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Topic 1

Introduction to
Financial
Management
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Objectives:
• What are the three basic areas of finance?
• What are the four types of financial management
decisions, and what questions are they designed
to answer?
• Who are the financial managers?
• What is the goal of financial management?
• What are the three major forms of business
organization?
• What are agency problems, and why do they
exist within a corporation?
• How do stock price and intrinsic value differ?
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Basic Areas Of Finance

• Financial Management (Corporate Finance)
• Financial Markets
• Investments

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Financial Management
Decisions
• Capital budgeting (Investment)
– What long-term investments or projects should the
business take on?
• Capital structure (Financing)
– How should we pay for our assets?
– Should we use debt or equity?
• Working capital management
– How do we manage the day-to-day finances of the
firm?
• Dividend Policy
– Should the firm retain all profits or distribute all
profits or retain a portion and distribute the
balance?

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Finance Within the Organization

Board of Directors

Chief Executive Officer (CEO)

Chief Operating Officer (COO) Chief Financial Officer (CFO)

Marketing, Production, Human Accounting, Treasury, Credit,

Resources, and Other Operating Legal, Capital Budgeting, and
Departments Investor Relations

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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)
– Treasurer – oversees cash management, credit
management, capital expenditures, and financial
planning
– Controller – oversees taxes, cost accounting,
financial accounting, and data processing

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Goal Of Financial Management

• What should be the goal of a corporation?
– Maximize profit?
– Minimize costs?
– Maximize market share?
– Maximize the current value of the company’s
stock?
• Does this mean we should do anything
and everything to maximize owner wealth?

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Forms of Business Organization

• Three major forms in the United States
– Sole proprietorship
– Partnership
• General
• Limited
– Corporation

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Sole Proprietorship

• Advantages • Disadvantages
– Easiest to start – Limited to life of owner
– Least regulated – Equity capital limited to
– Single owner keeps owner’s personal
all of the profits wealth
– Taxed once as – Unlimited liability
personal income – Difficult to sell
ownership interest

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Partnership

• Advantages • Disadvantages
– Two or more owners – Unlimited liability
– More capital available • General partnership
• Limited partnership
– Relatively easy to
start – Partnership dissolves
– Income taxed once as when one partner dies
personal income or wishes to sell
– Difficult to transfer
ownership

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Corporation
• Advantages • Disadvantages
– Limited liability – Separation of
– Unlimited life ownership and
– Separation of management (agency
ownership and problem)
management – “Double taxation”
– Transfer of ownership (income taxed at the
is easy corporate rate and
then dividends taxed
– Easier to raise capital at personal rate, while
dividends paid are not
tax deductible)

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The Agency Problem

• Agency relationship
– Principal hires an agent to represent its
interests
– Stockholders (principals) hire managers
(agents) to run the company
• Agency problem
– Conflict of interest between principal and
agent
• Management goals and agency costs

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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
– The threat of a takeover may result in better
management

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Stock Price and Intrinsic Value

• In equilibrium, a stock’s price should
equal its “true” or intrinsic value.
• Intrinsic value is a long-run concept.
• To the extent that investor perceptions are
incorrect, a stock’s price in the short run
may deviate from its intrinsic value.
• Ideally, managers should avoid actions
that reduce intrinsic value, even if those
decisions increase the stock price in the
short run.

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Determinants of Intrinsic Values
and Stock Prices
Managerial Actions, the Economic
Environment, Taxes, and the Political Climate

“True” Investor “True” “Perceived” Investor “Perceived”

Cash Flows Risk Cash Flows Risk

Stock’s Stock’s
Intrinsic Value Market Price

Market Equilibrium:
Intrinsic Value = Stock Price
• When the stock’s market price is higher than its intrinsic value, the
stock is said to be overvalued; and it is a good decision to sell the stock.
• When the stock’s market price is lower than its intrinsic value, the stock
is said to be undervalued; and it is a good decision to buy the stock.
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Figure 1.2

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Quick Quiz
• What are the three basic areas of finance?
• What are the four types of financial management
decisions, and what questions are they designed
to answer?
• Who are the financial managers?
• What is the goal of financial management?
• What are the three major forms of business
organization?
• What are agency problems, and why do they
exist within a corporation?
• How do stock price and intrinsic value differ?
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