Chapter 1.

Introduction to Financial Management

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 Chapter Outline

1.1 Finance: A Quick Look

1.2 Business Finance and The Financial Manager

1.3 Forms of Business Organization

1.4 The Goal of Financial Management

1.5 The Agency Problem and Control of the Corporation

1.6 Financial Markets and the Corporation

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 Chapter Outline

After studying this chapter, you should understand:

• The basic types of financial management decisions and the role of the
financial manager

• The goal of financial management

• The financial implications of the different forms of business organization

• The conflicts of interest that can arise between owners and managers

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 Four Basic Areas of Finance

• Corporate Finance

• Investments

• Financial Institutions

• International Finance

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 Corporate Finance

• Corporate finance is the main subject of this book.

• Corporate finance seems to imply that what we cover is only relevant to

corporations,

• but almost all of the topics we consider are much broader than that.

• Corporate finance = business finance

• In this field, we discuss basic financial ideas and principles applicable across
all the various areas of finance and beyond.

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 Corporate Finance

What is the corporate finance?

Suppose you decide to make a firm. To do this, you need the money for producing the
product.
In this case, you have two options for financing.
(i) you can borrow the money from financial institutions.
(ii) you bring the other owners who have money.
Now, with that money, you hire mangers to buy raw materials, and you also hire
employees who will produce the products and sell the products.
When you begin to sell the products, your company will generate cash.

•
•
• The amount of cash you invest in assets must be matched by an equal amount of cash
raised by financing.

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 Investments

• It deals with financial assets such as stocks and bonds.

• Some of the more important questions include:

(i)What determines the price of a financial assets, such as a share of stock?
(ii)What are the potential risks and rewards associated with investing in financial
assets?
(iii)What is the best mixture of the different types of financial assets to hold?

• Job opportunities
- Stockbroker or financial advisor
- Portfolio manager
- Security analyst

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 Financial Institutions/International Finance

Financial Institutions

•Companies that specialize in financial matters

• Banks – commercial and investment, credit unions, savings and loans
• Insurance companies
• Brokerage firms

International Finance

•An area of specialization within each of the areas discussed so far

•May allow you to work in other countries or at least travel on a regular basis
•Need to be familiar with exchange rates and political risk
•Need to understand the customs of other countries; speaking a foreign language
fluently is also helpful

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 What is the Business Finance?

• Imagine you were to start your own business. You have to answer the following
the three questions.

(i)What lines of business will you be in, and what sorts of buildings, machinery,
and equipment will you need?

(ii)Will you bring in other owners, or will you borrow the money?

(iii)

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 Financial Management Decisions

Capital budgeting
:

(i)What lines of business will you be in, and what sorts of buildings, machinery,
and equipment will you need? That is, what long-term investments
should the firm take on?

• How much cash they expect to receive?

• When they expect to receive it?
• How likely they are to receive it?
→ Evaluating the size, timing, and risk of future cash flows is very important
in capital budgeting.

• The financial manager tries to identify good investment opportunities.

• Good investment opportunity means that the value of the cash flows
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generated by an asset exceeds the cost of that asset.
 Financial Management Decisions

Capital structure
:
(ii) Will you bring in other owners, or will you borrow the money? That is,
where will you get the long-term financing to pay for your
investments?

• Should we use debt or equity?

• How much should the firm borrow?
• What are the least expensive sources of funds for the firm?
(There is a variety of lenders/loans in a number of different ways.)

• The financial manager decide how and where to raise the money.
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 Financial Management Decisions

Working capital management

:
(iii) How will we manage the everyday financial activities of the firm,
such as collecting from customers and paying suppliers?

• How much cash should we keep on hand?

• How much inventory should we keep now?
• How can we get the short-term financing?
• The term working capital refers to a firm’s short-term assets, such as
inventory, and short-term liabilities.
• a day-to-day activity

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 Forms of Business Organization

Three major forms of business organization

(1) Sole proprietorship

• a business owned by one person
• The owner of a sole proprietorship keeps all the profits and losses

(2) Partnership
• a business formed by two or more individuals or entities
• Similar to a proprietorship
• All the owners share in gains or losses

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 Forms of Business Organization

(3) Corporation

•The most important form of business organization

•A business created as a distinct legal entity owned by one or more individuals
or entities
•In a large corporation, the shareholders and the managers are usually
separate groups.
The shareholders elect the board of directors.
And then the board of directors select the managers (CEO).
Because of the separation of shareholders and managers, the companies
have several disadvantages, such as agency problem.

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 The Goal of Financial Management

• What should be the goal(s) of a corporation and thus corporate managers?

• Maximize profit?
• Minimize costs?
• Maximize market share?
• Maximize the current value of the company’s stock?

→ Maximizing the current stock price can increase the wealth of the
owners of the firm.

• Does this mean we should do anything and everything to maximize owner

wealth?

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 Agency Problem

• Agency relationship

• Principal hires an agent to represent its interests

• Stockholders (principals) hire managers (agents) to run the
company

→ In this case, will management act in the best interests of the stockholders?

• Agency problem

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 Example of an agency cost

• Example of an agency cost

• A corporation considers a new investment.

• This new investment is expected to impact the stock price, but it is also a
relatively risky venture.
• The owners of the firm will wish to take the investment,
• But managers may not because there is the possibility that things will turn out
badly and management jobs will be lost.
• Finally, the shareholders may lose a valuable opportunity which makes stock
price increase.

→ one example of an agency cost

• Agency problem

• The possibility of conflict of interest between the owners and management of

a firm
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 Method of solving the agency problem
• Two factors

(i)

(ii)

• Managerial compensation

(i) Suppose you hire someone to sell your car and pay her a flat fee when she sells the car.

(ii) Suppose you hire someone to sell your car and pay a commission of 10 percent of the
sales prices instead of a flat fee.

• Incentives need to be carefully structured to insure that they achieve their goal

• Corporate control

• Threat of a takeover may result in better management

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Cash Flows Between the Firm and the Financial Markets

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 Financial Markets

• Primary markets

-
- Public and private placements of securities, SEC registration, and underwriters
are all part of the primary market.
Public offering: selling securities to the general public
Private placement: a negotiated sale involving a specific buyer
- Money raised goes to the issuing company.

• Secondary markets

- The stock exchanges, such as the New York Stock Exchange(NYSE), Korea
Exchange (KRX)
- Funds are exchanged between buyer and seller with no participation by the
issuing company.
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