Chapter 1

The Field of Finance

• Finance is about making decisions that focus on creating value within the firm and
builds upon the disciplines of economics and accounting.
o economics provides theories about economic system and decision
making,
o accounting supplies financial data and data analysis tools.
• Finance has evolved from a pure descriptive discipline through an analytical, decision-
oriented discipline to now a discipline used by financial managers.

Finance tries to help financial managers to answer (i.e. make decisions about) the following
questions made within a risk-return framework:
1. What long-term investments or projects the firm
should undertake? (capital budgeting decision)
2. How the firm should pay for these assets? By issuing
equity or debt? (capital structure decision)
3. How much cash or inventory the firm should carry?
How much trade credit the firm should provide or
use? (working capital management decision).

Goals of Financial Management

• The primary goal is shareholder wealth maximization because the firm is owned by the
shareholders.
• This goal should be measured in terms of market share price, which is a value that
investors collectively are prepared to pay.
• The closest alternative – profit – fails to consider risk and timing and more importantly,
it is almost impossible to accurately measure profit.

• The goal of maximizing shareholder wealth may conflict with interests of management
(their compensation) and social/ethical goals.
• Agency theory is about the potential conflict between shareholders and managers.
• Tradeoffs exist among the agency costs of monitoring management actions, allowing
sufficient discretion for management and designing compensation packages to motivate
management.
• The goal of shareholder wealth maximization can be consistent with a concern for social
responsibility.
• Firms should take socially desirable actions even if certain actions like pollution control
may at times conflict with this goal.
• Managers should strictly follow the rules of fairness and honesty.
• Insider trading and manipulation of financial results have been proven to serve the
firm/shareholders as well as the management no good.
Functions of Financial Management

• The study of finance has a variety of functions

o Corporate finance
o Banking
o Securities Trading and Underwriting
o Money Management
o Financial Planning
o Risk Management (Insurance)
• Some of these functions are performed on a daily basis and others are less routine.
• All are carried out with the intention to proper balance profitability against risk.

Forms of Organisation

• Sole Proprietorship (one owner) - largest in actual number but smallest in total sales
revenue.
• Partnership - (two or more owners)
• Corporation (legal entity unto itself) - smallest in actual number but largest in total
sales revenue.

Sole Proprietorship (A business owned by one person)

Advantages
• Freedom
• Simplicity
• Low Starting Costs
• Tax Benefits
Disadvantages
• Unlimited Liability
• Lack of Continuity
• Difficult to raise money
• Reliance on one person
Partnership (A business owned by two or more persons)

Advantages
• More Capital
• Greater Talent Pool
• Ease of Formation
• Tax Benefits
Disadvantages
• Unlimited Liability
• Lack of Continuity
• Ownership transfer is difficult
• Possibility of Conflicts

Corporations (A corporation is a separate legal entity)

Advantages
• Limited Liability
• Continuity
• Greater Likelihood of Professional Management
• Easier Access to Capital
Disadvantages
• Higher Start-Up Costs
• More Regulations
• Double Taxation
• Potential Shareholder Conflicts

Role of Financial Markets

• Financial markets are a vast global network of corporations, financial institutions,
governments and individuals that either need money or have money to lend or invest.
• Public financial markets are those markets for governments to borrow funds for public
activities.
• Corporate financial markets are those markets for corporations to raise funds.
• The effect of managerial decisions on the value of the firm is realized in financial
markets.

Structure and Functions of Financial Markets

• Money markets deal in short-term securities
(Less than 1 year)
e.g. Treasury Bills, commercial paper
• Capital markets deal in long-term securities
(Greater than 1 year)
e.g. common stock, preferred stock, corporate bonds, government bonds
 • Primary market is where a firm issues new bonds or shares to raise new funds.
• Secondary market is where investors buy and sell (trade) outstanding bonds or shares.

Risk-Return Tradeoff

Increased Profitability = Increased Risk

Decreased Profitability = Decreased Risk
o e.g. investing in stocks vs. savings accounts
o Stocks may be more profitable but are riskier
o Savings accounts are less profitable and less risky (or safer)
A financial manager must choose appropriate combination of potential profit (return) and level
of risk (safety).

Securities in Financial Market

Common Stock (Common Share) = Ownership or Equity
o Shareholders own the company
Bond = debt or liability
o Bondholders are owed money by company

Role of Financial Markets

• Financial markets determine value and allocate capital to the most productive use on a
risk-return basis.
• Debt is an important component of a firm’s capital structure.
o Too much debt can erode the firm’s cash flow and increases the firm’s risk
o Interest rates or yields help establish the allocation of capital
o Greater risk increases the spread between inflation and yield