Slide 1

Introduction to Financial Management Definitions of Finance Financial Management Decisions and The Goal Forms of Business Organizations The Corporation and Financial Markets Ten Principles of Finance

Slide 2

Definition of Finance Finance is the study of how people allocate scarce

resources over time. Two characteristics of financial decisions; Costs and benefits of financial decisions are spread out

over time Costs and benefits are not known in advance

Finance consists of concepts to help you organize your decision making process and quantitative models to help you evaluate alternatives

Slide 3

Financial Management Decisions and The Goal Capital Budgeting: What assets should be

acquired? Capital Structure: What is the best way of

financing the assets? Working Capital Management: Short-term asset

and liability management

Slide 4

Financial Management Decisions and The Goal (Continued)

The Goal of Financial Managers Maximize profits How to define profits Risks associated with maximizing profits are ignored Profits of this year or the next should be maximized?

Maximize the market value of the existing owners’ equity

Slide 5

Forms of Business Organization

Ownership Form

Ease of Formation

Ability to Raise Funds

Management Personal Liability

Income Tax Treatment

Transfer of Ownership

Dissolution

Individual (Sole Proprietorship)

Simple and inexpensive

Limited Flexible, independent, may lack expertise

Unlimited Single Simple and inexpensive

Excellent

General Partnership

Moderately easy

Limited but superior to individual ownership

Designated partners

Unlimited Single Poor Fairly simple

Limited Partnership

Moderately difficult and expensive

Limited but superior to general partnership

General partners or agents

Limited for limited partners

Single Poor for general partners

Time consuming

Corporation Complex and expensive

Good Usually separate from ownership

Limited Double Superior

Simple but needs shareholders’ approval

Slide 6

The Corporation and Financial Markets

Corporation

Cash Flows: Reinvested or

Investors

Secondary Market

GovernmentTax

Cash

Securities

Dividends, Interest etc.

Slide 7

The Corporation and Financial Markets (Continued) Primary Market

Market in which new issues of a security are sold to initial buyers

Secondary Market Market in which previously issued securities are traded

Initial Public Offering (IPO) The first time the firm’s stock is sold to the general public

Seasoned Equity Offering (SEO) A new stock offering by a firm that already has stock that is

traded in the secondary market

Slide 8

Ten Principles of Financial Management Risk-Return Tradeoff

Save and invest for future consumption Investments should provide appropriate compensation

for forgone consumption

Slide 9

Ten Principles of Financial Management (Continued)

90%

Large-companystocks 13.3% 20.1

Small-companystocks 17.6 33.6

Long-termcorporate bonds 5.9 8.7

Long-termgovernment 5.5 9.3

Intermediate-termgovernment 5.4 5.8

U.S. Treasurybills 3.8 3.2

Inflation 3.2 4.5

-90% 0%

SeriesAverageReturn

StandardDeviation Distribution

Slide 10

Ten Principles of Financial Management (Continued)

The Time Value of Money A dollar received today is more valuable than a dollar

received in the future because of opportunity cost Costs and future benefits of investments should be

measured in present values If present value of future benefits exceed costs, then

investment should be made (Net Present Value (NPV)>0)

Slide 11

Ten Principles of Financial Management (Continued)

Cash is King Cash flows not accounting profits are important Cash flows received can be reinvested by the firm Accounting problems-depreciation and matching of

costs and expenses Incremental Cash Flows that Matter

Incremental cash flows are direct consequence of taking a specific course of action

Slide 12

Ten Principles of Financial Management (Continued)

Competitive Markets Project evaluation vs. value creation-investing for

returns above same risk alternatives It is not easy to find projects that create wealth-

competition Perfect market conditions: No entry and exit

restrictions, No one producer or buyer large enough to affect prices, Identical products are manufactured, Production costs are identical, Everyone is informed about everything

Slide 13

Ten Principles of Financial Management (Continued)

If markets are perfect then it is not possible to create wealth

How can we make markets less competitive? Product Differentiation based on features, quality,

image, service and distribution Cost Advantage through economies of scale,

technology, corporate culture and input supply control

Slide 14

Ten Principles of Financial Management (Continued)

Efficient Markets Price adjustments to new information is quick and

correct Many profit driven investors Information arrival is random

Slide 15

Ten Principles of Financial Management (Continued)

“Calwest Industrial Properties, a closely held real-estate concern, has agreed to acquire Cabot Industrial Trust (CTR) for about $1.06 billion plus the assumption of $925 million in preferred stock and debt, people familiar with the matter say. Under terms of the deal, Calwest would pay $24 a share for Boston-based Cabot. The price represents a 20% premium to Cabot's price in 4 p.m. trading Friday on the New York Stock Exchange, when its shares were changing hands at $19.95, down five cents for the day.” WSJ, October 29, 2001

Slide 16

Ten Principles of Financial Management (Continued)

Slide 17

Ten Principles of Financial Management (Continued)

Agency Problem Separation of ownership and management Principal-Shareholders Agents-Managers Will managers work in the shareholders’ best interest? Preference toward size over profitability Excessive perquisites Attitudes toward risk

Slide 18

Ten Principles of Financial Management (Continued)

Types of agency costs Costs of trying to get the agents to do what the

principal want-monitoring costs Lost opportunities caused by conflicts too expensive to

resolve Possible solutions

Managerial compensation Control of the firm

Slide 19

Ten Principles of Financial Management (Continued)

Taxes Bias Business Decisions After-tax cash flows received can be reinvested Favorable tax status for certain investments affects

decisions Financial leverage is affected by tax status-interest

payments are tax-deductible expenses

Slide 20

Ten Principles of Financial Management (Continued)

Diversification Eliminates Certain Type of Risk Diversifiable/Firm Specific/Unsystematic Risk Non-diversifiable/Market/Systematic Risk Firm specific good news and bad news wash each

other out

Slide 21

Ten Principles of Financial Management (Continued)

Slide 22

Ten Principles of Financial Management (Continued)

Ethical Behavior is Doing the Right Thing Doing something that is viewed right by many people An action that is not prohibited by law can be unethical Unethical behavior might be costly