CHAPTER I

AN OVERVIEW
OF FINANCIAL
MANAGEMENT
 WHAT IS FINANCE
Finance is defined as the management of
money and includes activities such as
investing, borrowing, lending, budgeting,
saving, and forecasting.

Note too that stock prices change over time as conditions change and as
investors obtain new information about a company’s prospects.

THREE TYPES OF FINANCE

A. PERSONAL
B. CORPORATE
C. PUBLIC/GOVERNMENT
 FINANCE VERSUS ECONOMICS AND
ACCOUNTING

FINANCE ECONOMICS

fundamentally a forward looking field, the social science that analyzes the
concerned with what an asset will be worth in production, distribution, and consumption of
the future goods and services.

ACCOUNTING

the process of communicating financial

information about a business.
FINANCE WITHIN AN
ORGANIZATION
 CORPORATE FINANCE, CAPITAL
MARKETS, AND INVESTMENTS

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 FINANCIAL
MANAGEMENT

also called corporate finance, focuses

on decisions relating to how much
and what types of assets to acquire,
how to raise the capital needed to buy
assets, and how to run the firm so as
to maximize its value.
 CAPITAL MARKETS

relate to the markets where interest

rates, along with stock and bond
prices, are determined.
 INVESTMENTS

relate to decisions concerning stocks

and bonds and include a number of
activities: (1) security analysis; (2)
portfolio theory; and (3) market
analysis
 SECURITY ANALYSIS

deals with finding the proper values of

individual securities (i.e., stocks and
bonds).
 PORTFOLIO THEORY

deals with the best way to structure

portfolios, or “baskets,” of stocks and
bonds.
 MARKET ANALYSIS

deals with the issue of whether stock

and bond markets at any given time
are “too high,” “too low,” or “about
right.”
 BEHAVIORAL FINANCE

where investor psychology is examined in

an effort to determine if stock prices have
been bid up to unreasonable heights in a
speculative bubble or driven down to
unreasonable lows in a fit of irrational
pessimism, is a part of market analysis.
 JOBS IN FINANCE

Accounting students need to know

Finance prepares students for jobs in finance, marketing, management, and
banking, investments, insurance, human resources; they also need to
corporations, and the government. understand finance, for it affects
decisions in all those areas.

most important management decisions are

evaluated in terms of their effects on the
firm’s value.
this is called value-based management,
and it is the “in” thing today.
 SOLE
Sole
PROPRIETOR
proprietorship
Limited SHIP
Liability
Partnership
Partnership
(LLPs) forms of business
organizations
Limited
Liability Corporation
Companies
(LLCs)
 STOCK PRICE AND
SHAKEHOLDER VALUE

The primary goal of a corporation should

we operate on the assumption that
be to maximize its owners’ value, but a
management’s primary goal is share-
proprietor’s goal might be quite different.
holder wealth maximization. That
translates into this rule: A manager should
The primary goal for managers of publicly try to maximize the price of the firm’s
owned companies implies that decisions stock, subject to the constraints discussed
should be made to maximize the long-run in the opening vignette.
value of the firm’s common stock.
 EXAMPLE 1

Consider Larry Jackson, the proprietor

of a local sporting goods store.
Jackson is in business to make
money, but he likes to take time off to
play golf on Fridays. He also has a few
employees who are no longer very
productive, but he keeps them on the
payroll out of friendship and loyalty.
 EXAMPLE 2

By contrast, Linda Smith is CEO of a large corporation. Smith

manages the company; but most of the stock is owned by
shareholders who purchased it because they were looking for an
investment that would help them retire, send their children to
college, pay for a long-anticipated trip, and so forth. The
shareholders elected a board of directors, which then selected Smith
to run the company. Smith and the firm’s other managers are
working on behalf of the shareholders, and they were hired to pursue
policies that enhance shareholder value. At the same time, the
managers know that this does not mean maximize shareholder
value “at all costs.” Managers have an obligation to behave ethically,
and they must follow the laws and other society-imposed
constraints that we discussed in the opening vignette to this chapter
 EXAMPLE 3

if you own 100 shares of GE’s

stock and the price is $40 per
share, your wealth in GE is
$4,000
 EXAMPLE 3

if you own 100 shares of GE’s

stock and the price is $40 per
share, your wealth in GE is
$4,000
Firms have a number of different departments,
including marketing, accounting, production,
human resources, and finance.
The finance department’s principal task is to
evaluate proposed decisions and judge how
they will affect the stock price and thus
shareholder wealth.
Firms have a number of different departments,
including marketing, accounting, production, human
resources, and finance.
The finance department’s principal task is to
evaluate proposed decisions and judge how they will
affect the stock price and thus shareholder wealth.
Note too that stock prices change over time as
conditions change and as investors obtain new
information about a company’s prospects.
Thank you :)
continuation
intrinsic value
which is an estimate of the stock’s “true” value as
calculated by a competent analyst who has the best
available risk and return data.
market price
which is the actual market price based on perceived but
possibly incorrect information as seen by the marginal
investor.
equilibrium
When a stock’s actual market price is equal to its intrinsic
value.
Important Business Trends

first trend
o profound changes in business practices.
second trend
increased globalization of business.
third trend
profound effect on financial management is ever-
improving infromation technology.
fourth trend
relates to corporate governance, or the way the top
managers operate and interface with stockholders.
Business Ethics

Ethics
is defined in Webster’s Dictionary as “standards
of conduct or moral behavior.
Business Ethics
can be thought of as a company’s attitude and
conduct toward its employees, customers,
community, and stockholders.
What Companies Are Doing

If the company released negative but perhaps

incorrect information, this announcement would
have hurt sales and possibly prevented some
patients who could have benefit from using the
product.
If the company delayed the release of this
additional information, more patients might have
suffered irreversible harm.
Consequences of
Unethical Behavior
ethical lapses have led to a number of
bankruptcies
top executives came under fire because of
misleading accounting practices that led to
overstated profits.
these executives reaped millions before the stock
declined, while lower-level employees and outside
investors were left “holding the bag.”
Some of these executives are now in jail.
Consequences of
Unethical Behavior
frauds also severely damaged other companies
and even whole industries.
improper actions caused many investors to lose
faith on business and to turn 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.
unethical actions can have adverse consequences
far beyond the companies that perpetrate them.
Consequences of
Unethical Behavior

employees lost their jobs.

in most other cases, individuals rather than firms

were tried; and while the firms survived, they
suffered damage to their reputations, which
greatly lowered their future profit potential and
value
How Should Employees Deal with Unethical Behavior?

Employees jeopardize their jobs if they come

forward over their bosses’ objections.

However, if they don’t speak up, they may suffer

emotional problems and contribute to the downfall
of their companies and the accompanying loss of
jobs and savings.
How Should Employees Deal with Unethical Behavior?

If employees obey orders regarding actions they

know are illegal, they may end up going to jail.
In most of the scandals that have gone to trial, the
lower-level people who physically entered the bad
data received longer jail sentences than the
bosses who presumably gave the directives.
 Conflicts Between Managers, Stockholders
, and Bondholders

managers might be more interested in

maximizing their own wealth than their
stockholders’ wealth; therefore, managers might
pay themselves excessive salaries.
good executive compensation plans can motivate
managers to act in their stockholders’ best
interests.
 Useful motivational tools include

reasonable compensation packages.

firing of managers who don’t perform.
the threat of hostile takeovers.
 Compensation Packages

should be sufficient to attract and retain able

managers, but they should not go beyond what is
needed.
also, compensation should be structured so that
managers are rewarded on the basis of the stock’s
performance over the long run, not the stock’s
price on an option exercise date
Stockholders can intervene directly with managers

firts, they can talk with managers and make

suggestions about how the business should be run.
second, any shareholder who has owned of a
company’s stock for one year can sponsor a
proposal that may be voted on at the annual
stockholders’ meeting, even if management
opposes the proposal.
 Corporate Raider

An individual who targets a corporation for

takeover because it is undervalued
 Hostile Takeover

The acquisition of a company over the opposition

of its management.
In the words of one executive, “If you want to keep
your job, never let your stock become a bargain.”
Again, note that the price managers should be
trying to maximize is not the price on a specific
day. Rather, it is the average price over the long
run, which will be maximized if management
focuses on the stock’s intrinsic value.
However, managers must communicate effectively
with stockholders (without divulging information
that would aid their competitors) to keep the
actual price close to the intrinsic value. It’s bad for
stockholders and managers when the intrinsic
value is high but the actual price is low. In that
situation, a raider may swoop in, buy the company
at a bargain price, and fire the managers.
 Stockholders versus Bondholders

Bondholders generally receive fixed payment

regardless of how well the company does, while
stockholders do better when the company does
better.
 Illustartion Problem

Suppose a company has the chance to make an investment

that will result in a profit of $10 billion if it is successful but the
company will be worthless and go bankrupt if the
investment is unsuccessful. The firm has bonds that pay an
8% annual interest rate and have a value of $1,000 per bond
and stock that sells for $10 per share. If the new project—say,
a cure for the common cold—is successful, the price of the
stock will jump to $2,000 per share, but the value of the
bonds will remain just $1,000 per bond. The probability of
success is 50% and the probability of failure is 50%
What is the expected stock price?
Another type of bondholder/stockholder conflict
arises over the use of additional debt.
The more debt a firm uses to finance a given
amount of assets, the riskier the firm is.
 For Example

if a firm has $100 million of assets and finances

them with $5 million of bonds and $95 million of
common stock, things will have to go terribly bad
before the bondholders will suffer a loss. On the
other hand, if the firm uses $95 million of bonds
and $5 million of stock, the bondholders will suffer
a loss even if the value of the assets declines only
slightly
End of chapter 1