Financial Management Ch 1

Finance Four Main Areas

Corporate Finance, Investments, Financial Institutions and Markets, International Finance

The Money market

Short Term debt instruments issued by borrowers who have high credit ratings, short-term = less than 1 year

Money market benefits

short term users who need funds for a seasonal or temporary financing, short term savers who have idle cash for a short time span that they wish to put in an interest-bearing instrument

Capital market

long term financial instruments, such as common stocks, bonds, preferred stock, long-term = more than 1 year

Financial Intermediaries

act as a go-between for savers and users of capital:

• Commercial Banks

• Thrift institutions

• Investment firms

• Pension funds

• Insurance companies

• Finance companies

Balance Sheet Formula

Total Assets = Liabilities + Stockholders’ equity

total assets

• things of value of the firm that will create wealth for the shareholders and income for the firm

• the items purchases with shareholders’ funds are an investment for the firm

Assets must be able to:

• generate cash flow for the firm

• generate income or revenues for the firm

• if possible, turn a profit for the firm

liabilities

• the amount of debt or money the firm has borrowed

• debt can be for short or long term

• short-term debt

• long-term debt

Equity

• ownership of the firm through the sale of common stock

• now the firm takes on partners in order to purchase assets so that it grows and expands

• The firm hopefully will make a profit through its growth and pass on some of its profits to the firm’s shareholders

Sole proprietorship advantages

• easy and cheap to start

• no formal charter for operations

• subject to few governmental regulations

• pays no corporate taxes only personal income tax

Sole proprietorship disadvantages

• difficult to get large sums of capital

• unlimited personal liability for business debt

• the business can only last as long as the owner does

• earnings taxed as personal income

Partnership advantages

• low cost

• easy to start

• pooling of various types of resources regarding individual skills, contacts, contribution of funds

Partnership disadvantages

• unlimited liability

• limited life of the organization if a partner dies or withdraws

• difficult to transfer ownership

• difficult to raise large amounts of capital

• risk personal assets and investments in the business

• all partners are jointly and separately liable for business debts

corporation advantages

• unlimited life

• ownership interest can be easily transferred

• limited liability

• better access to external sources of financial capital

corporation disadvantages

• corporation earnings subject to double taxation:

  • corporate earnings are taxed

  • earnings paid as dividends are taxed as income to shareholders

  • complex and time consuming to establish a corporation

Firm’s value will increase it is incorporates because

• investor’s risks reduced by limited liability

• the better a firm can attract capital, the better are its growth possibilities

• easier to raise capital due to liquidity of firm’s key asset: its stock

• under certain situations the tax laws favor corporations over partnerships and sole proprietorships

Ownership rights:

• dividend rights

• voting rights

• liquidation rights

• preemptive rights

Goal of a firm

not to maximize profits but to maximize shareholder wealth

Profit Maximization ignores:

• timing of returns

• cash flow

• Risk

Advantages of the concept of shareholder wealth maximization:

• managers must take into consideration timing and risk

• every financial decision must be geared toward this goal

• must be impersonal decision by the managers of the firm

Finance is undergoing changes such as:

• globalization

• Computerization

• telecommunications

• Corporate reorganization

Hybrid Corporations

a company that combines the characteristics of traditional for-profit businesses and nonprofit organization, mixed profit generation with a mission for social or environmental impact

Not-For-Profit Corporations

The profits are not taxed, set up for the benefit and service for society