Overview of Financial Management

Finance as we know today grew out of economics and accounting. Economists developed the
idea that an asset’s value is based on the future c ash flows the asset will provide, and
accountants provided information regarding the likely size of these cash flows.
 
Areas of Finance as taught in the academe:
 
Financial Management – also called corporate finance, focuses on decisions relating to
how much and what types of assets to acquired, how to raise the capital needed to buy assets,
and how to run the firm so as to maximize its value.
 
Capital Markets – relate to the markets where interest rates, along with stock and bond
prices, are determined.
 
Investments – relate to decisions concerning stocks and bonds and include a number of
activities such as:

Security analysis – deals with finding the proper values of individual securities
(stocks or bonds);

Portfolio theory – deals with the best way to structure portfolios, or “baskets” of
stock s and bonds.

Market analysis – deals with the issue of whether stock and bond markets at any
given timed are “too high” “too low” or “about right”.

Behavioral Finance – where investor psychology is examined in an effort to determine if

stock prices have been bid up to unreasonable heights in a speculative bubble or driven down
to unreasonable lows in a fit of irrational pessimism (doubt), is part of market analysis.

Forms of Business Organization

 
Single Proprietorship – an unincorporated business owned by one individual.

Three important advantages:

They are easily and inexpensively formed

They are subject to few government regulations
They are subject to lower income taxes than are corporations.
 
Three important limitations

Proprietors have unlimited personal liability for the business’s debts, so

they can lose more than the amount of money they invested in the
business.

The life of the business is limited to the life of the individual who created
it; and to bring in new equity, investors require a change in the
structure of the business.
 Because of the first two points, proprietorships have difficulty obtaining
large sum of capital; hence, proprietorships are used primarily for
small businesses.

Partnership – is an unincorporated association of two or more individuals to carry on, as co-

owners, a business, with the intention of dividing the profits among themselves.
 
The following distinguish a partnership from other types of entities:

A partnership is owned by two or more individuals while a sole

proprietorship is owned by only one individual.

A partnership is created by agreement between the partners while a

corporation or cooperative is created by the operation of law.

A partnership is formed for a business undertaking that is, normally, of

continuing nature while a joint venture may or may not be formed for an
undertaking that is to be continued over several years.
 
Advantages and disadvantages of a partnership:
 
Advantage Disadvantage
Ease of formation Easily dissolved/limited life
Shared responsibility of running the
business Unlimited liability
Flexibility in decision making Conflict among partners
Greater capital compared to sole Lesser capital compared to
proprietorship corporation
Relative lack of regulation as A partnership (other than a
compared to corporation general professional partnership) is
taxed like a corporation

Corporation – is a legal entity created by law, and it is separate and distinct from its owners
and managers. It is this separation that limits stockholders’ losses to the amount they invested
in the firm – the corporation can lose all of its money, but its owners can lose only the funds that
they invested in the company. Corporations also have unlimited lives, and it is easier to transfer
shares of stock in a corporation than one’s interest in an unincorporated business. These
factors make it much easier for corporations to raise the capital necessary to operate large
businesses.
 
Limited Liability Company (LLC) is a relatively new type of organization that is a hybrid
between a partnership and corporation. A limited liability partnership (LLP) is similar to an
LLC; but LLPs are used for professional firms in the fields of accounting, law, and architecture,
while LLCs are used by other businesses.
 
Stock Prices and Shareholder Value
 
primary goal of a corporation should be to maximize its owners’ value, but a proprietor’s
goal might be quite different. The primary goal of the management is shareholder wealth
maximization that is a manager should try to maximize the price of the firm’s stock or it implies
that decisions should be made to maximize the long-run value of the firm’s stock.
The top box indicates that managerial actions, combined with the economy, taxes, and political
conditions, determine stock prices and thus investors’ returns. Investors like high returns, but
they dislike risk; so the larger the expected profits and the lower the perceived risk, the higher
the stock’s price.
 
The second row of boxes differentiates what we call “true expected returns” and “true risk” from
“perceived” returns and “perceived” risk. By “True” we mean the returns and risk that investors
would be expected if they had all of the information that existed about a company. “Perceived”
means what investors expect, given the limited information they actually have.
 

The third row of boxes shows that each stock has an intrinsic value, which is an estimate of
the stock’s “true” value as calculated by a competent analyst who has the best available risk
and return data and a market price, which is the actual market price based on perceived but
possibly incorrect information as seen by the marginal investor (an investor whose views
determine the actual stock price).
 
When a stock’s actual market price is equal to its intrinsic value, the stock is in equilibrium
(there is no pressure for a change in the stock’s price). Market prices can and do differ from
intrinsic values, but eventually, the two values tend to converge.
 
Actual stock prices are easy to determine – they can be found on Internet and newspapers
everyday. However, intrinsic values are estimates; and different analysts with different data and
views about the future form different estimates of a stock’s intrinsic value. Indeed, estimating
intrinsic values is what security analysis is all about and is what distinguishes successful from
unsuccessful investors.
 
Business Ethics
 
Ethics as defined in Webster’s Dictionary as “standards of conduct or moral
behavior.” Business Ethics can be thought of as a company’s attitude and conduct toward its
employees, customers, community, and stockholders. A firm’s commitment to business ethics
can be measured by the tendency of its employees, from the top down, to adhere to laws,
regulations, and moral standards relating to product safety and quality, fair employment
practices, fair marketing and selling practices, the use of confidential information for personal
gain, community involvement, and illegal payments to obtain business.