Lecture 1

INTRODUCTION TO FINANCIAL
MANAGEMENT
- CHAPTER 1 &M:
6 Finance 3rd Edition
(P.129-P.141)
Cornett, Adair, and Nofsinger

Copyright 2016 by McGraw-Hill Education. All rights reserved.

What is Finance?
Finance applies specific value to
things we owned,
services we used,
decisions we made.

Financial management
organizations approach to valuation of

things, services and decisions.

Economic Participants
Type 1 Participants
Do not lend or spend in business context.
No direct role in financial markets.
Indirect role to provide labor and consume

products.

Economic Participants
Type 4 Participants
Use financial tools to

evaluate own businesses.

choose highest-potential ideas.
Are self-funded, so no need for financial

markets.

Economic Participants
Types 2 and 3 Participants
Use financial institutions and financial markets

for mutually beneficial exchange.

Type 2 (lenders) :
makes temporary loans to Type 3.
Type 3 (borrowers) :
typically consists of companies engaging in
Research & Development (R&D) and need
capital / funds.

Economic Participants
Two dimensions
Participants with extra investment money.
Participants with economically viable ideas.

Where Does the Cash / Fund Go ?

Economically successful projects

repay money (plus profit) to investors.

But, friction occurs when not all cash
is returned to investors.
Retained Earnings (funds the firm keeps for its

ongoing operations)
Taxes (funds that go to the Government)

Sub-areas of Finance
Investments
Involve methods and techniques for making

decisions about what kinds of securities (e.g.

stocks, bonds) to own.

Sub-areas of Finance
Financial Management
Decisions about acquiring and using cash.
Examples include :

Organizing and raising capital/funds

(Financing decisions).
Tax decisions.
Projects to fund (Capital Budgeting decisions
to be discussed in the future).

Sub-areas of Finance
Financial Institutions and Markets
Facilitate flow of capital between investors and

companies.

International Finance
Finance theory used in global business

environment.
Involves foreign exchange risk and political risk.

Financial Decision Application & Theory

Risk
Uncertainty of future cash flows due to timing

and size.

Financial Asset
Ownership in cash flow represented by

securities like stocks, bonds, and other assets.

These assets may provide regular or irregular,
constant or non-constant cash flows to the
investors.

Financial Decision Application & Theory

Real Assets
Physical properties like gold, machinery,

equipment, real estate.

Real Markets
Places / processes that facilitate trading of real

assets.

Time Value of Money (TVM)

Theory and application of valuing cash flows at

various points in time.

Finance vs. Accounting

Accounting
Tracks what happened to firms money in the

past (based on historical records or figures).

Financial Management
Combines historical figures and current

information (includes updated information or

figures).
Determines what should happen with firms
money now and in the future.

The Financial Managers

Chief Financial Officer (CFO)
Highest level financial officer

CFO

Controller
Oversees accounting function

Controller

Treasurer

Treasurer
Responsible for managing cash, credit,

financing, capital budgeting, risk management

Finance in Other Business

Functions

CFO and Treasurer

Most visible finance-related positions in the firm.

Finance permeates the organization

Provide guidance to develop and manage

strategy and day-to-day business operations.

Operations
Marketing
Human Resources

Finance in Your Personal Life

Help you make good personal

financial decisions such as :

Borrowing money for a new car.
Refinancing home mortgage at lower rate.
Making credit card or student loan payments.
Saving for retirement.

Business Organizations
Single Owners, Partners, and

Corporations operate businesses.

Advantages and disadvantages
related to :
Controls and ownership of firm
Owners risks
Access to capital and tax ramifications

Business Form Types

Sole Proprietorships
General Partnerships
Corporations
Hybrids

Sole Proprietorships
Not legally separate from the owner.
Advantages
Easy to start.
Light regulatory and paperwork burden.
Single taxation at the personal tax rate.
Disadvantages
Unlimited liability.
Limited access to capital.

General Partnerships
Partners own the business together.
Advantages

Relatively easy to start.

Single taxation.
Disadvantages

Partners jointly share unlimited liability.

Personally liable for legal actions and debts
of firm.
Difficult to raise large amounts of capital.

Public Corporations
Legally independent entity entirely

separate from its owners.

Advantages

Limited liability for owners.

Can raise large amounts of capital.
Easy to transfer ownership (buying and selling
shares).
Disadvantages
Double taxation (taxable at both corporate and
personal levels).

Hybrid Organizations
Combine attributes of several forms.
Advantages
Offer single taxation and limited liability to all
owners. Examples :
S Corporations
Limited Liability Partnerships (LLPs)
Limited Liability Companies (LLCs)

Business Form Types

Firm Goals
Owners seek to maximize shareholders

wealth and companys value through

Maximizing present value (PV) of future cash flows.
Maximizing owners equity.
Decisions about
attracting additional funds (e.g. raising funds for
business expansion).
projects in which to invest (Capital Budgeting
decisions).
returning profits to owners over time.

Corporate Goals
Maximize Value of Owners Equity
Increase current value per share (stock price) of

existing shares.

Common methods :
Maximize net income or profit.
Minimize costs.
Maximize market share.

Agency Theory
Problems arise when principal

(shareholder) hires agent (manager) to

operate firm but cannot monitor the agents
actions. (Principal-Agent problem)
Managers interest may not be aligned with
shareholder goals.
E.g. Managers may pursue short-term goals such as

promoting sales to increase their commission incomes

at the expense of long-term benefits to the firm.

Agency Theory
Three approaches to minimizing this

conflict of interest :
Ignore if effect is minimal.
Use accountants, debt holders to monitor

managers (can be very costly).

Provide incentives to managers
Equity stakes (make them owners) through :
Direct grant of stock options

Employee Stock Option Plan (ESOP)

Corporate Governance
The process of monitoring managers

and aligning their incentives with

shareholder goals.
Includes set of laws, policies,
incentives, and monitors designed to
handle issues arising from the
separation of ownership and control.

Corporate Governance
Inside Monitors
Board of Directors
Hires the CEO
Evaluates management
Designs compensation plans

Corporate Governance
Outside Monitors
Auditors
Analysts
Banks
Credit rating agencies (e.g. Standard &
Poors, Moodys, Fitch Ratings)

Corporate Governance Monitors

Ethics
Financial professionals manage other

peoples money or provide advices on

financial matters.
Corporate managers
Bankers
Investment advisors

Ethical dilemmas of corporate agency

relationship
Stealing from firms = stealing from shareholders

Financial Markets
Manage flow of funds
Two major market dimensions

Primary versus secondary markets

Money versus capital markets

Primary Markets
Used by corporations and

governments
Used to issue new financial
instruments such as initial public
offerings (IPOs)
Stocks
Bonds

Primary Market Transfer of

Funds

Secondary Markets
Benefit investors and issuers
Securities traded after issue between buyers

and sellers
Provide liquidity and diversification benefits for
investors
Security valuation information for issuers

Secondary Market Transfer of

Funds

Money Markets vs. Capital

Markets

Money markets trade debt securities or

instruments with maturities of one year or

less e.g. US Treasury bills, Commercial
paper etc.
Capital markets trade stocks and longterm debt with maturities greater than
one year e.g. US Treasury notes and
bonds, local government bonds,
corporate bonds or stocks etc.

Money Market vs. Capital Market

Maturities

Other Markets
Foreign Exchange Markets
Trade currency for immediate delivery (spot) or

for some future delivery

Subject to foreign exchange risk due to
currency fluctuations

Other Markets
Derivatives
Highly leveraged financial securities linked to

underlying security
Potentially high-risk
Used for hedging and speculating

Financial Markets and

Intermediaries

Financial intermediaries i.e. financial

institutions
Facilitate flow of capital from investors to firms

and back to investors.

Earn very high profits (from fees, commissions
and interests) because of their specialized
expertise and assets.

Financial Institutions
Commercial Banks
Thrifts i.e. depository institutions including

savings associations, savings banks, credit

union etc.
Insurance companies
Securities firms and/or investment banks
Mutual funds and/or Assets management
companies
Pension funds e.g. MPF

Financial Institutions
Perform vital economic functions
Monitoring costs: lower the costs of fund suppliers

to explore investment opportunities

Liquidity: provide liquidity by channeling funds
from fund suppliers (with surplus funds) to fund
demanders (shortage of funds)
Price risk: spreading risk by pooling funds
together from individual investors for investments.
By do this, individual investors can diversify their
holding risks into appropriate portfolios

Funds Flow with Financial Institutions

End of Lecture 1