Financial Management Overview and Shareholder Value

Financial Management Overview

• Businesses are organized primarily as proprietorships, partnerships, corporations, or limited liability companies (LLCs).
• Advantages of proprietorships: easy formation, minimal regulations, lower taxes, but face unlimited liability, limited life, and capital-raising difficulties.
• Partnerships allow for no corporate taxes and easier transfer of ownership but entail setup costs and similar liability issues.
• Corporations offer unlimited life, limited liability, and ease of capital raising but suffer from double taxation where profits and dividends are taxed separately.
• LLCs combine benefits of partnerships and corporations, providing limited liability and tax flexibility while needing legal support for establishment.

Shareholder Value

• Primary goal of financial management is to maximize shareholder wealth through long-run value maximization of common stock.
• Financial decisions should balance maximizing profits with social responsibility to maintain corporate reputation and stakeholder relationships.
• Actions solely aimed at increasing profits may jeopardize long-term viability if they neglect worker, customer, or community welfare.

Intrinsic Value and Stock Prices

• Intrinsic value reflects the “true” value of a stock and depends on future performance, estimable but imprecise, and influenced by new information.
• Stock prices are determined by market conditions, where equilibrium occurs when intrinsic value matches the stock price.
• Effective Annual Rate (EFF%) is vital for comparing investments with varying compounding intervals.

Amortized Loans

• Amortized loans are repaid in equal payments over time, with interest costs decreasing as principal is paid down.
• The total payment (PMT) consists of principal plus interest, which can be calculated through specific formulas to track payment schedules.
• Loan amortization calculations involve multiple steps to find principal repaid and ending balances after each payment.

Financial Markets and Institutions

• Financial markets facilitate efficient capital allocation, connecting suppliers (those with excess funds) with demanders (those needing funds).
• Key financial statements reflect a company's financial performance, including income statements, balance sheets, and cash flow statements.
• Tax treatment varies between dividends (often taxed again at personal income tax rates) and interest expense (usually deductible).
• Interest rates are influenced by various factors including inflation expectations, monetary policy, and economic conditions.

Risk and Rates of Return

• Stand-alone risk refers to the risk associated with holding a single asset, while portfolio risk considers the diversification effect.
• Investors' risk aversion leads to higher required returns on riskier investments, captured in the risk premium.
• Coefficient of Variation (CV) measures risk per unit of return, useful for comparing investments with differing expected returns.
• Market risk affects all stocks and is represented by beta, with values indicating relationship to market risk: beta of 1 equals market risk, greater than 1 indicates higher risk, and less than 1 indicates lower risk.

Capital Asset Pricing Model (CAPM)

• CAPM links required return on a stock to its risk, represented by beta, reflecting systematic risk post-diversification.
• Security Market Line (SML) represents a relationship between risk and expected return, helping investors assess whether a stock is undervalued or overvalued.
• Market risk premium measures additional return required over the risk-free rate and reflects investor risk aversion.