Overview of

Financial Management
and the Financial Environment
Topics in Chapter
 Finance and Financial Management
 Financial Decisions
 Forms of Business Organization
 Objective of the Firm: Maximize Wealth
 Determinants of Fundamental Value
 Financial Securities, Markets and Institutions

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 Finance and Financial Management
 All entities (households, businesses, governments)
earn/raise and spend/invest money. Finance is the art
and science of managing money. It is associated with
the process, instruments, institutions and instruments
that facilitate the transfer of money between entities.

 Financial Management: Part of finance that deals with

decisions as to how to raise and use money to maximize
the firm value. Unless otherwise stated the context is
assumed to be of a corporation and, therefore, FM is often
termed as Corporate Finance.

[Ref: Introduction to Managerial Finance by Gitman, L.J.]

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 Corporate Financial Decisions
 3 Major Financial Decisions:
 Investment decision
 Financing decision
 Dividend decision

 These decisions are interrelated and hence must be viewed

as an integrated whole. A firm that makes poor
investments may soon find itself with a dividend problem
and a financing problem (inability to meet, e.g., interest
payments).
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Finance: Economics, Accounting (and
Mathematics)
 Economists developed the notion that an asset’s
value is determined by the future cash-flows that
it generates.
In fact, finance as a separate discipline has grown out of economics.

 Accountants help you assess the likely size of

those cash-flows.
Mathematics is ubiquitous in any logical field of inquiry.

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Business Organization from Start-up to a
Major Corporation
 Sole proprietorship
 Partnership
 Corporation

(More . .)

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Starting as a Proprietorship
 Advantages:
 Ease of formation
 Subject to few regulations
 No corporate income taxes
 Disadvantages:
 Limited life
 Unlimited liability
 Difficult to raise capital to support growth

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Starting as or Growing into a Partnership
 A partnership has roughly the same advantages and
disadvantages as a sole proprietorship.

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Becoming a Corporation
 A corporation is a legal entity separate from its
owners and managers.
 File papers of incorporation with state.
 Charter: Proposed company name, types of activities to be pursued,
amount of capital stock, number, names and addresses of directors.
 Bylaws: Duties and obligations of the shareholders, directors and
officers, rules of appointing/removing officers and directors, how
corporate affairs (meetings) will run, election procedure of the
directors, whether existing stockholders will have priority in new
issues, procedure of changing bylaws if necessary, etc.

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Advantages and Disadvantages of a
Corporation
 Advantages:
 Unlimited life
 Easy transfer of ownership
 Limited liability
 Ease of raising capital
 Disadvantages:
 Cost of set-up and report filing
 Double taxation
 Governance problems

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Finance Within the Corporation

Board of Directors

Chief Executive Officer (CEO)

Chief Operating Officer (COO) Chief Financial Officer (CFO)

Marketing, Production, Human Accounting, Treasury, Credit,

Resources, and Other Operating Legal, Capital Budgeting, and
Departments Investor Relations

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 Management’s Primary Objective

 If an objective is not chosen, there is no systematic way of

making and evaluating decisions.
 The objective should be (1) clear and unambiguous, (2)
easily measureable (timely feedback), and (3) should not
be socially costly.
 Can you propose some alternative choices?
 Maximizing customer satisfaction?
 Maximizing size of the firm?
 Maximizing market share (sales)?
 Minimizing costs/maximizing profits or return on investment?
 Maximizing firm value/shareholder value/shareholder wealth?
 Maximizing stock price (which under certain conditions means the above)?
 How about some combination of two or more of them?

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 Management’s Primary Objective
 The primary objective should be shareholder wealth
(value) maximization, which, under certain conditions,
translates to maximizing stock price.
 When market price of shares reflect all relevant information, then
the observed price is the same as the intrinsic/fundamental value of
shares.
 There may be conflict of interests between stockholders and
managers; agency problem. Sometimes managers take deliberate
steps (illegal or legal) to influence market price of shares artificially.

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 What Determines a Firm’s
Fundamental, or Intrinsic, Value?

Intrinsic (fundamental) value of a firm is the

sum of all the future expected free cash flows
when converted into today’s dollars:

FCF1 FCF2 FCFn

Value   
(1  WACC) (1  WACC)
1 2
(1  WACC) n
n
FCFt
 .
t 1 (1  WACC)
t

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 Managerial Actions to Maximize
Firm/Shareholder Value

 Amount of expected cash flows (bigger is better)

 Timing of the cash flow stream (sooner is better)

 Risk of the cash flows (less risk is better)

The cash flows that matter are called free cash flows
(FCF).

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 Free Cash Flows (FCF)
 Free cash flows are the cash flows that are
available (or free) for distribution to all investors
(stockholders and creditors).

 FCF = sales revenues - operating costs - operating taxes -

required investments in operating capital.

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 What is the weighted average cost of
capital (WACC)?

 To generate cash flows, managers must decide how to

finance projects and operations of the firm.
 WACC is the average rate of return required by all of the
company’s investors.
 WACC is affected by:
 Capital structure (the firm’s relative mix of debt and equity)
 Interest rates
 Risk of the firm’s operations
 Investors’ overall attitude toward risk

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 Maximizing Profits, e.g., EPS
 Profit maximization as a goal has at least three
limitations:
 It ignores timing,
 Higher profits may not translate to higher future cash-
flows (dividends + capital gains) and hence higher
stock price for the owners,
 It ignores risk [value = f(cash-flow, risk)]

[Ref: Introduction to Managerial Finance by Gitman, L.J.]

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 Management’s Primary Objective
 How about other stakeholders?
 Aside from such illegal actions as fraudulent accounting, exploiting
monopoly power, violating environmental safety codes, the same actions
that maximize stock values also benefit society.
(1) To a large extent, the owners of stock are society:
(2) Consumer benefits: Firms that maximize stockholder value must
produce high quality goods and services at the lowest possible cost; charge
reasonable price (high consumer value). Price is constrained by competition
and consumer activism.
(3) Employee benefits: Employment growth is higher in firms (attract,
develop and retain) that try to maximize stock value.
 In summary, it is difficult for firms to maximize share price without paying
heed to other stakeholders’ wellbeing. Therefore, the firms should preserve
but not try to maximize it by putting stockholders at stake.

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 Conflicts Between Managers and
Stockholders
 Managers are naturally inclined to act in their own best
interest (which is not always the same as the interest of
stockholders).
 Principal-Agent Relation: The Agency Problem – The
potential conflict of interest between the principal and
agent.
 Market forces and agency costs help mitigate the agency
problem:
 Managerial compensation packages, i.e., agency costs
 Direct intervention by (major) shareholders
 The threat of takeover
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 Conflicts Between
Stockholders and Bondholders
 Stockholders are more likely to prefer riskier projects,
because they receive more of the upside if the project
succeeds. By contrast, bondholders receiving fixed
payments are more interested in limiting risk.
 Bondholders are particularly concerned about the use of
additional debt.
 Bondholders attempt to protect themselves by including
covenants in bond agreements (indenture) that limit the
use of additional debt and constrain managers’ actions.

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 Conflict of Interests and
Corporate Governance
 Corporate governance can help control potential
conflict of interests between stockholders and
managers and between stockholders and
bondholders.

 Corporate governance is the set of rules that

regulates a company’s behavior towards its
directors, managers, employees, shareholders,
creditors, customers, competitors, and
community.
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 An Overview of the
Capital Allocation Process
 Who are the providers (savers) and users
(borrowers) of capital?

 Households: Net savers

 Non-financial corporations: Net users (borrowers)
 Governments: Net borrowers
 Financial corporations: Slightly net borrowers, but
almost breakeven
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Transfer of Capital from
Savers to Borrowers

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 Transfer of Capital from
Savers to Borrowers
 Direct transfer (e.g., corporation issues commercial
papers to insurance companies)
 Through an investment banking house (e.g., IPO,
seasoned equity offering, or debt placement). Investment
banks merely transfer securities (claims) for a
margin/fees.
 Through a financial intermediary (e.g., individual
deposits money in bank, bank makes commercial loan to
a company). Financial intermediaries create their own
securities (claims).

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Financial Securities
Debt Equity Derivatives

Money •T-Bills •Options

Market •CD’s •Futures
•Eurodollars •Forward
•Fed Funds contract

Capital •T-Bonds •Common stock •Swaps

Market •Agency bonds •Preferred stock
•Municipals •LEAPS (Long term
•Corporate bonds equity anticipation
securities: These are
options having a maturity
of upto three years.

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Financial Securities
 Some securities are a mix of debt, equity, and derivatives.
For example, preferred stock has features of both debt and
equity, while convertible debts has features of both debt
and derivatives.
 Some securities are created from packages of other
securities, a process called securitization. For example,
mortgage backed securities (bonds).
 Returns tend to increase with the maturity and risk of the
security.

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Typical Rates of Return
Instrument Rate (April 2006)
U.S. T-bills 4.79%
Banker’s acceptances 5.11
Commercial paper 4.97
Negotiable CDs 5.07
Eurodollar deposits 5.10
Commercial loans:
Tied to prime 7.75 +
or LIBOR 5.13 + (More . .)

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Typical Rates (Continued)
Instrument Rate (April 2006)
U.S. T-notes and T-bonds 5.04%
Mortgages 6.15
Municipal bonds 4.66
Corporate (AAA) bonds 5.93
Preferred stocks 6 to 9%
Common stocks (expected) 9 to 15%

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 Cost of Money

 What do we call the price, or cost, of debt capital?

 The interest rate
 What do we call the price, or cost, of equity capital?
 Cost of equity = Required return = dividend yield +
capital gain
 Certain fundamental economic factors, economic
conditions and policies, and international factors affect the
demand and supply of loanable funds and their cost.

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Fundamental Factors Affecting the
Cost of Money
 Production opportunities – ability to turn capital
into benefits. The benefits are determined by the
expected rates of return on its production
opportunities.
 Time preferences for consumption (present)
 Risk (of return on investment)
 Expected inflation

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 Economic Conditions and Policies
Affecting the Cost of Money
 Federal Reserve policies – e.g., open market purchases of
govt securities add to money supply in the banking system and
increase govt security prices, leading to lower interest rate.
 Budget deficits/surpluses – borrow or print money (higher
inflation expectation pushes interest up).
 Level of business activity (recession or boom)
 International trade deficits/surpluses – borrow or use
reserve assets (gold, foreign currencies or securities, etc)

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International Conditions Affecting
the Cost of Money
 Country risk: Risk that arises from investing or doing business in
a particular country, and it depends on the country’s economic,
political, and social environment.
 Exchange rate risk: Non-native currency denominated
investment’s value depends on what happens to exchange rate.
Exchange rates affected by:
 International trade deficits/surpluses
 Relative inflation and interest rates
 Country risk

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What are some financial institutions?
 Savings & Loan Associations
 Credit unions – Cooperatives of people with common bond (employees of a firm,
residents of a locality)
 Commercial banks
 Investment banks – Specialized financial institutions (or division of banks) that
assist in raising and management of capital and provide advisory services. They do
underwriting, M&A consulting, wealth management for individuals/institutions,
brokerage. e.g., JP Morgan, Merrill Lynch (D), Lehman B. (D), Bear Stearns (D).
 Investment funds
 Mutual Funds (open) and Exchanged Traded Funds (ETFs)
 Hedge funds - Small number of large investors invests in many securities
including derivatives)
 Private equity funds - Small number of investors typically owns virtually all shares
in a firm (private company or public company tuned private).
 Life insurance companies
 Pension funds

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Types of financial markets?
 A market is a place (physical or virtual) of
exchanging one asset (usually cash) for another
asset.
 Physical assets vs. financial assets
 Spot versus future markets
 Money versus capital markets
 Primary versus secondary markets

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Primary vs. Secondary Security Sales
 Primary
 New issue (IPO or seasoned)
 Key factor: issuer receives the proceeds from the sale.
 Secondary
 Existing owner sells to another party.
 Issuing firm doesn’t receive proceeds and is not directly
involved.

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How are secondary markets organized?
 By “location”
 Physical location exchanges
 Computer/telephone networks
 By the way that orders from buyers and sellers are
matched
 Open outcry auction
 Dealers (i.e., market makers)
 Electronic communications networks (ECNs)

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Physical Location vs. Computer/telephone
Networks
 Physical location exchanges: e.g., NYSE, AMEX,
CBOT, Tokyo Stock Exchange
 Computer/telephone: e.g., Nasdaq, government
bond markets, foreign exchange markets

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Types of Orders
 Instructions on how a transaction is to be
completed
 Market Order– Transact as quickly as possible at current
price.
 Limit Order– Transact only if specific situation occurs.
For example, buy if price drops to $50 or below during
the next two hours.

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Auction Markets
 Participants have a seat on the exchange, meet
face-to-face, and place orders for themselves or for
their clients; e.g., CBOT. Thus auction markets
match buy and sale orders.
 NYSE and AMEX are the two largest auction
markets for stocks.
 NYSE is a modified auction, with a “specialist”
(market maker or dealer).

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Dealer Markets
 “Dealers” keep an inventory of the stock (or other
financial asset) and place bid and ask
“advertisements,” which are prices at which they
are willing to buy and sell.
 Often many dealers for each stock
 Computerized quotation system keeps track of bid
and ask prices, but does not automatically match
buy and sale orders.
 Examples: Nasdaq National Market, Nasdaq
SmallCap Market, London SEAQ, German Neuer
Markt.

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Electronic Communications Networks
(ECNs)
 Computerized system matches orders from buyers and
sellers and automatically executes transaction.
 Low cost to transact
 Examples: Instinet (US, stocks, owned by Nasdaq);
Archipelago (US, stocks, owned by NYSE); Eurex (Swiss-
German, futures contracts); SETS (London, stocks).

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Over the Counter (OTC) Markets
 In the old days, securities were kept in a safe
behind the counter, and passed “over the counter”
when they were sold.
 Now the OTC market is the equivalent of a
computer bulletin board (e.g., Nasdaq Pink
Sheets), which allows potential buyers and sellers
to post an offer.
 No dealers
 Very poor liquidity

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 Determinants of Intrinsic Value: The Big Picture
Sales revenues

− Operating costs and taxes

− Required investments in operating capital

Free cash flow

=
(FCF)

FCF1 FCF2 FCF∞

Value = + + +...
(1 + WACC)1 (1 + WACC)2 (1 + WACC)∞

Weighted average
cost of capital
(WACC)

Market interest rates Cost of debt Firm’s debt/equity mix

Market risk aversion Cost of equity Firm’s business risk

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