Chapter 1 Vocabulary Flashcards: Introduction to Financial Management
Finance: A Quick Look
- Finance is the study and management of money, focusing on decisions about investments, financing, and day-to-day financial activities.
- Basic scope: Finance is often divided into five key areas:
- Corporate finance (also called business finance)
- Investments
- Financial institutions
- International finance
- Fintech
- Why it matters: Finance underpins how organizations allocate resources, value assets, and manage risk across markets and borders.
Business Finance and the Financial Manager
- Core questions in business finance:
- What long-term investments should the firm undertake? (Capital budgeting)
- How should the firm raise the funds to pay for those investments? (Capital structure)
- How should the firm manage its day-to-day financial activities? (Working capital management)
- The financial manager's role:
- Ultimately, a firm’s top financial manager is typically the Chief Financial Officer (CFO).
- Key sub-functions:
- Treasurer: oversees cash management, credit management, capital expenditures, and financial planning.
- Controller: oversees taxes, cost accounting, financial accounting, and data processing.
- Real-world takeaway: Financial managers balance growth with risk and ensure liquidity to meet obligations while pursuing shareholder value.
- Three major forms in the United States:
- Sole proprietorship
- Partnership (General and Limited)
- Corporation (also LLC as a form with limited liability)
- Sole proprietorship
- Advantages: easiest to start, least regulated, single owner keeps profits, taxed as personal income.
- Disadvantages: life limited to owner, limited equity capital, unlimited liability, difficult to sell ownership.
- Partnership
- Advantages: two or more owners, more capital, relatively easy to start, income taxed once as personal income.
- Disadvantages: unlimited liability for general partners; limited partnership exists; dissolution on death/removal of a partner; difficult to transfer ownership.
- Corporation
- Advantages: limited liability, unlimited life, separation of ownership and management, easy ownership transfer, easier to raise capital.
- Disadvantages: agency problem (separation of ownership and management), double taxation (corporate-level taxes plus personal taxes on dividends).
- LLC (Limited Liability Company)
- Not expanded in detail in the transcript, but listed as a form alongside the three major forms.
- All international forms feature public ownership and limited liability; examples include:
- BMW AG (Germany) — Aktiengesellschaft (corporation)
- Montblanc GmbH (Germany) — Gesellschaft mit beschränkter Haftung (LLC)
- Rolls-Royce PLC (UK) — Public limited company
- Shell UK Limited (UK) — Limited (corporation)
- Unilever NV (Netherlands) — Naamloze Vennootschap (public company)
- Fiat SpA (Italy) — Società per Azioni (public company)
- Saab AB (Sweden) — Aktiebolag (joint-stock company)
- Peugeot SA (France) — Société Anonyme (joint-stock company)
- Key takeaway: International corporate forms vary by country but share common features like limited liability and public ownership in many cases.
The Goal of Financial Management
- Primary question: What should be the goal of a corporation?
- Options discussed: maximize profit, minimize costs, maximize market share, maximize the current value per share (CVPS) of existing stock, or maximize the market value of existing owners’ equity.
- The core objective emphasized: maximize the current value per share of the company’s existing stock, i.e., maximize shareholder wealth by increasing the market value of owners’ equity. In symbols, this aligns with maximizing the stock price today, $P_0$, or the present value of expected future cash flows, which drives $MVE$ (market value of equity).
- Important caveat: Should we pursue wealth maximization at any cost?
- The chapter raises ethical and practical concerns with an overzealous pursuit: outsourcing/offshoring decisions, questionable corporate behavior (e.g., Enron), or charitable causes as a corporate cover. The implication is that wealth maximization must be balanced with ethical, legal, and social considerations.
- Real-world implication: The Sarbanes-Oxley Act (SOX, 2002) was enacted in response to corporate scandals to strengthen financial fraud protection, but compliance is costly. This touches on the practicality of pursuing wealth maximization within a lawful and ethical framework.
The Agency Problem and Control of the Corporation
- Agency relationship: Principals (stockholders) hire agents (managers) to run the company.
- Agency problem: Conflicts of interest between principals and agents, leading to agency costs.
- Managerial incentives: Compensation plans can align management with stockholder interests, but must be carefully structured to be effective.
- Corporate control: Threat of a hostile takeover can discipline management when performance falters.
- Other stakeholders: Employees, customers, suppliers, and the community can influence or be affected by corporate decisions and governance.
The SOX Act (Sarbanes-Oxley) and Corporate Governance
- Origin: Enacted in 2002 due to major corporate scandals (e.g., Enron, Tyco, WorldCom, Adelphia).
- Purpose: Strengthen protection against accounting fraud and financial malpractice.
- Impact: Compliance is costly, and some firms have looked to go public outside the US or go private to avoid stringent regulations.
- Practical takeaway: Corporate governance and transparent financial reporting are essential for maintaining investor confidence and maximizing legitimate shareholder value.
Financial Markets and the Corporation
- Cash flows between the firm and financial markets: Firms raise capital and invest while markets allocate resources through buyers and sellers.
- Cash flow concepts to note: Primary markets (new securities issuance) vs. secondary markets (trading among investors).
- Market mechanisms: Dealer markets vs. auction markets.
- Listed vs. over-the-counter (OTC) markets.
- Examples of major markets:
- NYSE (New York Stock Exchange)
- NASDAQ
- Practical connection: Understanding where and how securities are priced and traded is fundamental to capital budgeting and capital structure decisions.
Quick Guide to Study Concepts
- Key questions to review:
- What are the three major forms of business organization? (Sole proprietorship, Partnership, Corporation, with LLC as a related form)
- What are the advantages and disadvantages of each form?
- What is the goal of financial management? (Maximize current value per share / shareholder wealth)
- What are agency problems, and why do they exist within a corporation?
- Practical activities:
- Use finance.yahoo.com to research real companies (e.g., Southwest Airlines LUV, Harley-Davidson HOG, American Express AXP).
- Visualize cash flows between the firm and financial markets (Figure 1.2 in the material).
Connections to Practice and Real-World Relevance
- The course links financial theory to real-world decision-making in corporate settings, including how investment opportunities are evaluated (capital budgeting), how to structure financing (capital structure), and how to manage working capital to sustain operations.
- Ethical considerations and governance (SOX, agency problem) illustrate that financial decisions have social and legal consequences beyond pure mathematics.
- The inclusion of fintech, international finance, and financial institutions acknowledges evolving landscapes where technology, cross-border operations, and regulatory frameworks shape financial strategy.
Highlights of Key Terms and Concepts
- Corporate finance = Business finance
- Investments: asset types (stocks, bonds); risk vs. return; asset allocation; career roles (stockbroker, portfolio manager, security analyst)
- Financial institutions: banks, insurance companies, brokerage firms; roles and career paths
- International finance: exchange rates, political risk, cross-border work, language skills
- Fintech: use of internet, mobile, software, cloud services to deliver financial services
- Capital budgeting: long-term investment decisions
- Capital structure: financing decisions (debt vs. equity)
- Working capital management: day-to-day financial operations
- Agency problem: conflict between stockholders and managers; agency costs
- Managerial incentives: compensation plans to align interests
- Corporate control: takeovers as governance mechanism
- SOX (2002): regulatory response to scandals; compliance implications
- Primary vs. secondary markets; dealer vs. auction markets; listed vs. OTC markets
- Examples of international corporate forms and origins (BMW AG; Rolls-Royce PLC; Unilever NV; etc.)
- Real-world research tool: Yahoo Finance for company data
- Chapter and section references (for studying navigation): 1.1 Finance: A Quick Look; 1.2 Business Finance and the Financial Manager; 1.3 Forms of Business Organization; 1.4 The Goal of Financial Management; 1.5 The Agency Problem and Control of the Corporation; 1.6 Financial Markets and the Corporation; 3-4-5-6 pages cover Basic Areas of Finance; 9-11 pages cover study of finance in practice; 12-13 Organization and decision areas; 18-19 International forms and goals; 21-22 SOX and agency; 25-27 market structure and quick quiz.
- Notable dates and terms: SOX, 2002; Primary vs secondary markets; NYSE; NASDAQ.
Quick Quiz (study prompts)
- What are the three major forms of business organization?
- What are the advantages and disadvantages of each form?
- What is the goal of financial management?
- What are agency problems, and why do they exist within a corporation?
- How do primary and secondary markets differ? What roles do NYSE and NASDAQ play in security trading?
- How does SOX influence corporate governance and financial reporting?
