Ch.

1 Overview of Financial Management

and Financial Environment
In this class, we want to know:
1) What Corporation is and its characteristics
are.
2) What is a goal of running Corporation in the
view point of a financial manager?
3) Why does Corporation need financial
institutions and markets?
 1. What is Finance and Corporate Finance
• What is Finance?
Finance is a discipline covering financial activities of
Corporation. Specifically it covers Corporate Finance,
Investment, International Finance and Institutional
Finance.
• What is Corporate Finance?
It is about financial activities within Corporation.
It covers topics of understanding financial statements
and valuation (time value of money) to handle capital
budgeting, capital structure, and working capital
management and to maximize the firm value.
• Capital budgeting: allocation of resources to
profitable projects.
• Capital structure: long term financing decision.
• Working capital management: short term
financing decision.
To deal with these functions, we need to know
how to read financial statement and how to
calculate time value of money.
 2. What is Corporation?
1) Types of Business Organization:
• Sole proprietorship
• Partnership
• Corporation
• Hybrid

(1) Sole proprietorship: an owner is a manager.

Advantages:
- Easily and inexpensively formed
- Subject to few government regulations
- Avoid corporate income tax
Limits:
- Unlimited personal liability
- Limited to the life of the individual who create
- Difficult to obtain large sums of capital
(2) Partnership – more than one owner who involves management too.
Advantages:
- Easy and inexpensive to set up
Limits:
- Unlimited liability
- Limited life
- Difficult to transfer ownership
- Difficult to raise capitals

• To stay away from unlimited liability, limited partnership is introduced. It has

limited partners and general partners. Limited partners do not involve in
management and can lose only his or her investment whereas general
partners involve in management and have unlimited liabilities. In both regular
and limited partnerships, at least, one partner is liable for debts of the
partnership. However, in a Limited Liability Company or Limited Liability
Partnership, all partners enjoy limited liability regard to the business liabilities
and their potential losses.
(3) Corporation
Separation of owners from management through Initial Public
Offering.

Advantages:
- Unlimited life
- Easy transferability of ownership
- Limited liabilities

Limits:
- Double taxations: corporate and individual levels
- More time consuming documentation and reports: charter and a
set of bylaws
• Charter includes; (1) name of proposed corporation,
(2) types of activities it will pursue, (3) amount of
capital stock, (4) number of directors, (5) names and
addresses of directors. This charter is filed with the
secretary of the state in which the firm will be
incorporated.
• Bylaw includes; (1) how directors are elected, (2)
whether the existing stockholders will have the first
right to buy any new shares the firm issues, (3)
procedure for changing the bylaws.
- Different types:
• Professional Corporation (PC) or Professional
Association (PA). Though Corporation, it does
not allow to relieve professional liability (e.g.
malpractice of doctors, lawyers, etc).
• S Corporation: small size business and 100
owners. Taxed like a proprietorship.
(4) Going Public
• After setting up Corporation, due to limitations
or restrictions from government, corporate can
not sell stocks right away. Those stocks are
called closely held stocks.
• After submitted prospectus to and getting
approvals from SEC (security exchange
committee) for being listed, those stocks can be
traded. Investment banks such as Goldman
Sachs help selling securities with their brokerage
firms.
3. Growing and managing a Corporation
• Agency problem: conflict of interest between
management and shareholders
• Corporate governance in order to address
agency problem. Here corporate governance
is a set of rules that control company’s
behavior towards its directors, managers,
employees, shareholders, creditors,
customers, competitors, and community.
 4. Primary Objective of Corporation
• Stock holders elect directors who then hire
managers to run a corporation. Directors and
managers are called “insiders.”
• Goal of management is to maximize the
fundamental or intrinsic price of common
stock (shareholder wealth) rather than the
market price.
• Maximizing stock price also benefit social
welfare: (1) owners of stocks are society, (2)
Consumer benefit resulting from high quality
and low cost, and (3) more employee, etc
• However some non US firm (European) has board of
directors representing the interests of employees or
government, not juts only shareholders.
• Benefit corporation (B corporation) which expands
fiduciary responsibilities including interests other than
shareholders. E.g.) Big Bad Wolf (B corp) mandates to
help the environment and society. The Big Bad Woof,
which sells products for companion pets, seeks to
purchase merchandise from small, local, minority-
owned businesses even if their prices are a bit higher.
 (1) Managerial actions to maximize
shareholder wealth
• Firm value is determined by a company’s
ability to generate free cash flows (FCF) now
and in the future. The improvement of FCF will
improve the intrinsic value of a firm.
• FCF = sale revenue – operating costs –
operating taxes – required new investments in
operating capital.
• Value
  (intrinsic or fundamental value)
• Here WACC is weighted average cost of capital
(Financing cost)

• Improvement of free cash flow and intrinsic

value affects ordinary citizen, consumers and
employee.
• Improvement of free cash flow and intrinsic value
also associates with ethics (e.g. penalties, law
suits, reputations, etc).
(2) Regulations for ethics and whisleblowing.
• SOX (Sarbanes-Oxley 2002)
• Dodd Frank Reform and Consumer Protection
(2010)
• Both protect whistleblowers reporting wrong
doing. E.g.) Occupational Safety and Health
Administration (OSHA) under SOX.
• 2017/2018 Tax Cut and Job Act (TCAJ)
• https://www.smith-howard.com/2018-tax-cut
s-jobs-act-overview/
 5. An overview of the Capital Allocation
Process
Corporations/Business need capitals to maintain or advance
their operation. When capitals are raised (transferred) to
Corporation/Business, financial securities/instruments will be
offered to Capital providers/Savers.

1) Direct Transfers
2) Indirect Transfers though Investment Bankers underwriting
the security issues.
3) Indirect Transfer through a Financial Intermediary such as
banks and funds.
Figure 1-1
6. Financial Securities/Instruments
1) Def of Financial instrument: claim on a future
cash flow. Def of Financial securities: a claim that is
standardized and regulated by government.

- Debts: documents with contractual provisions that

entitle their owners to specific rights and claims on
specific cash flows or values.
- Equity: a claim upon a residual value after debts.
- About rates and Maturity of Claims: prime rate
(the rate that US banks charge to most
creditworthy customers), LIBOR (London
Interbank Offered Rate, rate UK banks charge to
non UK banks for lending), and SOFR (secured
overnight financing rate) with using Treasury
securities as collaterals.

- Major Financial Instruments (Table 1-1)

Table 1-1 – Summary of Major Financial Instruments

1-22
Table 1-1 – Summary of Major Financial Instruments

1-23
2) Derivatives or hybrid: securities whose values
depend on or are derived from the values of
some other traded assets. (e.g. Option). Some
securities are a mix of debt, equity and
derivatives (e.g. preferred stock, convertible
bond).
3) The process of securitization – mortgage
securitization:
• S&L, banks or specialized mortgage
originating firms originate mortgage and sell
them to investment banks. The investment
bundle them into packages and then use these
package as collateral for bonds sold to pension
funds, insurance and other investors.
• Congress facilitated this process by creating two stockholder-owned
but government sponsored entities – Federal National Mortgage
Association (Fannie Mae) and Federal Home Loan Mortgage
Corporation (Freddie Mac) which have a small amount of equity and a
huge amounts of debt.
• Since then, S&L and banks originate and pool mortgage and then sell
them to Fannie Mae which uses them as collateral in order to sell
bonds. E.g) Collateralized debt obligation (CDO,
https://www.investopedia.com/terms/c/cdo.asp). CDS (Credit Default
Swap(https://www.investopedia.com/terms/c/creditdefaultswap.asp).
• This process (1) increases lendable funds, (2) transfer of risk of
mortgage to Fannie Mae or any purchaser, and (3) increases liquidity
for holders of the debts with the secondary market.
• This process benefit investors (lenders) through diversification –
bundled mortgage and an improved return.
4) Crypto currency:
(https://www.investopedia.com/terms/c/cryptocurrency
.asp)
• A cryptocurrency is a digital or virtual currency that
uses cryptography for security. A cryptocurrency is
difficult to counterfeit because of this security feature.
A defining feature of a cryptocurrency; it is not issued
by any central authority, rendering it theoretically
immune to government interference or manipulation.
7. Factors affecting the required rate of return (cost of money). The more
demand on money/capitals, the higher the rate is.
• Production opportunities
• The time preference for consumption
• Risk
• Expected Inflation

8. Economic condition and policies affecting required rate of return (cost of

money). The more money supply is, the lower the rate is.
• Federal Reserve Policy (open market operation – buying or selling
treasury securities to control money supply)
• Federal Budget Deficits or Surpluses (e.g. spending more or less than
collected taxes)
• Level of Business Activity
• Foreign Trade balance: Deficits or Surplus.
 9. Financial Institutions
1) Investment banks: an organization that underwrites and distributes
new investment securities and helps businesses obtain financing. It
also provides consulting and advisory services and brokerage services.
2) Deposit-taking financial intermediates
• Savings and Loan Association (S&Ls): accepted deposits from many
small savers and then loaned this money to home buyers and
consumers.
• Credit union: cooperative association whose members’ savings are
loaned only to other members.
• Commercial bank: raising money from deposits or by issuing stock or
bonds to investors. Some one with a bank account can write checks,
use debit cards, etc. And investors can receive dividends or
interests.
3) Investment Funds
• Mutual funds: organizations that pool investor
funds to purchase financial instruments and
thus reduce risk through diversification.
- Passively managed funds: investment in a
group of category and minimum expenses.
- Money market funds: investment in low-risk
securities and allow investors to write checks
against their accounts.
• Exchange Traded Funds (ETFs): similar to mutual funds. ETFs funds
buy a portfolio of stocks of certain type and then sell their own
shares to the public.
• Hedge funds: similar to mutual funds.
- Limited to institution investors and small number of net worth
individuals.
- Mutual funds are registered and regulated by SEC but hedge
funds are less regulated.
- Minimum investment requirement ( $1 million).
• Private Equity Companies: they buy and then manage entire firms.
- Limited to a small number of large investors.
- Tend to privatize public firms and then sell them later at
premium.
• 4) Insurance and Pension funds
• Pension funds: retirement funds. Primarily investing in
bonds, stocks, mortgages, and real estate.
• Life insurance companies: take premium and invest in bonds,
stocks, etc.
• 5) Regulation of Financial Institutions
• After repealing Glass-Steagall’s separation of commercial and
investment banking in 1999, huge financial service
corporations emerged. These financial service corporations
provide services of commercial banking, S&Ls, Mortgage,
investment banking, etc.
 10. Financial Markets
1) Physical asset markets: goods, tangible assets, real
assets markets
Financial markets: claims on real assets (financial
securities)

2) Spot and futures markets: assets are bought or sold for

“ on the spot” or for delivery at some future date.

3) Money markets: financial markets for short term and

high liquid debt securities.
Capital Market: financial markets for intermediate or
long term bonds and stocks.
4) Mortgage market: loans on residential, agricultural, commercial, and
industrial real estate.
Commercial credit market: loans on autos, appliance, education, vacations,
and so on.

5) World, national, regional and local market

6) Primary Markets: markets in which corporations raise capital by issuing

new securities.
Secondary market: markets in which existing, already outstanding,
securities are traded. Ex) NYSE

7) Private market: The market where transactions are worked out directly
between two parties. Ex) bank loan or private debt placement
Public market: The market where standardized contracts are traded on
organized exchange. Ex) issuing securities or public debts
 11. Trading Procedure
1) Two basic types of stock markets
• Physical location exchange: NYSE, AMEX and regional stock exchanges
• Electronic dealer-based markets: Nasdaq, over the counter and
electronic communication networks (ECNs)

2) Matching buy and sell orders:

- Outcry auction: meet and communicate with shout and hand signals.
E.g) CBOT
- Dealers market: list bid and ask quotes and then contact a specific
dealer to match. E.g) NASDAQ
- Automated Trading Platforms: post buy and sell prices and then ECN
automatically match with close prices. E.g) Instinet and Archipelago.
3) Types of stock market transactions:
- Going public and seasoned equity offering.

4) Secondary stock markets in US.

1) In the past, NYSE (physical market) and

NASDAQ (National Association of Securities
Dealers) were dominant secondary markets.
However now about a dozen active markets are
registered for stock trading.
2) NYSE has 3167 firms listed. NASDAQ has 3174
firms listed. Due to listing requirements,
relatively large firms can be listed in NYSE. Small
firms can be listed in NASDAQ.