Chapter 1

Chapter 01 Introduction to Financial Management

Key Concepts and Skills

• Upon studying this chapter, you should be able to:

  • Discuss the basic types of financial management decisions and the role of the financial manager.

  • Identify the goal of financial management.

  • Compare the financial implications of the different forms of business organizations.

  • Describe the conflicts of interest that can arise between managers and owners.

Chapter Outline

1. Finance: A Quick Look.

2. Business Finance and The Financial Manager.

3. Forms of Business Organization.

4. The Goal of Financial Management.

5. The Agency Problem and Control of the Corporation.

6. Financial Markets and the Corporation.

Basic Areas of Finance

• The major areas of finance include:

  • Corporate finance = Business finance.

  • Investments.

  • Financial institutions.

  • International finance.

  • Fintech.

Investments

• Investments involve:

  • Working with financial assets such as stocks and bonds.

  • Valuing financial assets, assessing risk versus return, and performing asset allocation.

  • Job opportunities in:

  • Stockbroker or financial advisor.

  • Portfolio manager.

  • Security analyst.

Financial Institutions

• Financial institutions are companies specializing in financial matters, including:

  • Banks (commercial and investment), credit unions, savings and loans.

  • Insurance companies.

  • Brokerage firms.

• Job opportunities available in these institutions.

International Finance

• International finance is a specialization in:

  • Working in different countries or traveling regularly.

  • Requires familiarity with exchange rates and political risk.

  • Understanding customs and language fluency of other countries is beneficial.

Fintech

• Fintech refers to:

  • The combination of finance (fin-) and technology (-tech).

  • A broad term describing companies that utilize the internet, mobile phones, software, and/or cloud services to provide financial services.

Why Study Finance?

• Importance of finance is evident in various fields:

  • Marketing:

  • Budgets, costs, and benefits in marketing research, marketing financial products.

  • Accounting:

  • Dual accounting and finance functions, preparation of financial statements.

  • Management:pStrategic thinking, job performance, profitability.

  • Technology:

  • Banking fintech, blockchain, cryptocurrencies, stock trading, budgeting apps.

  • Personal finance:

  • Budgeting, retirement planning, college planning, day-to-day cash flow management.

Business Finance

• Essential questions in business finance include:

  • What long-term investments should the firm pursue?

  • Where will we secure long-term financing to cover these investments?

  • How will we manage the day-to-day financial activities of the firm?

Financial Manager

• Financial managers address the essential business finance questions.

• The top financial manager, typically the Chief Financial Officer (CFO), oversees:

  • Treasurer: manages cash, credit, capital expenditures, and financial planning.

  • Controller: oversees taxes, cost accounting, financial accounting, and data processing.

Corporate Organization Chart

• A simplified organizational chart for financial management:

  • Titles and structures may vary by company.

Financial Management Decisions

• Three main decisions of financial management include:

  • Capital budgeting:

  • Determining what long-term investments or projects the business should undertake.

  • Capital structure:

  • Identifying how to finance assets, deciding between debt and equity.

  • Working capital management:

  • Managing daily financial operations of the firm.

Forms of Business Organization

• The three major forms of business organizations in the United States are:

  1. Sole Proprietorship:

  • Business owned by one person.

  • Advantages:

    • Easiest to start, least regulated, single owner keeps all profits, taxed once as personal income.

  • Disadvantages:

    • Limited to the life of the owner, equity capital limited to owner’s personal wealth, unlimited liability, difficult to sell ownership interest.

  1. Partnership:

  • Business owned by two or more persons.

  • Advantages:

    • Multiple owners contribute to more capital, relatively easy to start, income taxed once as personal income.

  • Disadvantages:

    • Unlimited liability, partnership dissolves when a partner dies or wishes to sell, difficult transfer of ownership.

  1. Corporation:

  • A legal entity distinct from its owners, residing in a state.

  • Advantages:

    • Limited liability, unlimited life, separation of ownership and management, easier transfer of ownership, easier capital raising.

  • Disadvantages:

    • Agency problem due to separation of ownership and management, double taxation on income and dividends.

International Corporate Forms

• 
  

• Forms of international corporations with public ownership and limited liability:
  

  Company	Country of Origin	Type of Company
  Bayerische Motoren Werke (BMW) AG	Germany	Aktiengesellschaft (Corporation)
  Montblanc GmbH	Germany	Gesellschaft mit beschränkter Haftung (Limited Liability Company)
  Rolls-Royce PLC	United Kingdom	Public limited company
  Shell UK Ltd.	United Kingdom	Limited Corporation
  Unilever NV	Netherlands	Naamloze Vennootschap (Limited Liability Company)
  Fiat SpA	Italy	Società per Azioni (Public Limited Company)
  Saab AB	Sweden	Aktiebolag (Joint Stock Company)
  Peugeot SA	France	Société Anonyme (Joint Stock Company)
  Goal of Financial Management

  • The primary question of financial management is:

    • What should be the goal of a corporation? Possible answers include:

    • Maximize profit.

    • Minimize costs.

    • Maximize market share.

    • Maximize the current value per share of the company’s existing stock. This translates to maximizing the market value of the existing owners’ equity—maximizing shareholder wealth.

  Goal of Financial Management (Continued)

  • Considerations in maximizing owner wealth:

    • Should we pursue all means to maximize wealth? Addressing ethical considerations:

    • Outsourcing practices

    • Offshoring

    • Corporate scandals (e.g., Enron)

    • Corporate charitable contributions.

  Sarbanes-Oxley Act (SarBox, 2002)

  • Legislative response to corporate scandals including those involving Enron, Tyco, WorldCom, and Adelphia.

  • Objectives:

    • Strengthen protection against accounting fraud and financial malpractice.

  • Compliance implications:

    • Can be highly costly for firms.

    • Potential responses by firms include:

    • Going public outside the U.S.

    • Going private (also termed as “going dark”).

  The Agency Problem

  • Agency relationship:

    • Engagement where a principal hires an agent to represent its interests.

    • In this context, stockholders (principals) hire managers (agents) to operate the company.

  • Agency problem:

    • A conflict of interest arising between the principal and the agent, typically manifesting in divergent management goals and agency costs.

  Do Managers Act in the Shareholders’ Interests?

  • To facilitate alignment between management and shareholders:

    • Managerial compensation must be effectively structured to create incentives.

    • The threat of a takeover can serve as an additional form of corporate control that may lead to improved management.

  Example: Work the Web

  • The internet can be a valuable resource for information about specific companies.

  • Finance-related websites include:

    • finance.yahoo.com

  • Companies highlighted in examples:

    • Southwest Airlines (LUV)

    • Harley-Davidson (HOG)

    • American Express (AXP)

  Financial Markets

  • Cash flows between firms and financial markets consist of:

    • Primary Markets: where new securities are created and sold.

    • Secondary Markets: where existing securities are traded among investors.

    • Types of securities:

    • Listed securities (e.g., New York Stock Exchange (NYSE))

    • Over-the-counter securities (e.g., Nasdaq).

  Quick Quiz

  • Potential questions for review:

    • What are the five basic areas of finance?

    • What are the three types of financial management decisions, and what questions do they answer?

    • What are the three major forms of business organization?

    • What is the goal of financial management?

    • What are agency problems, and why do they exist within a corporation?

  NEXT STEPS

  • Recommended actions for further learning:

    • Review the chapter thoroughly.

    • Add personal notes to notecards for retention.

    • Complete the Connect Assignment.

  • Additional resources include:

    • PowerPoint Slides covering key topics.

    • Connect SmartBook for guided reading.

    • Connect Quizzes for self-assessment.