Chapter 1

Chapter 1Introduction toFinancial ManagementCopyright 2014 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin1What is Finance?Finance applies specific value tothings ownedservices useddecisions madeFinancial managementorganizations approach to valuation

1-#2Economic ParticipantsTwo dimensionsParticipants with extra investment money Participants with economically viable ideas

1-#3Economic Participants Type 1 ParticipantsDo not lend or spend in business contextNo direct role in financial marketsIndirect role: to provide labor and consume products

1-#4Economic Participants Type 4 Participants Use financial toolsevaluate own businesseschoose highest-potential ideasAre self-funded, so no need for financial markets

1-#5Types 2 and 3 Participantsuse financial institutions and financial markets for mutually beneficial exchangeType 2: makes temporary loans to Type 3 Type 3: typically consists of companies engaging in R & D

Economic Participants 1-#6Where Does the Cash Go?Economically successful projects repay money (plus profit) to investorsFriction occurs when not all cash is returned to investors - Retained Earnings - Taxes1-#Retained earnings -Funds that the firm retains to support ongoing operationsTaxes -Used by the government to fund public services

7Figure 1.4: Complete Cash Flows of Finance

1-#figure 1.4The complete cash flows of financeAll the subareas of the financial system interact, with retained earnings and taxes playing a role in the flows.8Subareas of FinanceInvestments involves methods and techniques for making decisions about what kinds of securities to own

1-#9Financial management Decisions about acquiring and using cashExamples includeOrganizing and raising capitalTax decisionsProjects to fundSubareas of Finance1-#10Financial institutions and marketsFacilitate flow of capital between investors and companiesInternational financeFinance theory used in global business environmentSubareas of Finance1-#11Financial Decision Application & Theory Risk Uncertainty of future cash flows due to timing and sizeFinancial AssetOwnership in cash flow represented by securities like stocks, bonds, and other assets1-#12Real Assets Physical property like gold, machinery, equipment, real estateReal Markets Places/processes that facilitate real asset tradingTime Value of Money (TVM)Theory and application of valuing cash flows at various points in timeFinancial Decision Application & Theory 1-#13Finance vs. AccountingAccountingtracks what happened to firms money in the past Financial Managementcombines historical figures and current informationdetermines what should happen with firms money now and in the future1-#14The Financial ManagerChief Financial OfficerHighest level financial officerControllerOversees accounting functionTreasurerResponsible for managing cash, credit, financing, capital budgeting, risk management

1-#15Finance in Other Business FunctionsCFO and Treasurer most visible finance-related positionsFinance permeates the organizationUsed to develop and manage strategyUsed in day-to-day business operationsOperationsMarketingHuman Resources1-#16Finance in Your Personal LifeHelp you make good personal financial decisionsBorrowing money for a new carRefinancing home mortgage at lower rateMaking credit card or student loan paymentsSaving for retirement1-#17Business OrganizationSingle owners, partners, and corporations operate businesses Advantages and disadvantages related toControls and ownership of firmOwners risksAccess to capital and tax ramifications

1-#18Business Form TypesSole ProprietorshipsGeneral PartnershipsCorporationsHybrids1-#19Sole ProprietorshipsNot legally separate from the ownerAdvantagesEasy to startLight regulatory and paperwork burdenSingle taxation at the personal tax rateDisadvantagesUnlimited liabilityLimited access to capital

1-#20General PartnershipsPartners own the business togetherAdvantagesRelatively easy to startSingle taxationDisadvantagesPartners jointly share unlimited liabilityPersonally liable for legal actions and debts of firmDifficult to raise large amounts of capital

1-#21Public CorporationsLegally independent entity entirely separate from its ownersAdvantagesLimited liability for ownersCan raise large amounts of capitalEasy to transfer ownershipDisadvantagesDouble taxation (corporate level and personal level)

1-#22Hybrid OrganizationsCombine attributes of several formsAdvantagesOffer single taxation and limited liability to all ownersS CorporationsLimited Liability Partnerships (LLPs)Limited Liability Companies (LLCs)1-#23Firm GoalsOwner seeks to maximize shareholder wealth and companys value throughMaximizing present value of future cash flowsMaximizing owners equity Decisions aboutattracting additional funds projects in which to investreturning profits to owners over time

1-#24Corporate GoalsMaximize value of owners equityIncrease current value per share (stock price) of existing sharesCommon methodsMaximize net income or profitMinimize costsMaximize market share

1-#25Agency TheoryProblems arise when principal (shareholder) hires agent (manager) to operate firm but cannot monitor the agents actionsManagers interest may not be aligned with shareholder goals1-#26Three approaches to minimizing this conflict of interestIgnore if effect is minimalUse accountants, debt holders to monitor managersProvide incentives to managersEquity stakesStock optionsEmployee Stock Option Plan (ESOP)

Agency Theory1-#27Corporate GovernanceSet of laws, policies, incentives, and monitors designed to handle issues arising from the separation of ownership and control1-#28Inside monitorsBoard of DirectorsHires the CEOEvaluates managementDesigns compensation plansCorporate Governance1-#29Outside monitorsAuditorsAnalystsBanksCredit rating agencies

Corporate Governance1-#30Corporate Governance Monitors

1-#Corporate governance balances the needs of stockholders and managers. Inside the public firm, the members of the board of directors monitor how the firm is run. Outside the firm, auditors, analysts, investment banks, and credit rating agencies act as monitors.31EthicsFinancial professionals manage other peoples moneyCorporate managersBankersInvestment advisorsEthical dilemmas of corporate agency relationshipStealing from firms = stealing from shareholders

1-#32Financial Markets and IntermediariesFinancial markets and financial intermediariesFacilitate flow of capital from investors to firms and back to investorsEarn very high profits because of specialized expertise and assets1-#33Financial Institution Cash Flows

1-#1.10 Financial institutions cash flowsThe unique services and products that financial institutions provide allow them to make money.34The Financial CrisisSubprime Mortgage BorrowersHigher-risk borrowers charged higher interest rates due to higher risk of defaultSecuritizationLoan originators sell the loan repayment rights to other financial institutions or investors1-#35The Financial CrisisSparked by collapse of U.S. home prices in late 2006 and 2007Spread to other financial institutions via affected mortgage-backed securitiesResulted in credit tightening by financial institutions; loss of confidence by consumers1-#36