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Chapter 1

Chapter 1. Financial Management. Learning Objectives. Describe the cycle of money, the participants in the cycle, and the common objective of borrowing and lending. Distinguish the four main areas of finance and briefly explain the financial activities that each encompasses.

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Chapter 1

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  1. Chapter 1 Financial Management

  2. Learning Objectives Describe the cycle of money, the participants in the cycle, and the common objective of borrowing and lending. Distinguish the four main areas of finance and briefly explain the financial activities that each encompasses. Explain the different ways of classifying financial markets. Discuss the three main categories of financial management. Identify the main objective of the finance manager and how that objective might be achieved.

  3. Learning Objectives (continued) 6. Explain how the finance manager interacts with both internal and external players. 7. Define the three main types of business organizations and their respective advantages and disadvantages. 8. Illustrate agency theory and the principal-agent problem. 9. Review issues in corporate governance and business ethics.

  4. Definition of Finance Finance is the art and science of managing wealth. It is about making decisions regarding what assets to buy/sell and when to buy/sell these assets. Its main objective is to make individuals and their businesses better off.

  5. Definition of Financial Management Financial management is generally defined as those activities that create or preserve the economic value of the assets of an individual, small business, or corporation. Financial management comes down to making sound financial decisions.

  6. 1.1 The Financial Intermediary Function Financial intermediaries assist in the movement of money from lenders to borrowers and back again. This process is termed the cycle of moneyand its main objective is to make all the participants better off.

  7. FIGURE 1.1 The money cycle

  8. 1.2 Overview of Finance Areas Four main interconnected and interrelated areas: 1. Corporate Finance: set of financial activities that supports the operations of the firm. 2. Investments: activities such as buying and selling real and financial assets. 3. Financial Institutions and Markets which are the financial intermediaries that facilitate the flow of money. 4. International Finance the addition of the multinational element to the finance activities.

  9. 1.3 The Financial Markets Forums where buyers and sellers of financial assets and commodities meet. Financial markets can be classified by: 1.The Type of Asset Traded Equity markets for stocks Debt markets for bonds Derivatives markets for options, futures and forwards. Foreign exchange markets for currencies. 2.The Maturity of the Financial Asset moneymarket for short-term securities (maturity within a year) capital market for long-term securities (maturity over a year)

  10. 1.3 The Financial Markets - Continued 3.The Owner of the Financial Asset • primary market :sale for stocks for first time • secondary market: resell of the stocks 4. The Nature/Type of the Transaction • dealer markets :individual buying or selling securities out of his inventory. e.g. used car dealership. • auction markets :securities sold at same time to many buyers.

  11. 1.4 The Finance Manager and Financial Management The Finance Manager Determines the best repayment structure for borrowed funds. Ensures that debt obligations are met on time. Ensures that sufficient funds are available for carrying out daily operations.

  12. 1.4 The Finance Manager and Financial Management - continued Financial management involves three main categories: Capital Budgeting: the process of planning, evaluating, comparing, and selecting the long-term operating projects of the company(what business are you in) Capital Structure: the means by which company is financed; for public companies, usually a mix of debt and equity sold to investors and owners.

  13. 1.4 The Finance Manager and Financial Management - continued • Working Capital Management: the process of managing the day-to-day operating needs of the company through its current assets and current liabilities(short term day to day financing activities).

  14. 1.5 Objective of the Finance Manager The main objective: to maximize the wealth of the owners. for public companies its maximizing the current stock price. for private companies its maximizing the current market value of the company’s equity. Profit maximization vs. Stock price maximization Why are they not the same? Which one is more important? Its important to note that stock price reflect the company’s future cash flow.

  15. 1.6 Internal and External Players Financial managers have to interact with various internal and external stakeholders Internal players include all the departmental managers and other employees External parties(stakeholders) include: Customers Suppliers Government Creditors

  16. 1.7 The Legal Forms of Business There are three main legal categories of business organizations: 1. Sole proprietorship 2. Partnership 3. Corporation

  17. Sole Proprietorship Is a business that is owned entirely by an individual. Advantages Simplest and easiest form of business Least amount of legal documentation Least regulated Owner keeps all profits Disadvantages Owner pays personal tax rate on profits(which is usually higher than corporate tax rate). Obligations of the business are sole responsibility of owner, and personal assets may be necessary to pay obligations (personal and business assets are commingled) Business entity limited to life of owner Can have limited access to outside funding for the business

  18. Partnership Is a business owned jointly by two or more individuals. These individuals can be either: general partners who operate daily business, limited partners who participate in certain aspects, or silent partners who participate only as investors. Advantages Agreements between partners may be easily formed Involves more individuals as owners and therefore usually more expertise Larger amount of capital usually available to the business (compared to proprietorship) Disadvantages Assets of general partners are commingled with assets of the business Profits treated as personal income for tax purposes Difficult to transfer ownership from old to new partner.

  19. Corporation A business form in which the company is a legal separate entity from the owners. Advantages Business is legal, separate entity from owners Owners have limited liability to obligations of the business Easy to transfer ownership Usually greater access to capital for business Owners do not have any personal liability for default Disadvantages Most difficult business operation to form Double taxation of company profits that are taxed before distributions and then owners are taxed again on distributions. Most regulated e.g. annual reports.

  20. 1.8 The Financial Management Setting: The Agency Model Agency relationship :its the relationship between the principal (owners) and the agent (manager). Agency conflict: it arises when the interests of the principal and agent do not match. Principal-agent problem: its the problem of motivating one party(agent) to act in the best interest of another party(principal). Agency theory: is another name given to the Principal-agent problem.

  21. 1.8 The Financial Management Setting: The Agency Model - Continued • Agency costs: costs incurred to align the agent’s interests with those of the owners and the costs associated with tasks that are paid but not performed.

  22. 1.8 The Financial Management Setting: The Agency Model - Continued • to maximize the company’s current stock price, managers should forgive some of their bonuses or compensations. • Stock optiongiven to managers provide a solution by matching the incentives of the managers to the shareholder’s interests. Any increase in the stock price will increase the managers incentives.

  23. 1.9 Corporate Governance and Business Ethics Corporate governance deals with… how a company conducts its business and implements controls to ensure proper procedures and ethical behavior. The Sarbanes-Oxley Act, enacted in 2002, requires that The CEO and CFO attest to the fairness of the financial reports. The company maintains an effective internal control structure around financial reporting. The company and its auditors assess the effectiveness of the controls over the most recent fiscal year.

  24. 1.10 Why Study Finance? Understand how and why financial decisions are made in large and small companies Helps individuals increase their own compensations Improves contributions to the success of the companies that people work for Understand the tradeoffs we face in making personal financial choices and help us to select the most appropriate action

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