three primary business
decisions that financial managers make.

2. Identify the key differences between the

three major legal forms of business.

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 Learning Objectives (cont.)

3. Understand the role of the financial

manager within the firm and the goal for
making financial choices.

4. Explain the five principles of finance that

form the basis of financial management
for both businesses and individuals.

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What is Financial Management?

Concerns the acquisition,

financing, and management of
assets with some overall goal in
mind.

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Three Basic Questions Addressed by the
Study of Finance:

1. What long-term investments should the

firm undertake?--- Capital Budgeting
2. How should the firm raise money to fund
these investments? –--Capital Structure
3. How can the firm best manage its cash
flows as they arise in its day-to-day
operations? ----- working capital
Management
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 Investment Decisions
Most important of the three
decisions.
• What is the optimal firm size?
• What specific assets should be
acquired?
• What assets (if any) should be reduced
or eliminated?

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 Financing Decisions
Determine how the assets (LHS of balance sheet)
will be financed (RHS of balance sheet).

• What is the best type of financing?

• What is the best financing mix?
• What is the best dividend policy (e.g.,
dividend-payout ratio)?
• How will the funds be physically acquired?

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 Asset Management Decisions

• How do we manage existing assets

efficiently?
• Financial Manager has varying degrees
of operating responsibility over assets.
• Greater emphasis on current asset
management than fixed asset
management.

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Why Study Finance?

 Knowledge of financial tools is critical to

making good decisions in both corporate
world and personal lives.

- How will GM’s strategic decision to invest $740

million to produce the Chevy Volt require the
expertise of different disciplines within the
business school?

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 Role of financial manager
2 1

Firm’s Financial Financial

operations Manager 4(a) Markets

3 4(b)

(1) Cash raised from investors by using equity (stock) and debt (bonds)
(2) Cash invested in firm
(3) Cash generated by operations
(4a) Cash reinvested
(4b) Cash returned to investors 10
Business Organizational Forms

Business
Forms

Sole
Partnerships
Proprietorships Corporations

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Sole Proprietorship

 It is a business owned by a single individual who

is entitled to all of the firm’s profits and is
responsible for all of the firm’s debt.

 The sole proprietors typically raise money by

investing their own funds and by borrowing from
a bank.

 About 80% of the businesses are operated as sole

proprietorship.

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Sole Proprietorship (cont.)

 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
 The business ceases on the death of the
proprietor
 Harder to raise money
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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.

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Partnership (cont.)

 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
 It is not always easy to transfer ownership
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Partnership (cont.)

 In limited partnerships, there are two

classes of partners: general and limited.

 The general partner runs the business and

faces unlimited liability for the firm’s debts,
whereas the limited partner is only liable
up to the amount the limited partner
invested.

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Corporation

If very large sums of money are needed to

build a business, then the typical
organizational form chosen is the
corporation. The corporation is legally owned
by its current set of stockholders, or owners.

- in terms of dollar value of sales, 80% of all

business is done by corporations

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Corporation (cont.)

 Corporation legally functions separately

and apart from its owners (the
shareholders). Corporation can individually
sue and be sued.

 The Board of directors are elected by the

shareholder, and the board appoints the
senior management of the firm.

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Corporation (cont.)

 Advantages
 Liability of owners is 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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Corporation (cont.)

 Advantages
 Liability of owners is 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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Limited Liability Company (LLC)

Limited liability company (LLC) combines

the tax benefits of a partnership (no double
taxation of earnings) with the limited liability
benefit of corporation (the owner’s liability is
limited to what they invest).

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How the Finance Area Fits into a
Corporation

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CORPORATION
Shareholders

elect
Board of Directors

hire

Top Management

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 The Corporation and Financial
Markets

Corporation cash Investors

securities
reinvest
Secondary
markets
dividends,
Cash flow
etc.

tax

Government
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 What is the Goal of the Firm?

Maximization of Shareholder Wealth!

Value creation occurs when we maximize the

share price for current shareholders.

Shareholder wealth = number of shares outstanding

* market price per share.

Eg: If you own 100 shares of BTL and the price is $5

per share , then your wealth in BTL is $500 25
The Goal of the Financial Manager

The goal of the financial manager must be

consistent with the mission of the
corporation, which is to maximize
shareholder’s wealth.

Corporate Social Responsibility (CSR): A business

outlook that acknowledges a firm’s responsibilities
to its stakeholders and the natural environment.

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Corporate Mission

 While managers have to cater to all the

stakeholders (such as consumers, employees,
suppliers etc.), they need to pay particular
attention to the 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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 Managerial Actions to Maximize
Stockholder Wealth
 Making investment decisions (Capital Budgeting
Decisions):The decision by Apple to introduce the
iPod.
 Making decisions on how to finance these
investments (Capital Structure Decisions): How to
finance the development and Production of the iPod
 Managing funding for the company's day-to-day
operations(Working Capital Management):Apple’s
decision regarding how much inventory to hold.

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Factors that affect the value of the
firm’s stock price
 Projected cash flows to shareholders
 Timing of the cash flow stream
Cash received sooner is better than
cash received later
 Riskiness of the cash flows
Definite cash inflows are generally
preferred to uncertain cash inflows

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 Why not profit maximization?
 Profit maximization is an accounting
term derived by subtracting expenses
from revenues. But profit maximization
ignores three important things:
 1) The time value of money
 2) Risk
 3) Cash flow

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 Ethics in Finance

 What do we mean by Ethics?

Webster: “A standard of conduct and
moral behavior.”
 Business Ethics: A company’s attitude and
conduct toward its employees, customers,
community, and stockholders
 Eg.polluting air,water
 Enron, Wolrd Com, Accounting firm Arthur
Anderson 31
 Sarbanes-Oxley Act (SOX)

 SOX Act was passed in 2002 “to protect

investors by improving the accuracy and
reliability of corporate disclosures made
pursuant to the securities laws, and for
other purposes”.

 SOX Act mandates senior executives to

take responsibility for the accuracy and
completeness of financial reports.
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The Five Basic Principles of Finance

Principle 1: Money Has a Time Value

 A dollar received today is worth more than
a dollar received in the future.
 We can invest the dollar received today to
earn interest. Thus, in the future, you will
have more than one dollar, as you will
receive the interest on your investment.

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PRINCIPLE 2: There is a Risk-Return
Trade-off
 We won’t take on additional risk unless we
expect to be compensated with additional
return.

 Higher the risk, higher will be the expected

return. Note expected return may not be
equal to the realized rate of return.

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Figure 1.3 There Is a Risk-Return
Tradeoff

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PRINCIPLE 3: Cash Flows Are the
Source of Value
 Profit is an accounting concept and
measures a business’s performance. Cash
flow is the amount of cash that can
actually be taken out of the business.

 It is possible for a firm to report profits but

have no cash.

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Incremental Cash Flow

Financial decisions in a firm should consider

“incremental cash flow” i.e. the difference
between the cash flows the company will
produce with the potential new investment
and what it would make without the
investment.

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PRINCIPLE 4: Market Prices Reflect
Information
Investors react quickly to news/information
and decisions made by managers.

Good News ==> Higher stock prices

Bad News ==> Lower stock price.

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 The Modern Corporation

Modern Corporation

Shareholders Management

There exists a SEPARATION between

owners and managers.
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 Role of Management

Management acts as an agent

for the owners (shareholders)
of the firm.
• An agent is an individual authorized
by another person, called the
principal, to act in the latter’s behalf.

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PRINCIPLE 5: Individuals Respond to
Incentives
Managers (as agents) respond to incentives
they are given in the workplace. If their
incentives are not properly aligned with
those of the firm’s stockholders (the
principal) they may not make decisions that
are consistent with increasing shareholder
value leading to agency costs.

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PRINCIPLE 5: Individuals Respond to
Incentives (cont.)
The agency problems/costs can be mitigated through:
1. Compensation plans that reward managers when they act
to maximize shareholder wealth
2. Monitoring by the board of directors- firing managers
who do not perform well.
3. The underperforming firms seeing their stock prices fall
and face threat of being taken over and have their
management teams replaced.
Corporate Raider-An individual who targets a corporation
for takeover because it is undervalued.
Hostile Takeover- The acquisition of a company over the
opposition of its management
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