Chapter 1
types of investments to consider
Introduction to Financial
Management
The Four Basic Areas of Finance
• Corporate finance = Business
Finance
• Investments
• Financial institutions
• International finance
International
- Domestic
 Corporate Finance
 Financial Institutions
 Investments
Investments
• Work with financial assets such
as stocks and bonds
• Value of financial assets, risk
versus return, and asset
allocation
• Job opportunities
– Stockbroker or financial
advisor
– Portfolio manager
– Security analyst
Stockbrokers
- Often work for large companies
such as Merrill Lynch
- Advising customers on what
and helping them make buy and
sell decisions.
Financial Advisers
- Plays a similar role
(stockbrokers), but are not
necessarily brokers.
Portfolio Managers
- Manage money for investors.
- For example, individual investors
frequently buy mutual funds.
Such funds are simply a means
of pooling money that is then
invested by a portfolio manager.
- Invest and manage money for
pension funds, insurance
companies, and many other
types of institutions.
Security Analyst
- Researches individual
investments, such as stock in a
particular company, and makes a
determination as to whether the
price is right.
- Delves deeply into company and
industry reports, along with a
variety of other information
sources.
- Brokers and portfolio managers
rely on security analysts for
 information and
recommendations.
Financial Institutions
• Companies that specialize in
financial matters.
– Banks (deposits,
withdraws, payments
ATM) – commercial and
investment, credit unions
(cooperative), savings and
loans
– Insurance companies (like
life insurance)
– Brokerage firms
• Job opportunities
International Finance
• This is an area of specialization
within each of the areas
discussed so far
• It may allow you to work in other
countries or at least travel on a
regular basis
• Need to be familiar with
exchange rates risk and political
risk
• Need to understand the customs
and traditions of other countries;
speaking a foreign language
fluently is also helpful
Why Study Finance?
• Marketing
– Budgets, marketing
research, marketing
financial products
– It is important so that you
can develop a product that
the public will like.
• Accounting
– Dual accounting and
finance function,
preparation of financial
statements
– Financial statements will
tell you the business is
doing well.
• Management
– Strategic thinking, job
performance, profitability
• Personal finance
– Budgeting, retirement
planning, college planning,
day-to-day cash flow
issues
Business Finance
• Some important questions that
are answered using finance
– What long-term
investments should the
firm take on?
 – Where will we get the
long-term financing to pay
for the investments?
– How will we manage the
everyday financial
activities of the firm?
data processing – highest
accounting executive
Figure 1.1 A Simplified
Organizational Chart
The exact titles and organization differ
from company to company.

Financial Manager

• Financial managers try to answer

some, or all, of these questions

• The top financial manager within

a firm is usually the Chief
Financial Officer (CFO)

• Chief Financial Officer (CFO)

 Vice President of finance

 All about money reports to
him/her.

– Treasurer – oversees cash

management, credit
management, capital
expenditures, and financial
planning

Capital Expenditures

- Also called CapEx Financial Management Decisions

- entails large sum of • Capital budgeting

money
- All PPE are usually
capital expenditures.
– Controller – oversees
taxes, cost accounting,
financial accounting, and
– What long-term
investments or projects
should the business take
on?
– The process of planning
and managing a firm’s
long- term investments.
 – Evaluating the size, • Usually the
timing, and risk of future manager is the
cash flows is the essence owner.
of capital budgeting. • A business owned
by one person.
• Capital structure

– Also called financial

structure
– How should we pay for our
assets?
– Should we use debt or
equity?
– The mixture of debt and
equity maintained by a
firm.
• Working capital management
– How do we manage the
day-to-day finances of the
firm?
– Lifeblood of the business
– Working Capital = Current
Assets – Current Liabilities
– Partnership
• A business owned
by two or more
owners (partners).
• The way
partnership gains
(and losses) are
divided is describes
in the partnership
agreement (can be
an informal oral
agreement or a
lengthy, formal
written document)
• This form of
organization is
common in real
estate ventures.

– Working Capital - A firm’s

• General
short – term assets, such
Partnership
as inventory, and short –
term liabilities, such as - All the partners
money owed to suppliers. share in gains and
losses, an all have
unlimited liability for
Forms of Business Organization all partnership
debts, not just some
• Three major forms in the United particular share.
States
• Limited
– Sole proprietorship Partnership
 - One or more corporation's
general partners will name, its intended
run the business life (which can be
and have unlimited forever), its
liability, but there business purpose,
will be one or more and the number of
limited partners who shares that can be
do not actively issued.
participate in the
business. • The stockholders
elect the board of
- A limited partner's directors, who the
liability for business select the
debts is limited to managers
the amount that
partner contributes • Another name: joint
to the partnership. stock companies,
public limited
companies, or
– Corporation limited liability
companies.
• A business created
as a distinct legal
- S-Corp
entity owned by one
- Limited liability company
or more individuals
- The goal of this entity is to
or entities.
operate and be taxed like a
partnership but retain limited
• Involves preparing
liability for owners
articles of
- Essentially a hybrid of
incorporation (or a
partnership and corporation.
charter) and a set of
bylaws (rules
describing how the
corporation Sole Proprietorship
regulates its own – Business owned by one person
existence)
• Advantages
• The articles of
incorporation must – Easiest to start
contain a number of – Least regulated
things, including the
 – Single owner keeps all of
the profits
– Taxed once as personal
income
• Disadvantages
– Limited to life of owner
– Equity capital limited to
owner’s personal wealth
– Unlimited liability
– Difficult to sell ownership
interest because this
requires the sale of the
entire business to a new
owner.
Partnership
– Business owned by two or more
persons
• Advantages
– Two or more owners
– More capital available
– Relatively easy to start
– Income taxed once as
personal income
• Disadvantages
– Unlimited liability
• General partnership
• Limited partnership
– Limited life of the business
– Partnership dissolves
when one partner dies or
wishes to sell
– Difficult to transfer
ownership because a new
partnership must be
formed.
Corporation
– A legal “person” distinct from
owners and a resident of a state
• Advantages
– Limited liability. The most
they can lose is what they
have invested.
– Unlimited life
– Separation of ownership
and management
– Transfer of ownership is
easy
– Easier to raise capital
• Disadvantages
– Separation of ownership
and management (agency
problem)
– Double taxation (income
taxed at the corporate rate
and then dividends taxed
at personal rate, while
dividends paid are not tax
deductible)
Goal of Financial Management
• What should be the goal of a corporate accounting fraud
corporation? and financial malpractice.

– Maximize profit? – may • Key elements of Sarbox

refer to some sort of “long- took effect on November
run” or “average” profits. 15, 2004.
– Minimize costs?
• It contains a number of
– Maximize market share? requirements designed to
ensure that companies tell
– Maximize the current
the truth in their financial
value per share of the
statements.
company’s existing
stock
• Compliance is very costly:
– Maximize the market
value of the existing Firms driven to:
owners’ equity (1) Go public outside the
U.S.
• Does this mean we should do (2) Go private (“go dark”)
anything and everything to meaning that their shares
maximize owner wealth? are no longer traded in the
major stock markets, in
• Outsourcing?
which case Sarbox does
• Off-shoring? (the product
not apply. Their reason is
are manufactured in the
to avoid the cost of
other country)
compliance.
• Enron?
• Corporate support of
charities?
The Agency Problem
Sarbanes-Oxley Act In 2002
(SarBox, 2002) • Agency relationship

• Driven by corporate – Relationship between

scandals (Enron, Tyco, stockholders and
WorldCom, Adelphia) management

– Principal hires an agent to

• Known as “Sarbox”
represent its interests

• Intended to strengthen – Stockholders (principals)

protection against hire managers (agents) to
run the company
 • Agency problem
– Conflict of interest
between principal and
agent.
– The way an agent is
compensated is one factor
that affects agency
problems.
• Management goals and agency
costs
• If management does not
take the investment, then
the stockholders may lose
a valuable opportunity, this
is one example of an
agency cost.
unhappy stockholders can
act to replace existing
management.
– Proxy – is the authority to
vote someone else’s
stock.
• Other stakeholders – Someone
other than a stockholder or
creditor who potentially has a
claim on the cash flows of the
firm such as the employees,
customers, suppliers, and even
the government.
Figure 1.2 Cash Flows Between the
Firm and the Financial Markets

Do Managers Act in the

Shareholders’ Interests? (Managing
Managers)

• Managerial compensation

– Incentives can be used to

align management and
stockholder interests

– The incentives need to be

structured carefully to
make sure that they
achieve their goal

• Corporate control (or Control of

the Firm)

– The threat of a takeover

may result in better
management Financial Markets

– Proxy Fight – the • A way of bringing buyers and

mechanism by which sellers together. It is debt and
 equity securities that are bought
and sold.
• Cash flows to and from the firm
• Primary vs. secondary markets
Primary Market
- Refers to the original sale of
securities by governments and
corporations.
- The corporation is the seller, and
the transaction raises money for
the corporation.
- Corporation engage in two types
of primary market transactions:
1. Public offering – involves
selling securities top the
general public
2. Private placement – is a
negotiated sale involving a
specific buyer.
Secondary Markets
- Are those in which these
securities are bought and sold
after the original sale.
- There are two kinds of secondary
markets:
(1) Auction markets – or
exchange, have a physical
location (like Wall Street); the
primary purpose of this is to
match those who wish to sell
with those who wish to buy.
(2) Dealer markets – buy and sell
for themselves, at their own
risk.
Dealer markets in stocks and
long-term debt are called
over-the-counter (OTC)
markets. It refers to days of
old when securities were
literally bought and sold at
counters in offices around the
country. Today, many dealers
are connected electronically.
Equities
- Are issued solely by corporations.
Debt Securities
- Are issued by both governments
and corporations.
NYSE (New York Stock Exchange)
- Largest such market
- Has the most stringent
requirements of the stock
markets in the United States.
NASDAQ (National Association of
Securities Dealers Automated
Quotation)
- Large OTC market for stocks.
- An electronic quotation system
that NASD made available to
dealers and brokers.
Tokyo Stock Exchange and London
Stock Exchange – are some of the
examples of large and important
financial markets outside the United
States.

Listing

- Stocks that trade on an organized

exchange (or market) are said to
be listed on that exchange.

Quick Quiz

• What are the four basic areas of

finance?

• What are the three types of

financial management decisions,
and what questions are they
designed to 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?