Chapter 1

An Overview of Financial Management

Learning Objectives

After reading this chapter, students should be able to:

Explain the role of finance and the different types of jobs in finance.
Identify the advantages and disadvantages of different forms of
business organization.
Explain the links between stock price, intrinsic value, and executive
compensation.
Discuss the importance of business ethics and the consequences of
unethical behavior.
Identify the potential conflicts that arise within the firm between
stockholders and managers and between stockholders and
bondholders, and discuss the techniques that firms can use to mitigate
these potential conflicts.

Overview
This chapter provides an overview of financial management and should give
you a better understanding of the following: (1) how finance fits into the
structure of a firms organization, (2) how businesses are organized, (3)
what the goals of a firm are and how financial managers can contribute to
the attainment of these goals, (4) important business trends, (5) business
ethics: what companies are doing and the consequences of unethical
behavior, and (6) conflicts that arise between managers, stockholders, and
bondholders.

Outline

I. Finance grew out of economics and accounting and it is divided

into three areas: (1) financial management, (2) capital
markets, and (3) investments.

A. Financial management is also called corporate finance.

1. It focuses on:
a. decisions relating to how much and what types of
assets to acquire,
b. how to raise the capital needed to buy assets, and
c. how to run the firm so as to maximize its value.
B. Capital markets relate to the markets where interest rates, along
with stock and bond prices, are determined.
1. Financial institutions that supply capital to businesses are
 studied here.
2. Governmental organizations such as the Federal Reserve
System, which regulates banks and controls the supply of
money, and the SEC, which regulates the trading of
stocks and bonds in public markets, are also studied as
part of capital markets.
C. Investments relate to decisions concerning stocks and bonds. It
includes a number of activities.
1. Security analysis deals with finding the proper values of
individual securities.
2. Portfolio theory deals with the best way to structure
individual/institution portfolios.
a. A properly balanced portfolio is necessary to limit
risk.
3. Market analysis deals with the issue of whether stock and
bond markets at any given time are too high, too low, or
just right.
a. Behavioral finance examines investor psychology in
an effort to determine if stock prices have been bid
up to unreasonable heights or driven down to
unreasonable lows.

II. The legal structure of a firm affects some aspects of a firms

operations and thus must be recognized. The four main forms
of business organization are proprietorships, partnerships,
corporations, and limited liability corporations/partnerships.
72% of businesses operate as proprietorships, but when based
on dollar value of sales, 82% of all business is conducted by
corporations.

A. A proprietorshipis an unincorporated business owned by one

individual.
1. Its advantages are:
a. it is easily and inexpensively formed,
b. it is subject to few government regulations, and
c. it is subject to lower income taxes than are
corporations.
2. Its disadvantages are:
a. the proprietor has unlimited personal liability for
business debts, which can result in losses that
exceed the money they have invested in the
company,
b. it has a life limited to the life of the individual who
created it, and
 c. it is limited in its ability to raise large sums of
capital.
3. Proprietorships are used primarily for small businesses,
but they are converted to corporations when their
disadvantages outweigh their advantages.
B. A partnershipis a legal arrangement between two or more
persons who decide to do business together.
1. Its advantages are:
a. its low cost and ease of formation, and
b. its income is allocated on a pro rata basis to partners
and taxed on an individual basis.
2. Its disadvantages are:
a. unlimited personal liability,
b. limited life,
c. difficulty of transferring ownership, and
d. difficulty of raising large amounts of capital.
C. A corporation is a legal entity created by a state, and it is
separate and distinct from its owners and managers.
1. Its advantages are:
a. unlimited life,
b. ownership that is easily transferred through the
exchange of stock,
c. limited liability, and
d. ease of raising large amounts of capital to operate
large businesses.
2. Its disadvantages are:
a. corporate earnings may be subject to double
taxation and
b. setting up a corporation and filing required state and
federal reports are more complex and time-
consuming than for a proprietorship or partnership.
3. A drawback to corporations is taxes because most
corporations earnings are subject to double taxation.
a. As an aid to small business, Congress created S
Corporations that are taxed as if they were a
proprietorship or a partnership rather than a
corporation.
b. S status is retained until stock is sold to the public,
at which time they become C corporations.
D. A limited liability corporation (LLC) is a hybrid between a
partnership and a corporation.
1. LLCs have limited liability as do corporations.
2. LLCs are taxed like partnerships.
3. Limited liability partnerships are similar to LLCs, but are
 used for professional firms in such fields as accounting,
law, and architecture.
E. The value of any business other than a very small one will
probably be maximized if it is organized as a corporation for
three reasons.
1. Limited liability reduces the risks borne by investors, and
the lower the firms risk, the higher its value.
2. A firms value is dependent on its growth opportunities,
which are dependent on the firms ability to attract
capital. Corporations are better able to take advantage of
growth opportunities.
3. The value of an asset also depends on its liquidity, which
means the ease of selling the asset and converting it to
cash at a fair market value. Corporate investments are
more liquid than similar investments in proprietorships or
partnerships, and this enhances their value.

III. Managements primary goal is stockholder wealth

maximization; however, managers have an obligation to
behave ethically. They must follow the laws and other society-
imposed constraints.

A. Most managers recognize that being socially responsible is not

inconsistent with maximizing shareholder value.
1. Society can impose a wide range of costs on a company
that doesnt follow laws or other socially-imposed
constraints.
2. These costs would ultimately lead to a reduction in
shareholder value.
B. The finance departments principal task is to evaluate proposed
decisions and judge how they will affect the stock price and
therefore shareholder wealth.
C. Stock prices change over time as conditions change and as
investors obtain new information about companies prospects.
1. A firms investment decisions determine its future profits,
investors cash flows, and its stock price.

IV. Stock price maximization requires a long-run view of

operations. However, in recent years the focus for many
companies shifted to the short run.
A. Prior to the recent financial crisis, many Wall Street executives
received huge bonuses for engaging in risky transactions that
generated short-term profits.
B. In trying to reform the system, regulators are looking for ways
 to insure that financial institutions once again focus on their
firms long-run values.
C. Academics and practitioners stress the important role that
executive compensation plays in encouraging managers to focus
on the proper objectives.
1. Stock and stock options have been used increasingly as a
key part of executive pay.
2. The hope is that structuring compensation in this
manner, managers will think more like stockholders and
continually work to increase shareholder value.
D. Stock options, given to managers as an incentive to focus on
stock prices, led many managers to try to maximize the stock
price on the option exercise datenot over the long run.
E. Managerial actions, combined with taxes and economic and
political conditions, determine investorscash flows.
1. Expected and realized cash flows are quite different.
2. Investors like high cash flows but dislike risk, so the
larger the expected cash flows and the lower the
perceived risk, the higher the stock price.
F. There are differences between true expected cash flows and
risk versus perceived cash flows and risk.
1. By true we mean the cash flows and risk that investors
would expect if they had all the information that exists
about a company.
2. Perceived means what investors expect, given the
limited information that they actually have.
G. Each stock has an intrinsic value, which is an estimate of its true
value as calculated by a competent analyst who has the best
available data, and a market price, which is the actual market
price based on perceived but possibly incorrect information as
seen by the marginal investor.
1. The marginal investor determines the actual price.
2. The stock is said to be in equilibrium when there is no
pressure for a change in the stocks price. Actual market
price and intrinsic value will converge.
3. Intrinsic values are strictly estimates, and estimating
intrinsic values is what security analysis is all about and
is what distinguishes successful from unsuccessful
investors.
4. A firms managers have the best information about the
companys future prospects, so managersestimates of
intrinsic value are generally better than the estimates of
outside investors.
H. Intrinsic value is a long-run concept.
 1. Managements goal should be to take actions designed to
maximize the firms intrinsic value, not its current market
price.
2. Maximizing the intrinsic value will maximize the average
price over the long run.
3. Management should provide information that helps
investors make accurate estimates of the firms true
intrinsic value, which will keep the stock price closer to
its equilibrium level. However, there may be times when
management cannot divulge the true situation because
doing so would provide helpful information to its
competitors.

V. Three important business trends should be noted.

A. There is increased globalization of business.

1. Developments in communications technology have made
this possible.
2. The trend toward globalization is likely to continue, and
companies that resist it will have difficulty competing in
the 21st century.
B. Ever-improving information technology is having a profound
effect on financial management.
C. Corporate governance, or the way the top managers operate and
interface with stockholders, is changing the way things are done
within firms.

VI. As a result of financial scandals occurring during the past

decade, there has been a strong push to improve business
ethics. Business ethics can be thought of as a companys
attitude and conduct toward its employees, customers,
community, and stockholders.

A. A firms commitment to business ethics can be measured by the

tendency of its employees to adhere to laws, regulations, and
moral standards relating to product safety and quality, fair
employment practices, fair marketing and selling practices, the
use of confidential information for personal gain, community
involvement, and illegal payments to obtain business.
B. Most firms today have in place strong written codes of ethical
behavior and conduct training programs to ensure that
employees understand proper behavior in different situations.
1. Unethical actions can have consequences far beyond the
companies that perpetrate them.
 a. Many investors lost faith in American business and
turned away from the stock market, which made it
difficult for firms to raise the capital they needed to
grow, create jobs, and stimulate the economy.
2. Far too often the desire for stock options, bonuses, and
promotions drive managers to take unethical actions.
3. Ethics is an important consideration in both business and
business schools.

VII. It has long been recognized that managers personal goals may
compete with shareholder wealth maximization. Managers
might be more interested in maximizing their own wealth
rather than their stockholders wealth.

A. Good executive compensation plans can motivate managers to

act in their stockholders best interests.
1. Useful motivational tools include (a) reasonable
compensation packages; (b) firing managers who dont
perform well; and (c) the threat of hostile takeovers.
2. The compensation package should be sufficient to attract
and retain able managers but not go beyond what is
needed.
3. The compensation package should be structured so that
managers are rewarded on the basis of the stocks
performance over the long run, not the stocks price on
an option exercise date.
4. Options, or direct stock awards, should be phased in over
a number of years, so managers will have an incentive to
keep the stock price high over time.
B. Stockholders can intervene directly with managers.
1. Institutional money managers have the clout to exercise
considerable influence over firmsoperations.
a. They can speak with managers and make
suggestions about how the business should be run.
b. They act as lobbyists for the body of stockholders.
2. Any shareholder who has owned $2,000 of a companys
stock for one year can sponsor a proposal that must be
voted on at the annual stockholders meeting, even if
management opposes the proposal.
a. Shareholder proposals are nonbinding; however, the
results of such votes are clearly heard by top
management.
C. If a firms stock is undervalued, then corporate raiders will see it
to be a bargain and will attempt to capture the firm in a hostile
 takeover.
1. A corporate raider is an individual who targets a
corporation for takeover because it is undervalued.
2. A hostile takeover is the acquisition of a company over
the opposition of its management.
3. Managers should try to maximize their stocks intrinsic
value and then communicate effectively with
stockholders. That will cause the intrinsic value to be
high and the actual stock price to remain close to the
intrinsic value over time.
D. Conflicts can also arise between stockholders and bondholders.
1. Bondholders generally receive fixed payment regardless
of how the firm does, while stockholders do better when
the firm does better. This situation leads to conflicts
between these two groups.
a. Investments in risky ventures, that have great
payoffs to stockholders if successful but threaten
bankruptcy if they fail, create a conflict between a
firms bondholders and stockholders.
2. Another type of bondholder/stockholder conflict arises
over the use of additional debt.
3. Bondholders attempt to protect themselves by including
covenants in bond agreements that limit firms use of
additional debt and constrain managers actions.