Lecture Note 1.

Introduction to Finance

Financial Management
Main Contents

Why Should We Study Finance?

Types of Firms

The Financial Manager

The Financial Manager’s Place in the Corporation

The Stock Market

Financial Institutions

Financial Management 2 Lecture Note 1. Introduction

Learning Objectives

Grasp the importance of financial information in both your personal and

business lives

Understand the important features of various types of firms

Why have the advantages of the corporate form led it to dominate economic activity?

Explain the goal of the financial manager and the three main types of
decisions a financial manager makes

Know how a corporation is managed and controlled

Understand some of the ethical issues financial managers face

Understand the importance of financial markets

Recognize the role that financial institutions

Financial Management 3 Lecture Note 1. Introduction

1. Why Should We Study Finance?

What is the financial management?

A broad sense: Finance
It is an academic area, which study and analyze all activities managing and controlling the
application of funds (cash inflows and outflows or investing and financing of funds) through
various financial markets
It includes various areas and topics
 Corporate finance
 Investment
 Financial and security markets
 Derivatives and derivatives markets
 Financial institutions
 Business and financial analyses, etc.

A narrow sense: Corporate Finance

It is a kind of Finance in a broad sense
It studies and analyzes all activities managing and controlling the application of corporate
funds (investing and financing of corporate funds)

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1. Why Should We Study Finance?(Cont.)

Why should we study finance?

Financial information and financial decisions are very important in both your personal
and business lives

Individuals take charge of their personal finances with decisions such as:
When to start saving and how much to save for retirement
Whether a car loan or a lease is more advantageous
Whether a particular stock is a good investment
How to evaluate the terms for a home mortgage

In your business career, you may face such questions such as:
Should your firm launch a new product?
Which supplier should your firm choose?
Should your firm produce a part or outsource production?
Should your firm issue new stock or borrow money instead?
How can you raise money for your start-up firm?

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2. The Types of Firms

Sole proprietorship
A business owned and run by one person

The key features of a sole proprietorship

It has the advantage of being straightforward to set up
 Many new businesses use this organizational form
Principal limitation(or weakness) is that there is no separation between the firm and the owner
 The firm can have only one owner who runs the business
The owner has unlimited personal liability for the firm’s debts
The life of a sole proprietorship is limited to the life of the owner
 It is difficult to transfer ownership of a sole proprietorship

For most businesses, the disadvantages of a sole proprietorship outweigh the

advantages
As soon as the firm reaches a particular phase, the owners typically convert the business into a
form that limits the owner’s liability

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2. The Types of Firms (Cont.)

There are five types of firms in Korean Commercial Act

(General) partnership (합명회사)
Limited partnership (합자회사)
Private company (or limited company, 유한회사)
Limited liability company (LLC, 유한책임회사)
Corporation (주식회사)

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2. The Types of Firms (Cont.)

(General) Partnership
It is identical to a sole proprietorship except it has more than one owner
Often firms, in which the owners’ personal reputations are the basis for the business, remain as
partnerships → law firms, accounting firms, or consulting firms, etc.

The key features of partnership

Unlimited liability: all partners are liable for the firm’s debt
The partnership ends on the death or withdrawal of any single partner
Partners can avoid liquidation if the partnership agreement provides for alternatives such as a
buyout of a deceased or withdrawn partner

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2. The Types of Firms (Cont.)

Limited partnership
A partnership with two kinds of owners, general partner and limited partner

General partner
She/he has the same rights and privileges as partners in any general partnership
She/he is personally liable for the firm’s debt obligations

Limited partner
She/he has a limited liability and her/his ownership interest is transferable
She/he has no management authority

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2. The Types of Firms (Cont.)

Private company
A company consisting only of limited partners (or limited liability employees)

It is similar to a corporation but has several differences

It has fewer stakeholders than the corporation, and is less regulated in terms of establishment
and operation
It is not possible to convert a company's stake(or ownership) into a security such as stock, but it
is possible to transfer the stake to another person
There is a employees meeting of the company as the decision-making body
 It makes all decisions related to the management of the company

It is a type of firm suitable for small and medium companies rather than large
companies

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2. The Types of Firms (Cont.)

Limited liability companies (LLC)

Limits the owners’ liability to their investment
The owners cannot be held personally liable for the firm’s debts
It is similar to private company

LLCs were introduced for small businesses, knowledge-based industries and other
companies where ownership and management are concentrated in individuals and
where human capital is more important
It is only necessary for the executive to execute the work without the need to establish a
director or an employee general meeting
It is easy to utilize the human ability of employees because the profit distribution can be
different regardless of their investments
The stake can not be securitized and the stake can be transferred to another freely only when
that is permitted in the Articles of Incorporation

In U.S., there are private limited companies and public limited companies
Public limited companies are allowed to have their shares traded on an exchange
 But most companies choose not to be listed
The owners of private limited companies are not allowed to trade their shares on an organized
exchange
 Private limited companies are a relatively new phenomena in the U.S.

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2. The Types of Firms (Cont.)

Corporation
A company consisting of only shareholders who are obligated to contribute to the
capital of the company and who are not responsible for the creditors (limited liability)

Features of corporations
A corporation is a legally defined, artificial being, separate from its owners
A corporation is a legal entity separate and distinct from its owners
 A corporation is solely responsible for its own obligations
 The owners of a corporation are not liable for any obligations the corporation enters into
 The corporation is not liable for any personal obligations of its owners

The formation of a corporation must be legally formed

A legal document (or corporate charter) is created on formation of the company
Corporate charter specifies the initial rules that govern how the corporation is run
More costly than setting up a sole proprietorship or a partnership

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2. The Types of Firms (Cont.)

Features of corporations (Cont.)

Ownership of a corporation
No limit on the number of owners
 The entire ownership stake of a corporation is divided into shares
 The collection of all the outstanding shares of a corporation is known as the equity of it

An owner of a share is known as a shareholder, stockholder, or equity holder

 Shareholders are entitled to dividend payments
 Usually they receive a share of the dividend payments that is proportional to the amount of
stock they own

No limitation on who can own its shares in most countries, not all

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2. The Types of Firms (Cont.)

Tax implications for corporate entities

A corporation’s profits are subject to taxation separate from its owners’ tax obligations
Shareholders of a corporation pay taxes twice: double taxation
The corporation pays tax on its profits
When the remaining profits are distributed to the shareholders, the shareholders pay their own
personal income tax on this income

Tax problem: Example 1.1

You are a shareholder in a corporation. The corporation earns $5 per share before taxes. After it
has paid taxes, it will distribute the rest of its earnings to you as a dividend
When the corporate tax rate is 20% and your marginal tax rate on dividend income is 35%,
How much of the earnings remains after all taxes are paid?
 Corporation earning after tax = $5×(1-0.2) = $4
 Individual income after tax = $4×(1-0.35) = $2.6
 Total effective tax rate = 2.4/5 = 48%

Financial Management 14 Lecture Note 1. Introduction

2. The Types of Firms (Cont.)

C Corporations and S Corporations in the US

C Corporations
Must pay corporate taxes on its profits
 Since individuals must pay personal income taxes on these dividends, shareholders in such
corporations effectively must pay taxes twice
Most corporations in the US are C corporations
S Corporations
The firm’s profits/losses are not subject to corporate taxes
 Profits/losses are allocated directly to shareholders based on their ownership
Shareholders must include these profits as income on their individual tax returns, even if no
money is distributed to them
Problem: Example 1.2
Rework Example 1.1 assuming the corporation in that example has elected subchapter S
treatment and your tax rate on non-dividend income is 30%
 Corporate tax rate = 0%
 Individual income after tax = $5*(1-0.3) = $3.5
 Shareholder pays substantially lower effective tax rate

Financial Management 15 Lecture Note 1. Introduction

[참고] 2023년 종합소득세율 및 법인세율

과세표준구간별 종합소득세율표
과세표준 세율 누진공제
1,200만 원 이하 6% -
1,200만 원 초과 ~ 4,600만 원 이하 15% 108만 원
4,600만 원 초과 ~ 8,800만 원 이하 24% 522만 원
8,800만 원 초과 ~ 1억5,000만 원 이하 35% 1,490만 원
1억 5000만원 초과 ~ 3억 원 이하 38% 1,940만 원
3억 원 초과 ~ 5억 원 이하 40% 2,540만 원
5억 원 초과 ~ 10억 원 이하 42% 3,540만 원
10억 원 초과 45% 6,540만 원

영리법인의 과세표준구간별 법인세율

과세표준 세율 누진공제
2억 원 이하 9% -
2억 원 초과 ~ 200억 원 이하 19% 2,000만 원
200억 원 초과 ~ 3,000억 원 이하 21% 4억 2,000만 원
3,000억 원 초과 24% 94억 2,000만 원

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3. The Financial Manager

The goal of the firm

The overriding goal of financial management is to maximize the wealth of the
shareholders or the firm value

The financial manager has three main tasks

Making investment decisions
Main objective: Making the optimal asset structure to maximize the firm value
 The financial manager must weigh the costs and benefits of each investment or project
 They must decide which investments or projects qualify as good uses of the shareholders’
money
Making financing decisions
Main objective: Making the optimal capital structure to maximize the firm value
 The financial manager must decide whether to raise more money from new and existing
owners by selling more shares (equity) or to borrow the money (bonds and other debt)
Managing cash flow from operating activities (working capital)
The financial manager must ensure that the firm has enough cash on hand to meet its
obligations at each point in time
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4. The Financial Manager’s Place

Shareholders own the corporation but rely on financial managers to

actively manage the corporation
The board of directors and the management team headed by the CEO possess direct
control of the corporation

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4. The Financial Manager’s Place (Cont.)

Ethics and incentives in corporations

Agency Problems
When managers (agent) put their own self-interest ahead of the interests of those shareholders
(principal)
 Further potential for conflict of interest and ethical considerations arise when some
stakeholders in the corporation benefit and others lose from a decision
The main cause of agency problems is the information asymmetry about the firm value and
business activities
There are two types of agency problems
 Agency problems between shareholders and managers
 Agency problems between shareholders and creditors (or debt holders)

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4. The Financial Manager’s Place (Cont.)

Ethics and Incentives in Corporations (cont.)

How to reduce the agency problems
Reducing information asymmetry:
 Strengthen monitoring of managers’ activities
Trying managers’ compensation too closely to performance
Using the market discipline
 When the share price deteriorates due to lower performance, the board of directors might
react by replacing the CEO
 A corporate raider may initiate a hostile takeover

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5. The Stock Market

The financial markets

The markets in which various financial assets or securities are traded
We classify the financial markets into various submarkets based on several criteria

Types of financial markets according to financial trading ways

Direct financing: the consumers and supplies are directly trading the financial assets in the
market
Indirect financing: the consumers and supplies are indirectly trading the financial assets
through financial intermediaries (or financial institutions)

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5. The Stock Market (Cont.)

The financial markets (Cont.)

Types of financial markets according to maturities of financial assets
Money market
 The markets in which financial assets with less than 1-year maturity are traded
 Major financial assets: Treasury bill, Eurodollar, certificate of deposit(CD), commercial
paper(CP), Repurchase paper(RP or repo), MSB in Korea, etc

Capital market
 The markets in which financial assets with more than 1-year maturity are traded
 Major financial assets: stock and bond

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5. The Stock Market (Cont.)

Corporations can be private or public

A private company has a limited number of owners and there is no organized market
for its shares
The value of shares issued by a private company can be difficult to determine
A public company has many owners and its shares trade on an organized market,
called a stock market (stock exchange or bourse)
Stock markets provide liquidity for a company’s shares and determine the market price
for those shares

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5. The Stock Market (Cont.)

Primary and secondary markets

Primary market refers to a corporation issuing new securities(stock or bond) and
selling them to investors
Secondary market is a market where already issued securities are traded between
investors in

Auction market and dealer market

Auction market is a market where share prices are set through direct interaction of
buyers and sellers without market makers → order-driven market
Ex: NYSE(New York Stock Exchange), KRX(Korea Exchange)
Market makers (Specialists in NYSE)
 Individuals on a stock exchange who match buyers with sellers
 They provide stock markets with price information and liquidity
 Bid-Ask Spread: transaction costs of stock trading
⚫ The difference between bid price (buying price of market maker) and ask(offer) price (selling price of
market maker)
Dealer market is a market where dealers buy and sell for their own accounts
Ex: NASDAQ, over-the-counter(OTC) markets

Financial Management 24 Lecture Note 1. Introduction

[참고] Stock trading procedure in Korea

금융위원회(FSC)
금융감독원(FSS)

투자자(매입) 증권회사 유가증권시장 증권회사 투자자(매도)

(한국거래소)

한국예탁 현금흐름
결제원
유가증권흐름

감독∙통제

Financial Management 25 Lecture Note 1. Introduction

6. Financial Institutions

Financial institutions
Entities that provide financial services, such as taking deposits, managing investments,
brokering financial transactions, or making loans

The Financial cycle

The circulation process of fund in financial markets
Step 1: People invest and save their money
Step 2: Through loans and stock, that money flows to companies who use it to fund growth
through new products, generating profits and wages
Step 3: The money then flows back to the savers and investors

All financial institutions play a role at some point in the financial cycle

Financial Management 26 Lecture Note 1. Introduction

6. Financial Institutions (Cont.)

Types of Financial Institutions

Market intermediaries
Financial institutions that provide financial services in direct financial markets
Investment banks, security companies, various types of funds, asset management companies,
etc

Financial intermediaries
Financial institutions that provide financial services in indirect financial markets
Commercial banks, credit unions, insurance companies, etc

Financial conglomerates/financial services firms combine more than one type of

institution

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6. Financial Institutions (Cont.)

Role of Financial Institutions

Financial institutions i) move funds from savers to borrowers, ii) move funds through
time, iii) help spread out risk-bearing

Reducing transaction costs

FIs can reduce transaction costs of financial trading using the effects of economy of scale

Changing the characteristics of financial assets

FIs can make various financial assets with different shape, contract condition, maturity, risk
structure, etc

Creating the means of payment and settlement

Currency, check, credit card, electronic money, etc

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