Introduction to Financial Management

Chapter 1

Forms of Business Organization Stock Prices and Shareholder

Value Intrinsic Values, Stock Prices, and

Executive Compensation Important Business Trends Conflicts Between Managers,

Stockholders, and Bondholders 1-1

Finance Within the Organization

1-2

Forms of Business Organization

Proprietorship

Partnership

Corporation

1-3

Proprietorships and Partnerships

Advantages Ease of formation

Subject to few regulations

No corporate income taxes

Disadvantages Difficult to raise capital

Unlimited liability

Limited life

1-4

Corporation

Advantages Unlimited life

Easy transfer of ownership

Limited liability

Ease of raising capital

Disadvantages Double taxation

Cost of set-up and report filing

1-5

Stock Prices and Shareholder Value

The primary financial goal of management is shareholder wealth maximization, which translates to maximizing stock price. Value of any asset is present value of cash

flow stream to owners.

Most significant decisions are evaluated in terms of their financial consequences.

Stock prices change over time as conditions change and as investors obtain new information about a company’s prospects.

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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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Determinants of Intrinsic Values and Stock Prices

1-8

“True” Risk

“Perceived” Investor Returns

“Perceived” Risk

Managerial Actions, the Economic Environment, Taxes, and the Political

Climate

Stock’s Intrinsic Value

Stock’s Market Price

Market Equilibrium:Intrinsic Value = Stock

Price

Some Important Business Trends

Recent corporate scandals have reinforced the importance of business ethics, and have spurred additional regulations and corporate oversight.

Increased globalization of business.

The effects of ever-improving information technology have had a profound effect on all aspects of business finance.

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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).

But the following factors affect managerial behavior: Managerial compensation packages

Direct intervention by shareholders

The threat of firing

The threat of takeover1-10

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 receiving fixed payments 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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