Chapter 1

McGraw-Hill/Irwin

Introduction to
Financial
Management

Copyright 2014 by The McGraw-Hill Companies, Inc. All rights reserved.

What is Finance?
Finance applies specific value to
things owned
services used
decisions made
Financial management
organizations approach to valuation

1-2

Economic Participants
Two dimensions
Participants with extra investment money
Participants with economically viable ideas

1-3

Economic Participants
Type 1 Participants
Do not lend or spend in business context
No direct role in financial markets
Indirect role: to provide labor and
consume products

1-4

Economic Participants
Type 4 Participants
Use financial tools
evaluate own businesses
choose highest-potential ideas

Are self-funded, so no need for financial

markets

1-5

Economic Participants
Types 2 and 3 Participants
use financial institutions and financial
markets for mutually beneficial exchange
Type 2: makes temporary loans to Type 3
Type 3: typically consists of companies

engaging in R & D

1-6

Where Does the Cash Go?

Economically successful projects repay

money (plus profit) to investors

Friction occurs when not all cash is
returned to investors
- Retained Earnings
- Taxes

1-7

Figure 1.4: Complete Cash Flows

of Finance

1-8

Subareas of Finance
Investments
involves methods and techniques for

making decisions about what kinds of

securities to own

1-9

Subareas of Finance
Financial management
Decisions about acquiring and using cash
Examples include
Organizing and raising capital
Tax decisions
Projects to fund

1-10

Subareas of Finance
Financial institutions and markets
Facilitate flow of capital between
investors and companies
International finance
Finance theory used in global business

environment

1-11

Financial Decision Application &

Theory
Risk
Uncertainty of future cash flows due to timing

and size
Financial Asset
Ownership in cash flow represented by

securities like stocks, bonds, and other assets

1-12

Financial Decision Application &

Theory
Real Assets
Physical property like gold, machinery,

equipment, real estate

Real Markets
Places/processes that facilitate real asset
trading
Time Value of Money (TVM)
Theory and application of valuing cash flows at

various points in time

1-13

Finance vs. Accounting

Accounting
tracks what happened to firms money in the

past
Financial Management
combines historical figures and current
information
determines what should happen with firms
money now and in the future
1-14

The Financial Manager

Chief Financial Officer
Highest level financial officer
Controller
Oversees accounting function
Treasurer
Responsible for managing cash, credit,

financing, capital budgeting, risk management

1-15

Finance in Other Business

Functions
CFO and Treasurer
most visible finance-related positions
Finance permeates the organization
Used to develop and manage strategy
Used in day-to-day business operations
Operations
Marketing
Human Resources
1-16

Finance in Your Personal Life

Help you make good personal financial

decisions
Borrowing money for a new car
Refinancing home mortgage at lower rate
Making credit card or student loan payments
Saving for retirement

1-17

Business Organization
Single owners, partners, and corporations

operate businesses
Advantages and disadvantages related to
Controls and ownership of firm
Owners risks
Access to capital and tax ramifications

1-18

Business Form Types

Sole Proprietorships
General Partnerships
Corporations
Hybrids

1-19

Sole Proprietorships
Not legally separate from the owner
Advantages
Easy to start
Light regulatory and paperwork burden
Single taxation at the personal tax rate
Disadvantages
Unlimited liability
Limited access to capital

1-20

General Partnerships
Partners own the business together
Advantages
Relatively easy to start
Single taxation
Disadvantages
Partners jointly share unlimited liability
Personally liable for legal actions and debts of
firm
Difficult to raise large amounts of capital
1-21

Public Corporations
Legally independent entity entirely separate

from its owners

Advantages
Limited liability for owners
Can raise large amounts of capital
Easy to transfer ownership

Disadvantages
Double taxation (corporate level and personal
level)
1-22

Hybrid Organizations
Combine attributes of several forms
Advantages
Offer single taxation and limited liability
to all owners
S Corporations
Limited Liability Partnerships (LLPs)
Limited Liability Companies (LLCs)

1-23

Firm Goals
Owner seeks to maximize shareholder

wealth and companys value through

Maximizing present value of future cash
flows
Maximizing owners equity
Decisions about
attracting additional funds
projects in which to invest
returning profits to owners over time

1-24

Corporate Goals
Maximize value of owners equity
Increase current value per share (stock price) of
existing shares
Common methods
Maximize net income or profit
Minimize costs
Maximize market share

1-25

Agency Theory
Problems arise when principal

(shareholder) hires agent (manager) to

operate firm but cannot monitor the agents
actions
Managers interest may not be aligned with
shareholder goals

1-26

Agency Theory
Three approaches to minimizing this

conflict of interest

Ignore if effect is minimal

Use accountants, debt holders to monitor

managers
Provide incentives to managers

Equity stakes
Stock options
Employee Stock Option Plan (ESOP)
1-27

Corporate Governance
Set of laws, policies, incentives, and

monitors designed to handle issues arising

from the separation of ownership and
control

1-28

Corporate Governance
Inside monitors
Board of Directors
Hires the CEO
Evaluates management
Designs compensation plans

1-29

Corporate Governance
Outside monitors
Auditors
Analysts
Banks
Credit rating agencies

1-30

Corporate Governance Monitors

1-31

Ethics
Financial professionals manage other

peoples money

Corporate managers
Bankers
Investment advisors

Ethical dilemmas of corporate agency

relationship

Stealing from firms = stealing from shareholders

1-32

Financial Markets and

Intermediaries
Financial markets and financial

intermediaries
Facilitate flow of capital from investors to

firms and back to investors

Earn very high profits because of
specialized expertise and assets

1-33

Financial Institution Cash Flows

1-34

The Financial Crisis

Subprime Mortgage Borrowers
Higher-risk borrowers charged higher
interest rates due to higher risk of default
Securitization
Loan originators sell the loan repayment

rights to other financial institutions or

investors
1-35

The Financial Crisis

Sparked by collapse of U.S. home

prices in late 2006 and 2007

Spread to other financial institutions via
affected mortgage-backed securities
Resulted in credit tightening by financial
institutions; loss of confidence by
consumers
1-36