Chapter 1:

Introduction

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 Finance
• Finance is the central to most of the
organization decision making dealing with
raising and using of money. (Important for
corporations, individual and government.)
• These decisions include whether or not to invest;
how to finance an investment; how to value a
company & whether or not dividends should be
paid.
• To deal with such issues its necessary to
understand the principle methods and
techniques of financial management.
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• This course provide you a through
understanding of the principle methods and
techniques of financial management
enabling you to deal with complex financial
issues and handle them effectively.

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 Key Concepts

• Know the basic types of financial

management decisions and the role of the
financial manager
• Know the goal of financial management
• Know the financial implications of the
different forms of business organization
• Understand the various types of financial
markets
• Understand the conflicts of interest that can
arise between owners and managers 1-3
 Corporate Finance
• Addresses several important questions:
• What L-T investments should the firm take
on?
• Eg. Whether or not to open new store
• Where will we get the L-T financing to pay for
the investment?
• Eg. Borrow money or use equity
• How will we manage the everyday financial
activities of the firm?
• Eg. Collecting from customer & paying supplier 1-4
Financial Management Decisions

• The financial manager is concerned

with 3 primary categories of
financial decisions:
1. Capital Budgeting
2. Capital Structure
3. Working Capital Management

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 1. Capital Budgeting

• Process of planning and managing firms

L-T investment decisions.
• What L-T investments or projects
should the business take on?
• i.e. whether or not to buy a new building,
equipment, machinery or to expand
manufacturing plant

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 2. Capital Structure

• Where will we get the L-T financing to pay

for the investment?
• How should we pay for our
assets?
• i.e. borrow money from the bank or issue new
securities
• When should the firm raise funds?
• What are the least expensive sources of
funds for the firm?
• Should the firm use debt or equity? Is there
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an optimal mix of debt and equity?
3. Working Capital Management

• How will we manage the day-to-day

financial activities of the firm?
• Day to day activities ensure that the firm have
sufficient resources to continue its operations.
• Are we collecting from customer & paying
supplier
• Managing S-T assets and liabilities.
• Eg. How much inventory should the firm
carry? What credit policy is best? (Eg.
credit collection period) 1-8
 Corporate Form of Organization
(Organizational Chart highlights the finance activities
in a large firm) Board of director . select
manager .Managers running
In corporate form of the corp. affairs in the
ownership stockholders stockholders interest.
are owner of the firm and
are usually not directly
involved in making
business decision,
particularly on a day t o
day basis.
CFO is the top financial manager within a firm.

These treasury activities are Coordinate activities of..

all related to the 3 general
question-raised earlier.

Responsible for managing Handles

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 Financial Manager
• The Chief Financial Officer (CFO)
coordinate the activity of treasurer and
controller.
• Treasurer – Corporate finance is
concentrate with the function of treasurer
office. The firms chief financial manager, who
is responsible for the firm’s financial
activities, such as,
• Eg. Managing cash, credit, making capital
expenditure decisions, financial planning and fund
raising and the pension fund, and foreign
exchange (managing the firms exposure to loss
from currency fluctuations). 1-10
• Controller – The firms chief accountant,
who is responsible for the firm’s accounting
activities, such as;
• Handles cost and financial accounting, corporate
accounting, tax management, auditing and data
processing.

• Treasurer and controller report directly to the

CFO.
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 The Goal of Financial Management

• ANSWER: The Goal of Financial

Management is to maximize the current
market value of owners equity (maximize
owner wealth).

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• Stockholder Perspective;
• “The goal of Financial Management is to
maximize the current value per share of the
existing stock”
• Eg. Increase the market value of the company from
$1 million to $1.5 million. Assume that company have
10,000 shares outstanding.
=1 million / 10,000=$100 earning per share
=1.5 million / 10,000= $150 earning per share

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Forms of Business Organization
• Sole proprietorship
• A business owned by one person

• Partnership
• A business with multiple owner, but not incorporated
– General Partnership : All partners have unlimited liabilities
– Limited Partnership : One more general partners run the
business and have unlimited liabilities. And one or more limited
partners liability is limited to the amount of their investment in the
business.

• Corporation
• Largest form of organization
• A distinct legal entity compose of one or more individuals
• Owners liability is limited to the amount of investment in the firm
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• Role of financial market is important for corporations
 Sole Proprietorship

• Advantages • Disadvantages
• Easiest to start • Limited to life of owner
• Least regulated • Equity capital limited to
• Single owner keeps all owner’s personal
the profits wealth
• The owners are also • Hard to raise capital
the managers fund
• Taxed once as personal • Unlimited liability
income • Difficult to sell
ownership interest

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 Partnership

• Advantages • Disadvantages
• Two or more owners • Unlimited liability
• More capital available • General partnership
• Relatively easy to start • Partnership dissolves
• Income taxed once as when one partner dies
personal income or wishes to sell
• Difficult to transfer
ownership

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 Corporation
• Advantages • Disadvantages
• Limited liability, which • Separation of ownership
quarantees that they can not and management (Agency
lose more than they invested. Cost)
• Unlimited life • More expensive to
• Transfer of ownership is easy organize than other
• Easier to raise capital business forms
• Double taxation (income
taxed at the corporate rate
“Last two advantages are
and then dividends taxed
improved by the existence of
at the personal rate)
financial market.”
• Subject to greater
(owners hold c/s certificates
government regulations
and ownership can be
transfer by selling the • Lacks secrecy, because
certificates) stockholders must receive
financial reports. 1-17
 How firm raises money?
When corporation need to invested in new
plant and equipment, it requires money. To
raise money, firm can either,

• Borrow the cash from bank on a L-T bases (or

Issue bond / debt securities) (Chp. 7)

• Issue new securities (i.e. sell additional shares

of common stock, such as common stocks or
preferred stock) (Chp. 8)
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• Financial Market function as both
primary and secondary market
for Debt and Equity securities.

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 Primary Market
• Market in which newly-issued securities are
sold by the company to raise cash.
• IPO (Initial Public Offering) – occur when
private company sell stocks/bonds to the
company for the first time
• Eq. IBM comp. issued stock to raise
money for the first time. Corp. is a seller
and transaction raises money for the
corporation.
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 Secondary Market

• Market in which already-issued

securities are bought or sold among
investors.
• One owner or creditor selling to
another – is a mean of transferring
ownership of corporate securities.
• There are two kinds of secondary
markets: Dealer Market and Auction
Market
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 Dealer Market

– Dealer Market
• The buyer and seller, buy and sell for
themselves, at their own risk.
• Eg. Car dealer, buys and sells automobiles.

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Eg. Dealer market in stocks and L-T debt are
called over-the counter (OTC) Market.

The expression over the counter refers to

days of old when securities were bought
and sold at counter in offices around the
country.

Today, for stock and long-term debt have

no central location; the many dealers are
connected electronically.
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Eg. NASDAQ (National Association of Security
Dealer Automated Quatation System), worlds 1st
electronic stock market set in 1971 –
Computerized system facilitate trading. (NASDAQ
had its origin in the OTC market, but is today
considered as totally seperate entity.)

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 Auction Market
• Auction Market (Broker Market)

• Brokers and agents match buyer and sellers, but

they do not actually own the commodity that is
bought or sold.

• Eg. Real estate agent, does not normally buy and

sell houses.

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Auction market differ from dealer market
There is a physical location (the exchange),
which matches those who wishes to buy with
those who wishes to sell. Eg. NYSE,ASEX,
ISE, TSE, LSE ..etc.
The primary purpose of an auction market , is
to match those who wishes to sell and those
who wishes to buy. In a sense, with the help
of a broker, the securities effectively change
hands on the floor of the exchange.
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 The Agency Problem

• Agency relationship
• Stockholders (principals) hire managers (agents)
to run the company and to act on their behalf.
• Agency Problem
• is the conflicts of interest that can arise between
owners and managers. i.e the likelihood that
managers may place personal goals ahead of
corporate goals.

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Separation of ownership from control causes
Agency Problem. Why?
• Management may act in its own best
interest rather than the those of the
shareholders.
• Conflict of interest between principal
and agent – Contradict the goal of
maximizing share price of the equity
of the firm.
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Do Managers act in the stockholders’ interest? Depends on
whether management goal align with stockholders goal

• Managerial compensation can be used to

encourage managers to act in the best
interest of stockholders. The idea is
that if management have an
ownership interest in the firm,
they will be more likely to try to
maximize owner wealth.
•How can stockholders make sure that
‘managers act in the stockholders’ interest’?

• Performance Plans , such as cash bonus

or performance share
• Stock options plan
– Eg. Allow manager to purchase stock,
help to convince manager to work in the
best interest of stockholder.

Then agency problem not exist.

Because agent is compensated.
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 Quick Quiz

• What are the three types of financial management

decisions and what questions are they designed to
answer?
• Write down the advantages & disadvantages of
Corporation forms of business organization
• What is the goal of financial management?
• What are agency problems and why do they exist
within a corporation? How can you prevent?
• What is the difference between a primary market and
a secondary market? Give example
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