Financial Management - Chapter 1 Introduction PDF

Introduction to Financial Management CHAPTER ONE Topics 1. Finance and Business 2. Goal of the Corporation 3. Ethics and Shareholder Wealth Maximization 4. Financial Institutions and Financial Markets Finance and Business Areas of Finance: 1. Financial Management ◦ Investment decisions, financing...

Introduction to Financial Management CHAPTER ONE Topics 1. Finance and Business 2. Goal of the Corporation 3. Ethics and Shareholder Wealth Maximization 4. Financial Institutions and Financial Markets Finance and Business Areas of Finance: 1. Financial Management ◦ Investment decisions, financing decisions, shareholder wealth maximization 2. Capital Markets ◦ Study of financial markets and institutions 3. Investments ◦ Security analysis, portfolio theory, market analysis and behavioral finance Finance and Business Finance and Business Forms of Business Organizations: 1. Sole Proprietorship 2. Partnership 3. Corporation 4. Cooperative Finance and Business Sole Proprietorship ◦ A business owned by a person who has complete control over business decisions ◦ Advantages ◦ Owner receives all benefits ◦ Ease of entry and exit ◦ Few governmental regulations ◦ Low organizational costs ◦ Income included and taxed in the owner’s personal tax return Finance and Business Sole Proprietorship ◦ Disadvantages ◦ Owner has unlimited liability ◦ Limited fund-raising ◦ Lack of continuity Finance and Business Partnership ◦ Two or more people who bind themselves to contribute money, propery or industry to a common fund, with the intention of dividing the profits among themselves ◦ Advantages ◦ Can raise more capital then sole proprietorship ◦ More available skills ◦ Income included and taxed on partner’s personal tax return Finance and Business Partnership ◦ Disdvantages ◦ Owners have unlimited liability ◦ Easily dissolved ◦ Difficult to transfer or liquidate partnership Finance and Business Corporation ◦ An artificial being created by operation of law, having the right of succession and the powers, attributes, and properties expressly authorized by law or incident to its existence ◦ Advantages ◦ Owners have limited liability ◦ Unlimited life of the firm ◦ Ownership is readily transferable ◦ Ability to raise capital Finance and Business Corporation ◦ Disadvantages ◦ Taxes are generally higher ◦ Expensive organization costs ◦ Subject to greater government regulation Finance and Business Cooperative ◦ A member-owned business organization with at least five members, all of whom have equal voting rights regardless of their level of involvement or investment ◦ Advantages ◦ Inexpensive to register ◦ Members are involved in running the cooperative ◦ Limited liability ◦ Members can vote Finance and Business Cooperative ◦ Disadvantages ◦ May be difficult to attract members ◦ Only one vote per member ◦ Requires continuous training in running the cooperative Goal of the Corporation Reasons why profit maximization is not for corporations: ◦ Profits are earnings which do not represent cash flows available to stockholders ◦ Profit fails to consider investment risks ◦ Profit is only concerned with the short-term income of the company Goal of the Corporation Intrinsic value of stock ◦ It is difficult to determine the correct market price for the company’s stock ◦ To obtain the intrinsic value of the stock, we must first differentiate between “true” risk and cash flows, from “perceived” risk and cash flows ◦ Stock market price is usually based on perceived risks and perceived cash flows ◦ Intrinsic value of stock is based on accurate risk and return data Goal of the Corporation Intrinsic value of stock ◦ When the intrinsic value of a stock is higher than the market prices, stock in the market is undervalued ◦ When the intrinsic value of a stock is lower than the market price, stock in the market is overvalued ◦ When the stock’s actual market price is equal to its intrinsic value, the stock is in equilibrium Ethics and Shareholder Wealth Maximization The Agency Problem: Possible causes ◦ There is a separation of ownership and control ◦ Goals of the agents are different from those of the stakeholders ◦ Stakeholders do not get full information about their company from the managers or the market Ethics and Shareholder Wealth Maximization Corporate Governance ◦ The framework of rules, systems and processes in the corporation that governs the performance by the Board of Directors and Management of their respective duties and responsibilities to the stockholders Financial Institutions and Financial Markets Financial Institutions ◦ Accept savings and transfer them to those that need funds ◦ Directly or indirectly pay saver’s interest on deposited funds, others provide service fees ◦ Individuals, businesses and governments all need or supply funds ◦ Individuals are net suppliers in financial institutions ◦ Businesses and governments are net demanders in financial institutions Financial Institutions and Financial Markets Financial Markets ◦ Transactions in short-term debt instruments, or marketable securities, take place in the money market ◦ Financial relationships between suppliers and demanders of short-term funds are created in the money market ◦ Transactions for long-term securities, bonds and stocks are traded in the capital market ◦ Financial relationships between demanders and suppliers of long-term funds are formed in the capital market