FIN 101: Chapter 1

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CHAPTER 1:
1.1 Learning Objectives
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FINANCE AND THE FINANCIAL MANAGER

Organizational forms for business and the advantages and disadvantages of the corporate form

The role and the organizational position of the financial manager Separation of ownership and management Financial markets and financial institutions

1.2 CORPORATE AND OTHER FORRMS OF BUSINESS ORGANIZATION

Common organizational forms for businesses include: sole proprietorship: owned and managed by a single individual, partnerships: owned and managed by two or more individual, and corporations: owned by a large number of stockholders but managed by professional managers, and have distinct legal identity and are governed by the articles of incorporation.

Sole Proprietorships Partnership Corporations

Unlimited Liability Personal tax on profits

Limited Liability Ability to attract large amounts of capital Corporate tax on profits + Personal tax on dividends

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FIN 101: Chapter 1

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1.3 FINANCIAL MANAGERS ROLE:

Corporations use different real assets to run their business. Many of these assets are tangible such as machineries, factories and offices; others are intangible, such as technical expertise and trademarks.

To obtain partly the necessary money the corporation sells pieces of papers called financial assets or securities that are in the financial markets. These papers have value because they are claims on the firms real assets and the cash they produce.

The financial manager stands between the firms operation and the financial market, where investors hold the financial assets issued by the firm.

2 Firms Operations Financial Manager

1 4a 4b Financial Markets

1. Cash raised from investors 2. Cash invested in firm 3. Cash generated by operations 4a. Cash reinvested 4b. Cash returned to investors

Financial Managers primary role is deciding which assets to invest in and how to finance them. Thus the two types of decisions the financial manager is called upon to make are investing decisions (capital budgeting) and financing decisions. Corporate finance is primarily concerned with these decisions. ___________________________________________________________________________
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The work of the financial manager is typically split into separate positions with

the treasurer dealing with cash management, raising capital and dealing with investors and financial institutions; and

the controller entrusted with responsibility for managing the firms internal accounting, preparation of financial statements, and tax obligations.

As the firm gets larger, the organization of the financial management function becomes more complex and a chief financial officer (CFO) supervises the treasurer and the controller with additional responsibility for financial policy and corporate planning.

Chief Financial Officer (CFO) Financial Policy Corporate Planning

Treasurer Cash Management Raising Capital Banking Relationships

Controller Preparation of Financial Statements Accounting Taxes

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FIN 101: Chapter 1

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1.4 Objective of the firm

The company should make investment and financing decisions with the aim of maximising long-term shareholder wealth. Maximising wealth can be defined as maximizing purchasing power. Maximising shareholder wealth means maximising the flow of dividends to shareholders through time. Maximising shareholder wealth is maximising purchasing power or maximising the flow of discounted cash flow to shareholders over a long time horizon.

1.5 SEPARATION OF OWNERSHIP AND MANAGEMENT

Large corporations have hundreds of thousands of shareholders and it will be impossible to have the owners manage the business directly. Thus:

Separation of ownership and management becomes a necessity allowing continuity in management, un-affected by changes in ownership.

It also opens the way for hiring of professional managers to manage the business.

The disadvantage of this separation of ownership and management is that it causes potential principal-agent problems. The managers are the agents of the stockholders, who are the principals. The principal-agent problem arises because different parties have different information about the value of the business. In other words, agency problems are complicated by information asymmetry.

This results to agency costs. Agency costs are incurred when: 1. managers do not attempt to maximize firm value, and 2. shareholders incur costs to monitor the managers and influence their actions

Agency costs (a) Monitor managers behaviour (b) Create incentive schemes and controls for managers to encourage the

pursuit of shareholders wealth maximisation ___________________________________________________________________________

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___________________________________________________________________________ Agency cost of the loss of wealth caused by the extent to which prevention measures do not work Some solutions Linking rewards to shareholder wealth improvements Sackings Selling shares and the takeover threat Corporate governance regulations Information flow

Agency problem can also arise in financing. Banks and bondholders who lend money to the company are united with the shareholders in good times, as they want the company to prosper. When the company faces financial difficulties, the lenders are concerned to get their money back and are unwilling to see the firm taking risks that could put in danger the safety of their loans.

Difference in Information Stock prices and returns Issues of shares and other securities Dividends Financing

Different Objectives Managers vs. stockholders Top mgmt vs. operating mgmt Stockholders vs. banks and lenders

1.6 FINANCIAL MARKETS & INSTITUTIONS:

1.6.1 Financial Markets

Financial markets are markets in which funds are transferred from people who have an excess of available funds to people who have a shortage of funds In finance, financial markets facilitate The raising of capital (in the capital markets); The transfer of risk (in the derivatives markets); ___________________________________________________________________________
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___________________________________________________________________________ International trade (in the currency markets) and are used to match those who want capital to those who have it

Markets are divided into primary and secondary markets The Primary market is the market where investors purchase newly issued securities. Initial public offering (IPO): An initial public offer occurs when a company offers stock for sale to the public for the first time. The Secondary market is the market where investors trade previously issued securities. An investor can trade: Directly with other investors. Indirectly through a broker who arranges transactions for others. Directly with a dealer who buys and sells securities from inventory. Secondary markets can be organized as exchanges, in which titles are traded in a central location, such as a stock exchange, or alternatively as over-thecounter markets in which titles are sold in several locations.

Financial institutions such as banks and insurance companies are also important sources of financing for businesses, and they are essential to well-functioning market economies.

Financial institutions are intermediaries that gather the savings of many individuals and reinvest them in the financial market. For example, banks raise money by taking

deposits, and then they lend the money to individuals.

Financial institutions provide payment mechanism for the economy. Checking accounts, credit cards, and electronic transfers allow firms and individuals to send and receive payments quickly and safely.

Financial institutions offer risk pooling to their customers. For example insurance companies make it possible to share the risk of a car accident or a household on fire.

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