Chapter 1

Financial
Management and
the Firm

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Learning Objectives

Identify the goal of the firm.

Understand the five basic principles

Describe the role of finance in business.

Distinguish between the different legal forms of

business.

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What is finance?
Two related activities: the study of how
money is managed and the actual process
of acquiring needed funds.
Individuals, businesses and government
entities all need funding to operate.

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The Goal of the Firm

The goal of the firm is to create value for the
firms legal owners (that is, its shareholders).
Thus the goal of the firm is to maximize
shareholder wealth by maximizing the price
of the existing common stock.

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Five
Principles of Finance

Cash flow is what matters

Money has a time value
Risk requires a reward
Market prices are generally right
Conflicts of interest cause agency
problems

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Principle 1:
Cash flow is what matters
Accounting profits are not equal to cash flows. It is
possible for a firm to generate accounting profits but
not have cash or to generate cash flows but not
report accounting profits in the books.
Cash flow, and not profits, drive the value of a
business.
We must determine incremental cash flows when
making financial decisions.
Incremental cash flow is the difference between the
projected cash flows if the project is selected, versus what
they will be, if the project is not selected.

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Principle 2:
Money has a time value
A dollar received today is worth more than a
dollar received in the future.
Since we can earn interest on money received
today, it is better to receive money earlier rather
than later.

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Principle 3:
Risk requires a Reward
We wont take on additional risk unless we
expect to be compensated with additional
reward or return.
Investors expect to be compensated for
delaying consumption and taking on risk.
Thus investors expect a return when they put their
savings in a bank (i.e. delay consumption) and
they expect to earn a higher rate of return on
stocks relative to bank savings account (i.e. taking
on risk)

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Figure 1-1

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Principle 4: Market Prices

are generally Right
In an efficient market, the prices of all traded assets
(such as stocks and bonds) at any instant in time fully
reflect all available information.
Thus stock prices are a useful indicator of the value
of the firm. Prices changes reflect changes in
expected future cash flows. Good decisions will tend
to increase the stock prices and vice versa.
Note there are inefficiencies in the market that may
distort the prices.

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Principle 5: Conflicts of interest

cause agency problems
The separation of management and the
ownership of the firm creates an agency
problem. Managers may make decisions that
are not consistent with the goal of maximizing
shareholder wealth.
Agency conflict is reduced through monitoring
(ex. Annual reports), compensation schemes
(ex. stock options), and market mechanisms
(ex. Takeovers)

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The Role of Finance

in Business
Three broad issues addressed by the study of
finance:
Where to Invest? (Capital budgeting
decision)
How to raise money to fund the investment?
(Capital structure decision)
How to manage cash flows from daily
operations? (Working capital decision)
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The Role of Business in

Finance (cont.)
Knowledge of financial tools is relevant for
decision making in all areas of business
(be it marketing, production etc.).
Decisions involve an element of time and
uncertainty financial tools help adjust for
time and risk.
Decisions taken in business should be
financially feasible financial tools help
determine the financial viability of decisions.

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The Role of a Financial

Manager in a Firm

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The Legal Forms of

Business Organization
1.
2.
3.
4.

Sole Proprietorship
Partnerships
Corporation
Hybrid

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Sole Proprietorship
Business owned by an individual
Owner maintains title to assets and
profits
Unlimited liability
Termination occurs on owners death or
by owners choice
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Partnerships
Two or more persons come together as co-owners
General Partnership: All partners are fully responsible
for liabilities incurred by the partnership.
Limited Partnerships: One or more partners can have
limited liability, restricted to the amount of capital
invested in the partnership. There must be at least one
general partner with unlimited liability. Limited partners
cannot participate in the management of the business
and their names cannot appear in the name of the firm.

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Corporation
Legally functions separate and apart from its owners
Corporation can sue, be sued, purchase, sell, and own property

Owners (shareholders) dictate direction and policies of

the corporation, oftentimes through elected board of
directors.
Shareholders liability is restricted to amount of
investment in company
Life of corporation does not depend on the owners
corporation continues to exist through easy transfer of
ownership
Taxed separately
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Hybrid Organizations:
S-Type Corporation and
Limited liability Companies (LLC)

S-Type Corporations
Benefits
Limited liability
Taxed as partnership (no double taxation like
corporations)

Limitations
Owners must be people so cannot be used for
joint ventures between two corporations

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Hybrid Organizations:
S-Type Corporation and
Limited liability Companies (LLC) (cont.)

Limited Liability Companies (LLC)

Benefits
Limited liability
Taxed like a partnership

Limitations
Qualifications vary from state to state
Cannot appear like a corporation otherwise it
will be taxed like one

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Why do companies
go abroad?
To increase revenues
To reduce expenses (land, labor, capital, raw
material, taxes)
To lower governmental regulation standards
(ex. Environmental, labor)
To increase global exposure

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Risks/challenges
Country risk (changes in government
regulations, unstable government, economic
changes in foreign country)
Currency risk (fluctuations in exchange rates)
Cultural risk (differences in language,
traditions, ethical standards etc.)

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