CHAPTER 1

FINANCE AND THE FIRM

LEARNING OBJECTIVES

LO1. Describe the field of finance

LO2. Discuss the duties of financial managers
LO3. Identify the basic goal of a business firm
LO4. List factors that affect the value of the firm
LO5. Discuss the legal and ethical challenges financial
managers face
LO6. Identify the different forms of business organization
 FIELD OF FINANCE

- Finance is important to business people.

- Financial decisions about how to raise, spend and allocate money
can affect every aspect of a business - from personnel to
products.
 FIELD OF FINANCE
Finance offers career opportunities in three main areas: Financial management,
financial markets and institutions, and investments.

Careers in the Field of Finance

Financial Manage the finances of a business firm. Analyze, forecast, and plan a
management firm’s finances; assess risk; evaluate and select investments; decide
where and when to find money sources, and how much money to raise;
and determine how much money to return to investors in the business.
Financial markets Handle the flow of money in financial markets and institutions, and
and institutions focus on the impact of interest rates on the flow of that money.
Investments Locate, select, and manage money - producing assets for individuals and
groups.
 FIELD OF FINANCE - Apple Inc

Careers in the Field of Finance

Financial Financial managers, Directors and Managing Directors, Financial
management Controllers, Cash Managers, ...

Financial markets Banker, Brokers, Dealers, Capital Markets Specialists, Financial

and institutions Institution Derivative Marketers, ...
Investments Security analysts, Mutual fund managers, Investment sales
consultants, Asset managers, ...
 LO2.
Financial
Management

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 FINANCIAL MANAGEMENT
Financial management is essentially a combination of accounting and
economics.
- Financial managers use accounting information—balance sheets,
income statements, and statements of cash flows—to analyze,
plan, and allocate financial resources for business firms.
- Financial managers use economic principles to guide them in
making financial decisions that are in the best interest of the firm.
 Financial management is an applied area of economics that relies
on accounting for input.
 THE ROLE OF THE FINANCIAL MANAGER

- to manage and report the firm’s performance;

- to analyze the financial condition;
- to draw up financial budgeting and;
- to manage financial risks.
FINANCE IN THE ORGANIZATION OF THE FIRM
THE ORGANIZATION OF THE FINANCE TEAM
THE ORGANIZATION OF THE FINANCE TEAM

- Chief financial officer (CFO) supervises a team of employees who

manage the financial activities of the firm. CFO directs and
coordinates the financial activities of the firm.
- Treasurer generally is responsible for cash management, credit
management, and financial planning activities
- Controller is responsible for cost accounting, financial accounting,
and information system activities.
 LO3.
Basic
Financial
Goal of a
business
firm
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 What the basic goal of a firm is?

maximize the wealth of the firm’s owners

maximize the value of the firm

The value of a firm is measured by the price investors are
willing to pay to own the firm.
* For businesses that sell stock to the general public, stock
price indicates the firm’s value because shares of stock are
units of ownership. So the basic financial goal of such firms
is to maximize the price of the firm’s stock.
* Businesses do not sell stock to the general public, focus
on stock price as a measure of the value of the firm.
 LO4.
Factors that
affect the
value of a
firm

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FACTORS THAT AFFECT THE VALUE OF A FIRM
The value of a firm is affected by

the size of future timing riskiness

cash flows
Cash Flow

The term cash flow to describe cash moving through a business.

- Cash inflows—cash that flows into a business
- Cash outflows—cash that flows away from a business.
 Financial managers concentrate on increasing cash inflows and
decreasing cash outflows
 Timing

Owners and potential investors look at when firms can expect to receive cash
and when they can expect to pay out cash. All other factors being equal, the
sooner a company expects to receive cash and the later it expects to pay out
cash, the more valuable the firm and the higher its stock price will be.
Riskiness

Risk affects value because the less certain owners and investors are about a
firm’s expected cash inflows, the lower they will value the company. The
more certain owners and investors are about a firm’s expected cash inflows,
the higher they will value the company.

In short, companies whose expected future cash flows are doubtful will
have lower values than companies whose expected future cash flows are
virtually certain.
 Accomplishing the Primary Financial Goal of the Firm
The Goal Maximize the wealth of the firm’s owners
Measure of the Goal Value of the firm (measured by the price of the stock
on the open market for corporations)

FACTOR EFFECT ON STOCK PRICE

Size of expected Cash inflows increase a firm’s value, whereas cash
future case flows outflows decrease it.
Timing of future cash The sooner cash flows are expected to be received, the
flows greater the value. The later those cash flows are
expected, the less the value.
Riskiness of future The less risk associated with future cash flows, the
cash flows higher the value. The more risk, the lower the value.
 LO5.
Legal and
ethical
challenges

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 Legal and ethical challenges

Several legal and ethical challenges influence financial managers as they

pursue the goal of wealth maximization for the firm’s owners. Three legal and
ethical influences of special note include
- the agency problem
- the interests of non-owner stakeholders
- the interests of society as a whole.
 Agency problem

Agency problem describes conflict between the owners and managers of

firm. Owners appoints managers as their agents to act on behalf of them.
- A strategic investor or the owner of the firm would be majorly concerned
about the longer term performance of the business; that can lead to
maximization of shareholder’s wealth.
- Whereas, a manager might focus on taking such decisions that can bring
quick result, so that he/she can get credit for good performance.
Agency problem

The agency problem can be lessened by tying the managers’ compensation

to the performance of the company and its stock price. This tie brings the
interests of the managers and those of the firm’s owners closer together.
That is why companies often make shares of stock a part of the
compensation package offered to managers, especially top executives. If
managers are also stockholders, then the agency problem should be
reduced.
 The interest of non-owner stakeholders

Stakeholders are generally

defined as groups of people who
have a relationship with the
business. Stakeholders supply a
company with its productive
resources. As a result, they have
a claim on and stake in the
company.
The interests of society as a whole
- The interests of a business firm’s owners sometimes are not the same as
the interests of society.
- For instance, the cost of properly disposing of toxic waste can be so high
that companies may be tempted to simply dump their waste in nearby
rivers. In so doing, the companies can keep costs low and profits high, and
drive their stock prices higher (if they are not caught). However, many
people suffer from the polluted environment.
 LO6.
Forms of
business
organizations

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Proprietorship Partnership

Corporation
 A business owned by one person. An
individual raises some money, finds a
location from which to operate, and starts
selling a product or service. The sole
Proprietorship proprietor is responsible for any tax liability
generated by the business, and the tax rates
are those that apply to an individual.
Proprietorship

+ Easy formation - Limited resource

+ Taxation - Limited business life
+ Prompt decisions - Unlimited liability
+ Easy Dissolution - Small scale of business
 Two or more people may join together to
form a business as a partnership. This can
be done on an informal basis without a
written partnership agreement, or a
contract can spell out the rights and
responsibilities of each partner (articles of
Partnership partnership)

The partners pay any taxes owed. The partnership itself is not taxed
because the income merely passes through the partnership to the
partners, where it is taxed.
Partnership

+ Easy to form - More people to share in the profits

+ Combine capital and expertise - General partners have unlimited liability
+ Spread workload - Disagreements can occur
+ Easier to raise fund - Partnerships may be dissolved if partner
dies
Partnership

General partners Limited partners

participate actively in the take no part in running the
management of the business business
unlimited liability for the only liable for the amount they
partnership’s activities. invest in the partnership

Every partnership must have at least one general partner

 Corporations (C Corporations) are separate
legal entities. That is, corporations must pay
their own income tax just as if they were
individuals => double taxation.
- First, a corporation pays income tax on the
profit it earns.
Corporation - Then the corporation may distribute to the
owners the profits that are left after paying
taxes. These distributions, called dividends,
count as income for the owners and are
taxed on the individual owners’ income tax
returns.
=> collects taxes twice on the same income
Corporation

To form a corporation, the owners specify the governing rules for the
running of the business in a contract known as the articles of
incorporation. They submit the articles to the government of the state
in which the corporation is formed, and the state issues a charter that
creates the separate legal entity.
Corporation

+ Limited liability - Double taxation

+ Transfer of ownership => Perpetual life - Disclosure of information
+ External sources of funds - Expensive to form

Subchapter S Corporation
and LLC
Subchapter S Corporation: the owners are
taxed as if they were members of a
partnership - thereby avoiding the double -
taxation problem. Subchapter S
Corporation are generally very small, can
have no more than 75 shareholders, and
the shareholders must be individuals. The
stockholders of Subchapter S Corporations
also have limited liability.

Limited liability company (LLC): avoids the double taxation C corporation

face while shielding the owners from personal liability. LLCs are similar to
S corporations but have fewer restrictions. For example, LLCs can have
more than 75 owners.
 Characteristics of Business Ownership Forms

Proprietorship Partnership Corporation

Ease of formation Very easy Relatively easy More difficult
Owners’ liability Unlimited Unlimited for Limited
general partners
Life of firm Limited Limited Perpetual life
Legal entity No No Yes
Degree of control by Complete May be limited for May be very limited for
owners individual partner individual stockholder