Financial Decision Making Objective

Study Notes

Financial Decision Making

The objective of financial decision making is to maximize the value of a business or firm.
It involves three main decisions:
Investment Decision (capital budgeting): deciding whether to invest in a project, e.g., developing and producing a new iPhone.
Financing Decision: deciding how to finance the project, e.g., through debt or equity.
Working Capital Management Decision: making decisions about day-to-day operations within the business.

Financial Concepts

Assets: what a firm owns.
Liabilities: what a firm owes.
Equity: capital received from owners (investors), perpetual and represents ownership of the company.
To raise capital, businesses must either have debt or equity.

Balance Sheets

Assets = Liabilities + Equity.
Accounts receivable: when someone owes you money (usually less than 12 months).
Accounts payable relates to debt and liabilities.

Forms of Business

Sole Proprietorship:
- One person responsible for managing business and providing capital.
- Advantages: simple, no profit/loss sharing, cheap, taxed once as personal income.
- Disadvantages: limited access to capital, costly to change owners, unlimited liability.
Partnership:
- Two or more owners joined to manage business and share profits.
- General Partnership: all partners are owners and active within business.
- Limited Partnership: has both general partners (active) and limited partners.
- Advantages: more owners, more capital, easy to start, taxed once as personal income.
- Disadvantages: unlimited liability, dissolves when one partner wishes to sell.
Corporation:
- Legal process used to form a corporate entity.
- Advantages: separate from owners entity, easy to transfer owners, limited liability.
- Disadvantages: separation may create conflict, costly to establish, corporate tax rate.

Agency Problems/Costs

Agency problems arise from conflicts of interest that may hurt the overall value of the business.
Managers may make decisions that hurt firm value, therefore hurting shareholders.
Disciplinary mechanisms include:
- Shareholders' annual meeting to evaluate managers' performance.
- Board of Directors to oversee management of a firm.
- Compensation plan based on performance of manager.

Raising Capital

Firms sell securities to savers (investors) to raise capital.
Firm invests in a profitable project.
Firm distributes some of the money back to savers:
- Debt holders get a percentage of interest on $ and return of principal.
- Shareholders get ownership claims and a share in the earnings.

Flow of Funds

Primary Market Transaction:
- Firm issues new securities and sells them to investors.
- Cash changes hands between the business and investors.
- Facilitated by an investment bank (underwriter).
Secondary Market Transaction:
- Securities continue to trade between investors without involvement of the firm.
- Cash changes hands among investors.
- Facilitated by a dealer for trading of bonds and a broker for trading of shares.

Description

Learn about the key objectives of financial decision making, including maximizing business value, investment decisions, financing decisions, and working capital management. Understand the importance of assets and other factors in financial decision making.