Chapter 1: An Overview of Financial Management

I. What is Financial Management?

Definition: the study of decisions relating to the internal and external

activities of the corporation in the acquisition, financing, and management of
assets to produce value for shareholders.

The three other major areas of finance include:

Investments
International Finance
Banking and Financial Institutions

A. Major areas of Financial Management

Capital Budgeting (acquisition of assets): What long-term (capital)

investments in assets should the firm make?

Capital Structure (financing these acquisitions): Where does the money

come from?

Working Capital Management (daily operations): How does the firm manage
the daily operations, including inventory management, collecting from
customers, and paying the bills?

Fin 335: Chapter 1, page 1

B. Forms of Business Organizations

Form Advantages Disadvantages

Sole - easy & cheap to form - unlimited personal liability

Proprietorship - little regulation - limited life
- pays no corp. tax - hard to transfer ownership
- hard to raise lots of capital

Partnership - same as SP - same as SP

Corporation - limited liability - double taxation of earnings

C-Corp - unlimited life
S-Corp - easy to transfer
LLC
ownership

C. Organizational Chart of a Corporation (finance only)

Board of Directors
Chairman of the Board/CEO
President/COO
V.P. of Finance / Chief Financial Officer (CFO)

- Treasurer - external financial activities

Cash and Credit Management

Capital Expenditures
Financial Planning

- Controller - internal financial activities

Tax Management
Internal Accounting (Cost and Financial)
Information and Data Processing

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Directors are elected by shareholders at the annual shareholders meetings
and their terms may be staggered. A minimum number of independent
(outside directors) may be required. (GE Board) (Google Rules)

The Articles of Incorporation, also known as the Corporate Charter, is

the contract between the corporation and a state that establishes the
corporation as a legal entity. It must be filed in a specific state and Delaware
is a popular choice. Basic required information includes:

Name of the corporation

Term (usually in perpetuity)
Purpose (Type of business)
How it is organized (basic organizational structure)
Type and number of shares authorized

The bylaws include additional information and the internal rules of

governance. These are not required to be filed with the state of
incorporation.

80% of all businesses are sole proprietorships, with the rest evenly divided
between partnerships and corporations.

Based on dollar value of sales, about 80% of all business is conducted by

corporations, with 13% conducted by sole proprietorships, and 7% by
partnerships.

A corporation can be public (shares sold to the general public) or private

(shares closely held by a small group or even a single individual). The
advantages of incorporating will most likely increase the value of all but the
smallest businesses.

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II. The Goal of Financial Management
(a more complete definition) and Another View

Goals of the financial manager of a corporation

- Maximize the value of the firm

- Maximize the shareholders wealth

- Maximize the current market price of stock

Why is share price maximization the appropriate goal?

- Share price is an unambiguous measure of wealth

- Share price is indifferent...it has no agenda

- By maximizing share price you maximize every shareholders

happiness

Why is profit maximization not the appropriate goal?

- Profits can be manipulated by using different accounting rules

- Profit maximization does not focus on long-term

Penetration pricing (where MC MR) will not maximize profits in the

short-term but may increase market share and achieve greater value in the
long-term

On the other hand, one way to maximize profits this year is to sell all
assetsleaving nothing to generate profits in future years.

The problem with profit maximization is that it is restricted in time. There is

no model that maximizes profits indefinitely. The only alternative is to
maximize the value of all the future cash flows, which is what that price of
the stock represents.

Corporate Governance: USA vs Europe

Fin 335: Chapter 1, page 4
III. Agency Theory and Control of the Corporation

Agency refers to the relationship that exists when one person (the agent) is
hired to act on the behalf of another person (the principal).

A. Examples of agency relationships: (where problems arise)

- Shareholders and managers

- The corporation and employees
- Managers and bondholders
- All are potential sources of conflict

B. Agency conflict:

- The board is too cozy with management & fails to supervise

- Managers allow themselves too many perquisites (perks)
- Managers resist hostile takeovers
- Employees shirk
- Managers invest in very risky projects

C. Agency costs:

- Share price is not maximized

- Management must be monitored (audits, activist board)
- Restrictive covenants in the bond contracts (indentures)
- Other lenders demand collateral
- Employees require supervision

D. Activities that protect the principals:

- Market discipline: threat of takeovers, drop in price

- Internal & external audits
- Performance related compensation
- Restrictive covenants in bond the contracts

CFA manual for effective corporate governance

The Greed Cycle by John Cassidy, 2002

Review of The Greed Cycle

Fin 335: Chapter 1, page 5