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Chapter 01 Introduction toFinancial Management
McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.
What is Finance?
• Finance applies specific value to– things owned– services used– decisions made
• Financial management– organization’s approach to valuation
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Economic Participants• Two dimensions
– Participants with “extra” investment money – Participants with economically viable ideas
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• Type 1 Participants
– Do not lend or spend in business context
– No direct role in financial markets
– Indirect role: to provide labor and consume products
Economic Participants
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• Type 4 Participants
– Use financial tools
• evaluate own businesses
• choose highest-potential ideas
– Are self-funded, so no need for financial markets
Economic Participants
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• Types 2 and 3 Participants– use financial institutions and financial markets for
mutually beneficial exchange
• Type 2: makes temporary loans to Type 3
• Type 3: typically consists of companies engaging in
R & D
Economic Participants
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Where Does the Cash Go?• Economically successful projects repay money
(plus profit) to investors• Friction occurs when not all cash is returned
to investors - Retained Earnings - Taxes
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Figure 1.4
Complete Cash Flows of Finance
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Subareas of Finance
• Investments – involves methods and techniques for making
decisions about what kinds of securities to own
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Subareas of Finance
• Financial management
– Decisions about acquiring and using cash
– Examples include
• Organizing and raising capital
• Tax decisions
• Projects to fund
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Subareas of Finance
• Financial institutions and markets– Facilitate flow of capital between investors and companies
• International finance– Finance theory used in global business environment
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Financial Decision Application & Theory
• Risk – Uncertainty of future cash flows due to timing and
size• Financial Asset
– Ownership in cash flow represented by securities like stocks, bonds, and other assets
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• Real Assets – Physical property like gold, machinery, equipment,
real estate• Real Markets
– Places/processes that facilitate real asset trading• Time Value of Money (TVM)
– Theory and application of valuing cash flows at various points in time
Financial DecisionApplication & Theory
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Finance vs. Accounting
• Accounting– tracks what happened to firm’s money in the past
• Financial Management– combines historical figures and current
information– determines what should happen with firm’s
money now and in the future
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The Financial Manager
• Chief Financial Officer– Highest level financial officer
• Controller– Oversees accounting function
• Treasurer– Responsible for managing cash, credit, financing, capital
budgeting, risk management
CFO
Controller Treasurer
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Finance in Other Business Functions• CFO and Treasurer
– most visible finance-related positions• Finance permeates the organization
• Used to develop and manage strategy• Used in day-to-day business operations
– Operations– Marketing– Human Resources
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Finance in Your Personal Life• Help you make good personal financial
decisions– Borrowing money for a new car– Refinancing home mortgage at lower rate– Making credit card or student loan payments– Saving for retirement
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Business Organization• Single owners, partners, and corporations
operate businesses
• Advantages and disadvantages related to• Controls and ownership of firm• Owners’ risks• Access to capital and tax ramifications
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Business Form Types
• Sole Proprietorships
• General Partnerships
• Corporations
• Hybrids
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Sole Proprietorships• Not legally separate from the owner
– Advantages• Easy to start• Light regulatory and paperwork burden• Single taxation at the personal tax rate
– Disadvantages• Unlimited liability• Limited access to capital
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General Partnerships• Partners own the business together
– Advantages• Relatively easy to start• Single taxation
– Disadvantages• Partners jointly share unlimited liability• Personally liable for legal actions and debts of firm• Difficult to raise large amounts of capital
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Public Corporations• Legally independent entity entirely separate
from its owners– Advantages
• Limited liability for owners• Can raise large amounts of capital• Easy to transfer ownership
– Disadvantages• Double taxation (corporate level and personal level)
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Hybrid Organizations• Combine attributes of several forms
– Advantages• Offer single taxation and limited liability to all
owners– S Corporations– Limited Liability Partnerships (LLPs)– Limited Liability Companies (LLCs)
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Firm Goals• Owner seeks to maximize shareholder wealth
and company’s value through– Maximizing present value of future cash flows– Maximizing owners’ equity – Decisions about
• attracting additional funds • projects in which to invest• returning profits to owners over time
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• Maximize value of owners’ equity– Increase current value per share (stock price) of
existing shares• Common methods
– Maximize net income or profit– Minimize costs– Maximize market share
Corporate Goals
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Agency Theory
• Problems arise when principal (shareholder) hires agent (manager) to operate firm but cannot monitor the agent’s actions
• Manager’s interest may not be aligned with shareholder goals
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• Three approaches to minimizing this conflict of interest– Ignore if effect is minimal– Use accountants, debt holders to monitor managers– Provide incentives to managers
• Equity stakes• Stock options• Employee Stock Option Plan (ESOP)
Agency Theory
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Corporate Governance
• Set of laws, policies, incentives, and monitors designed to handle issues arising from the separation of ownership and control
• Current CG Issues– http://www.business-standard.com/article/companies/murty-s-elevation-may
-raise-corporate-governance-issues-at-infy-113082600671_1.html
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• Inside monitors– Board of Directors
• Hires the CEO• Evaluates management• Designs compensation plans
Corporate Governance
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• Outside monitors• Auditors• Analysts• Banks• Credit rating agencies
Corporate Governance
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Corporate Governance Monitors
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Ethics• Financial professionals manage other people’s
money– Corporate managers– Bankers– Investment advisors
• Ethical dilemmas of corporate agency relationship– Stealing from firms = stealing from shareholders
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Financial Markets and Intermediaries• Financial markets and financial intermediaries
– Facilitate flow of capital from investors to firms and back to investors
– Earn very high profits because of specialized expertise and assets
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Financial Institution Cash Flows
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The Financial Crisis
• Subprime Mortgage Borrowers– Higher-risk borrowers charged higher interest
rates due to higher risk of default• Securitization
– Loan originators sell the loan repayment rights to other financial institutions or investors
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• http://www.nytimes.com/2009/12/24/business/24trading.html?pagewanted=all
• Sparked by collapse of U.S. home prices in late 2006 and 2007
• Spread to other financial institutions via affected mortgage-backed securities
• Resulted in credit tightening by financial institutions; loss of confidence by consumers
The Financial Crisis
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Financial Crisis Overview
• http://www.youtube.com/watch?v=_xIO731MAO4
• http://www.youtube.com/watch?v=qqUGoVez8xg