0 chapter 1 introduction to financial management
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Chapter 1
Introduction to Financial Management
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Chapter Outline
Finance: A Quick Look Business Finance and The Financial Manager Forms of Business Organization The Goal of Financial Management The Agency Problem and Control of the
Corporation Financial Markets and the Corporation
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Key Concepts and Skills
Know the basic types of financial management decisions and the role of the financial manager
Know the financial implications of the different forms of business organization
Know the goal of financial management Understand the conflicts of interest that can
arise between owners and managers
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Basic Areas Of Finance
Corporate finance Investments Financial institutions International finance
A
B C
ACBD
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Investments
Work with financial assets such as stocks and bonds
Value of financial assets, risk versus return, and asset allocation
Job opportunities Stockbroker or financial advisor Portfolio manager Security analyst
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Financial Institutions
Companies that specialize in financial matters Banks – commercial and investment,
credit unions, savings and loans Insurance companies Brokerage firms
Job opportunities
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International Finance
This is an area of specialization within each of the areas discussed so far
It may allow you to work in other countries or at least travel on a regular basis
Need to be familiar with exchange rates and political risk
Need to understand the customs of other countries; speaking a foreign language fluently is also helpful
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Why Study Finance?
Marketing Budgets, marketing research, marketing
financial products Accounting
Dual accounting and finance function, preparation of financial statements
Management Strategic thinking, job performance,
profitability Personal finance
Budgeting, retirement planning, college planning, day-to-day cash flow issues
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Business Finance
Some important questions that are answered using finance What long-term investments should
the firm take on? Where will we get the long-term
financing to pay for the investments? How will we manage the everyday
financial activities of the firm?
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Financial Management Decisions Capital budgeting
What long-term investments or projects should the business take on?
Capital structure How should we pay for our assets? Should we use debt or equity?
Working capital management How do we manage the day-to-day
finances of the firm?
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Financial Management DecisionsCompany
(2004 Revenue)
Capital Budgeting Financing
Boeing ($52.5b) $7b to design, build, test and sell 787 Dreamliner aircraft
Negotiate with suppliers to help to finance the Dreamliner project. A Japanese supplier, who will build the wing and fuselage, are raising and investing more than $1.5b
Bank of America ($48.9b)
Acquired Fleet Boston Financial for $49b
Issued about 600 million new shares to finance the acquisition
BP ($285b) Invested $ 600m to develop oil fields offshore in the Gulf of Mexico
Announced plans to return surplus cash flow to shareholders through share repurchase
LVMH ($17.1b) Acquired Glenmorangie PLC, a producer of scotch malt whiskies
Issued a 7-year bond in July 2004, raising the euro equivalent of $812 m
Pfizer ($52.5b) $7.7b on research and testing of new medicines
Finance the research and testing with reinvested cash flow generated by sales of pharmaceutical products
Toyota ($164b) Building an $800m automobile plant in San Antonio, Texas
Total borrowings increased by $2.9b, mainly due to issuance of short-term debt in US
Wal-Mart ($285b) Plan for 2005 call for up to 530 new retail stores in US and 165 stores in other countries
Issued $1883m long-term debt, maturing in 2036 and paying interest at 5.25% per year
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Balance Sheet Model of the Firm
Current Assets
Fixed Assets
1 Tangible
2 Intangible
Total Value of Assets:
Shareholders’ Equity
Current Liabilities
Long-Term Debt
Total Firm Value to Investors:
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The Capital Budgeting Decision
What long-term investments should the firm choose?
Current Assets
Fixed Assets
1 Tangible
2 Intangible
Total Value of Assets:
Shareholders’ Equity
Current Liabilities
Long-Term Debt
Total Firm Value to Investors:
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The Capital Structure Decision
Current Assets
Fixed Assets
1 Tangible
2 Intangible
Total Value of Assets:
How should the firm raise funds for the selected investments?
Shareholders’ Equity
Current Liabilities
Long-Term Debt
Total Firm Value to Investors:
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Short-Term Asset Management
How should short-term assets be managed and financed?
Current Assets
Fixed Assets
1 Tangible
2 Intangible
Total Value of Assets:
Shareholders’ Equity
Current Liabilities
Long-Term Debt
Total Firm Value to Investors:
Net Working Capital
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Financial Manager
Financial managers try to answer some, or all, of these questions
The top financial manager within a firm is usually the Chief Financial Officer (CFO) Treasurer – oversees cash management, credit management,
capital expenditures, and financial planning Controller – oversees taxes, cost accounting, financial
accounting, and data processing
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StockholdersStockholders
Board of DirectorsBoard of Directors
President, Vice-President, President, Vice-President, and Other Officersand Other Officers
Employees of the CorporationEmployees of the Corporation
Organizing and Managing a Corporation
Ultimate control.
Ultimate control.
Stockholders usually meet once a year.
Stockholders usually meet once a year.
Selected by a vote of the
stockholders.
Selected by a vote of the
stockholders.
Overall responsibility for managing the company.
Overall responsibility for managing the company.
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Hypothetical Organization Chart
Chairman of the Board and Chief Executive Officer (CEO)
Board of Directors
President and Chief Operating Officer (COO)
Vice President and Chief Financial Officer (CFO)
Treasurer Controller
Cash Manager
Capital Expenditures
Credit Manager
Financial Planning
Tax Manager
Financial Accounting
Cost Accounting
Data Processing
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Forms of Business Organization
Sole Proprietorship
Sole Proprietorship
PartnershipPartnership CorporationCorporation
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Forms of Business Organization
Three major forms in the United States Sole proprietorship Partnership
General Limited
Corporation Limited liability company
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Sole Proprietorship Advantages
Easiest to start Least regulated Single owner keeps all
of the profits Taxed once as personal
income
Disadvantages Limited to life of owner Equity capital limited to
owner’s personal wealth Unlimited liability Difficult to sell ownership
interestSole
Proprietorship
Sole Proprietorship
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Partnership Advantages
Two or more owners More capital available Relatively easy to start Income taxed once as
personal income
Disadvantages Unlimited liability
General partnership Limited partnership
Partnership dissolves when one partner dies or wishes to sell
Difficult to transfer ownership
PartnershipPartnership
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Corporation Advantages
Limited liability Unlimited life Separation of ownership
and management Transfer of ownership is
easy Easier to raise capital
Disadvantages Separation of ownership
and management (agency problem)
Double taxation (income taxed at the corporate rate and then dividends taxed at personal rate, while dividends paid are not tax deductible)CorporationCorporation
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A Comparison Corporation Partnership
Liquidity Shares can be easily exchanged
Subject to substantial restrictions
Voting Rights Usually each share gets one vote
General Partner is in charge; limited partners may have some voting rights
Taxation Double Partners pay taxes on distributions
Reinvestment and dividend payout
Broad latitude All net cash flow is distributed to partners
Liability Limited liability General partners may have unlimited liability; limited partners enjoy limited liability
Continuity Perpetual life Limited life
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Goal of Financial Management
What should be the goal of a corporation? Maximize profit? Minimize costs? Maximize market share? Maximize the current value of the company’s stock?
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Goal of Financial Management
Goal: Maximize the current value per share of existing stock
More general goal: Maximize the market value of the existing owner’s equity
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Goal of Financial Management
Does this mean we should do anything and everything to maximize owner wealth?
Sarbanes-Oxley Act
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The Agency Problem Agency relationship
Principal hires an agent to represent its interests
Stockholders (principals) hire managers (agents) to run the company
Agency problem Conflict of interest between
principal and agent Management goals and agency
costs
I hire you to run my
company OK!
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Managerial Goals
Managerial goals may be different from shareholder goals Expensive perquisites Survival Independence
Increased growth and size are not necessarily equivalent to increased shareholder wealth
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Managing Managers
Managerial compensation Incentives can be used to align
management and stockholder interests
The incentives need to be structured carefully to make sure that they achieve their goal
Corporate control The threat of a takeover may result
in better management Other stakeholders
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Options are given to key employees to motivate them to: focus on company performance, take a long-run perspective, and remain with the company.
Options are given to key employees to motivate them to: focus on company performance, take a long-run perspective, and remain with the company.
Stock Options
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Example: Work the Web
The Internet provides a wealth of information about individual companies
One excellent site is finance.yahoo.com Click on the Web surfer to go to the site,
choose a company and see what information you can find!
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Financial Markets
Cash flows to the firm Ultimately, the firm must be a cash generating
activity. The cash flows from the firm must exceed the
cash flows from the financial markets. Primary vs. secondary markets
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Figure 1.2
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Financial Markets
Primary Market Issuance of a security for the first time
Secondary Markets Buying and selling of previously issued securities Securities may be traded in either a dealer or
auction market Dealer vs. auction markets Listed vs. over-the-counter securities
NYSE NASDAQ
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Financial Markets
FirmsInvestors
Secondary Market
money
securitiesSueBob
Stocks and Bonds
Money
Primary Market
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Quick Quiz
What are the four basic areas of finance? What are the three types of financial
management decisions, and what questions are they designed to answer?
What are the three major forms of business organization?
What is the goal of financial management? What are agency problems, and why do they
exist within a corporation? What is the difference between a primary
market and a secondary market?