Introduction to Financial Management

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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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 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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 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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 Definition of Financial Mgt.
• Financial Management- is the process of
transforming existing assets into new,
contractual forms, as well as the analytical
techniques needed to support this process, for
the purpose of wealth creation in modern,
capitalistic economies.
 Another Definition:
Financial Management entails planning for the
future for a person or a business enterprise to
ensure a positive cash flow. It includes the
administration and maintenance of financial
assets. Besides, financial management covers
the process of identifying and managing risk.
 Scope of Financial Management
• Money and Capital Markets -which deals with
securities markets and financial institutions;

• Investments -which focuses on the decisions.

 Cont.,
• made by both individual and institutional
investors as they choose securities for their
investment portfolios.

• Financial Management-or ‘business finance’,

which involves decisions within firms.
 Financial Mgt. Decisions
• Capital Budgeting: The process of planning
and managing a firm’s long term investment.
• Capital Structure: The mixture of debt and
equity maintained by the firm.
• Working Capital Management short terms
asset and liabilities.
 Capital Budgeting
• Capital Budgeting(or investment appraisal)- is the planning
process used to determine whether a firm's long term
investments such as new machinery, replacement machinery,
new plants, new products, and research development
projects are worth pursuing. It is budget for major capital, or
investment, expenditures.
 Capital Budgeting Techniques
• Net Present Value (NPV) -each potential project's
value is estimated using a
discounted cash flow (DCF) valuation, to find its
NPV.
• Profitability Index (PI) -identifies the
relationship of investment to payoff of a proposed
project.
 Cont.,
• Profitability index (PI) -identifies the
relationship of investment to payoff of a proposed
project.
• Internal rate of return (IRR) -defined as the
discount rate that gives a net present value of zero.
It is a commonly used measure of investment
efficiency
 Importance of Working Capital
Management
1. Cash Management- Identify the cash balance
which allows for the business to meet day to
day expenses, but reduces cash holding
costs.
 Cont.,
2. Inventory Management- Identify the level of
inventory which allows for uninterrupted
production but reduces the investment in raw
materials -and minimizes reordering costs -
and hence increases cash flow;
 Cont.,
3. Debtors Management. Identify the
appropriate credit policy, i.e. credit terms
which will attract customers, such that any
impact on cash flows and the Cash
conversion cycle will be offset by increased
revenue and hence Return on Capital (or vice
versa).
 Cont.,
4. Short Term Financing- Identify the appropriate
source of financing, given the cash conversion cycle:
the inventory is ideally financed by credit granted by
the supplier; however, it may be necessary to utilize
a bank loan (or overdraft), or to "convert debtors to
“ cash" through "factoring".
 Basic Areas Of Finance
• Corporate finance
• Investments
• Financial institutions
• International finance

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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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 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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 The Goal of the Firm

• The goal of the firm is maximization of shareholder

wealth

or

• Maximization of the price of the existing common

stock
 Profit Maximization

• Stresses the efficient use of capital resources

• Not specific to time frame for profits to be measured

• Goals are not precise, allow for misinterpretation

• Ignores uncertainty and timing

Benefits of Maximizing Shareholder
Wealth

• Good decisions are those that create wealth for

the shareholder

• Societal benefits as businesses compete to create

wealth

• Includes effects of all financial decisions

 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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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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 Forms of Business Organization
• Three major forms in the United States
– Sole proprietorship
– Partnership
• General
• Limited
– Corporation
• S-Corp
• Limited liability company

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 Sole Proprietorship

• Advantages • Disadvantages
– Easiest to start – Limited to life of owner
– Least regulated – Equity capital limited to
– Single owner keeps all owner’s personal wealth
of the profits – Unlimited liability
– Taxed once as personal – Difficult to sell
income ownership interest

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 Partnership

• Advantages • Disadvantages
– Two or more owners – Unlimited liability
– More capital available • General partnership
• Limited partnership
– Relatively easy to start
– Income taxed once as – Partnership dissolves
personal income when one partner dies
or wishes to sell
– Difficult to transfer
ownership

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 Corporation
• Advantages • Disadvantages
– Limited liability – Separation of ownership
– Unlimited life and management
– Separation of ownership (agency problem)
and management – Double taxation (income
– Transfer of ownership is taxed at the corporate
easy rate and then dividends
taxed at personal rate,
– Easier to raise capital while dividends paid are
not tax deductible)

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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?
• Does this mean we should do anything and
everything to maximize owner wealth?
• Sarbanes-Oxley Act
• http://www.accounting-degree.org/scandals/
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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

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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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 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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Figure

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 Financial Markets
• Cash flows to the firm
• Primary vs. secondary markets
– Dealer vs. auction markets
– Listed vs. over-the-counter securities
• OTCEI
• NASDAQ

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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?

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