Chapter 1

Introduction to Financial Management

• Importance of finance
• Forms of business organizations
• Intrinsic values, stock prices, and executive compensation
• Business ethics
• Conflicts between managers, stockholders, and bondholders

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 What is Finance

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 Areas of Finance
§ Corporate finance:
§ what assets to acquire
§ How to raise capital
§ How to run the firm to maximize value.
§ Capital Markets:
§ Relate to markets where stock and bond prices are determined.
§ Financial institutions.
§ Investments:
§ Security analysis
§ Portfolio theory
§ Market Analysis
§ Behavioral Finance
§ They are closely interconnected

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 Forms of Business Organization
1. Proprietorship
2. Partnership
3. Corporation
4. Limited liability companies (LLC or LLP)

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 Proprietorships and Partnerships
§ Proprietorship: An unincorporated business owned by one
individual.
§ Partnership: An unincorporated business owned by two or more
persons.
§ Advantages
§ Ease of formation
§ Subject to few regulations
§ No corporate income taxes
§ Disadvantages
§ Difficult to raise capital
§ Unlimited liability
§ Limited life

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 Corporation
§ Corporation: a legal entity created by a state, and it is
separate and distinct from its owners and managers.
§ Advantages
§ Unlimited life
§ Easy transfer of ownership
§ Limited liability
§ Ease of raising capital
§ Disadvantages
§ Double taxation
§ Cost of setup and report filing

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 Limited liability companies (LLC or LLP)
§ Limited liability companies: a relatively new type of
organization that is a hybrid between a partnership and a
corporation.
§ They have limited liability like corporations but are taxed like
partnerships.

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 Why most successful businesses organize as a
corporation?

§ Limited liability reduces the risks faced by investors

§ Easier to attract capital

§ The liquidity of the corporations’ stocks

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 What is a stock

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 Stock Prices and Shareholder Value
§ The primary financial goal of management is to..
maximize shareholder wealth, which translates to
maximizing stock price.
§ How can management affect stock price?
Through their investment decisions which change expectations
of the firm’s future
§ Is maximizing shareholder value inconsistent with
being socially responsible

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 Determinants of Intrinsic Values and Stock Prices

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 Stock Prices 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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 § Should managers maximize the stock price then or the
intrinsic value?

§ Should managers help investors improve their estimate’s of

the firm’s intrinsic value?

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 Some Important Business Trends
§ Increased globalization of business
§ Improvement in information technology
§ More data and better decisions

§ Corporate Governance

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 Conflicts Between Managers and Stockholders

§ Managers are naturally inclined to act in their own best

interests (which are not always the same as the interest
of stockholders).
Disney’s former president Disney’s former CEO Tyco’s CEO’s $1 million
severance package of pay of $575 million birthday party for his
$140 million after 14 wife
months on the job

§ But the following factors affect managerial behavior:

§ Managerial compensation packages
§ Direct intervention by shareholders
§ The threat of firing
§ The threat of takeover

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 Conflicts Between Stockholders and Bondholders
§ Stockholders are more likely to prefer riskier projects,
because they receive more of the upside if the project
succeeds. By contrast, bondholders receive fixed payments
and are more interested in limiting risk.
§ Bondholders are particularly concerned about the use of
additional debt.
§ Bondholders attempt to protect themselves by including
covenants in bond agreements that limit the use of additional
debt and constrain managers’ actions.

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 What did we
talk about

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