Chapter 1

Overview of Financial
Management

ACT3211 Financial Management

 Chapter 1 Learning Goals

LG1: Connect finance sub-area descriptions with corporate financial tasks

LG2: Show why and how finance is at the heart of sound business
decisions

LG3: Apply finance in your personal life

LG4: Compare and contrast the advantages and disadvantages of the

three most common business organizational forms in corporate
world

LG5: Differentiate between financial managers’ appropriate and

inappropriate goals

LG6: Identify the firm’ primary agency relationship and discuss

why
agency relationships can create conflicts
LG7: Incorporate ethics into financial management

LG8: Describe the complex and necessary relationships among firms,

financial
ACT3211 Financial institutions, and financial markets
Management
 What is Finance?
 The study of valuation
 Stocks, bonds
 Mortgage payments
 Companies
 Projects
 Business decisions

Financial Management focuses on valuing things

from the perspective of a company rather than an
individual, but the same concepts apply to both

ACT3211 Financial Management

 Economic Participants
We can segment participants along two
dimensions:
 Those with “extra” money available to invest
 Those with economically viable ideas

No extra money Extra money

No economically Type 1: No Type 2: Money,
viable business money and no but no ideas
ideas ideas
Economically Type 3: No Type 4: Both
viable business money, but ideas money and ideas
ideas

ACT3211 Financial Management

 We can set aside Types 1 and 4
 Type 1 people play no direct role in financial markets as
either lenders or users of capital, but they play an indirect
role by providing labor and consuming products
 Type 4 people are self-funded, so they don’t need financial
markets. They do use the financial tools discussed below,
however.

 Types 2 and 3 use financial institutions and financial

markets to engage in mutually beneficial exchange
 Type 2 people lend money to Type 3 people to invest in good
business ideas.

ACT3211 Financial Management

Type 1 participants are usually individual
investors

Type 3 participants are usually companies

which may have R&D departments dedicated
to developing innovative ideas

Investors lend capital to businesses, who then

expand, hire more employees, and create a
promising future. The investor has increased
wealth for the future as well.

ACT3211 Financial Management

 Where Does the Cash Go?

Successful companies repay investors (plus profit)

for the use of their capital. But not all the cash will
return to investors due to friction.
Two sources of friction:
1. Retained earnings
 Funds that the firm retains to support ongoing operations
2. Taxes
 Used by the government to fund public services

ACT3211 Financial Management

 Sub-Areas of Finance

1. Investments
 Studies the methods and techniques needed to make
appropriate decisions about what kind of securities (bonds
and stocks) to own
2. Financial Management
 Examines firm decisions
 How to organize
 What type of capital to raise
 Which projects to fund
 How much capital to retain and how to pay back providers of
capital

ACT3211 Financial Management

 Sub-Areas of Finance

3. Financial Institutions and Markets

 Studies capital flows between investors and firms
 Examines financial institutions such as banks, mutual funds,
pension funds
 Studies interest rates
4. International Finance
 Applies all three of the above areas in a global setting
 Examines exchange rates, political risk, international
investment, risk management

ACT3211 Financial Management

 Applying Finance Theory
 Future cash flows are uncertain in both size and timing
 We refer to this uncertainty as risk
 Assessing the value of financial assets, such as stocks
and bonds, involves examining the expected cash flows
from the asset and computing their risk-adjusted present
value using the Time Value of Money.
 These financial assets trade in financial markets, and
are very likely to worth exactly what they cost.
 In contrast, a firm may find real assets such as projects,
to be worth more than they cost. We will learn a variety of
methods to analyze such opportunities.

ACT3211 Financial Management

 The Financial Function

In most companies, the financial function is closely

associated with the accounting function
 Accounting generally looks backward in time to record
things that have already happened
 Finance generally looks ahead to the future
 Making decisions based on economic analysis
 Valuation

ACT3211 Financial Management

 The Financial Manager
 Chief Financial Officer
Highest level financial officer
CFO


 Controller Controller Treasurer
 Oversees the accounting function
 Treasurer
 Responsible for managing cash, credit, financing, capital
budgeting, risk management

ACT3211 Financial Management

 Finance in Other Business Functions
While the CFO and Treasurer are the most visible
finance–related positions, finance permeates the
entire business organization
 Strategy
 Day-to-day operations
Finance is used by all areas within the firm
 Operations
 Marketing
 Human resources

ACT3211 Financial Management

 Finance in Your Personal Life
The financial concepts you learn in this course will
also apply to your personal financial situation
 Borrowing money
 Refinancing
 Investing
 Retirement planning
 Rise of defined contribution plans vs. defined benefit

ACT3211 Financial Management

 Business Organization

Single owners, partners, and corporations operate

businesses. The advantages and disadvantages of
forms of organization can be expressed through the
following dimensions:
 Who controls the firm
 Who owns the firm
 What are the owners’ risks
 What access to capital exists
 What are the tax ramifications

ACT3211 Financial Management

 Sole Proprietorships
The most common type of business organization
in the U.S. (over 70% of businesses). There is no
distinction between the owners’ personal and
business assets
Advantages:
 Easy to start
 Light regulatory and paperwork burden
 Single taxation at the personal tax rate
Disadvantages
 Unlimited liability
 Limited access to capital

ACT3211 Financial Management

 General Partnerships

Involves multiple individual owners. Firm control is

determined by the size of the partners’ ownership
stakes. Profits are taxed at personal income tax
rates.
Advantages:
 Relatively easy to start
 Single taxation
Disadvantages:
 Partners jointly share unlimited liability
 Difficult to raise large amounts of capital

ACT3211 Financial Management

 Limited Partnerships

Much like general partnerships

General partners make decisions regarding the
firm and are liable for the firm’s debts
Limited partners are liable only for their
investment in the firm
 Can’t materially participate in the firm’s operations or they
lose their ‘limited’ status

ACT3211 Financial Management

 Corporations
 Corporations are legally independent entities entirely
separate from their owners. The world’s largest businesses
are organized as corporations.
 Owners are called shareholders. They elect the board of
directors, who then hire managers of the firm.
 Advantages:
 Limited liability for owners
 Can raise large amounts of capital
 Easy to transfer ownership
 Disadvantages
 Double taxation (corporate level and personal level)

ACT3211 Financial Management

 Hybrid Organizations

To promote the growth of small businesses, the

U.S. government allows for business organizations
that simultaneously offer single taxation and
limited liability
S Corporations
Limited Liability Companies (LLCs) and
Partnerships (LLPs)

ACT3211 Financial Management

 Goals of the Firm
Owners perspective: Maximize shareholder
wealth (stock price)
 Another way of saying the same thing: maximize the
value of the company
 Adam Smith’s invisible hand: firms that pursue
activities that maximize firm value also benefit society
 Requires maximizing the present value of future cash
flows, which requires that the firm do things that are
generally desirable: making products that people want
in an efficient way that results in increased growth,
employment, and tax revenue

ACT3211 Financial Management

 What about Profit Maximization?
 Profits are not cash flows
 Which profits? This year? This quarter? This goal
ignores timing of returns
 This goal ignores differences in risk between projects
 This goal doesn’t reflect returns to equity holders

ACT3211 Financial Management

What about other goals such as minimizing
costs or maximizing market share or
employee welfare or customer satisfaction?
 These kinds of worthy goals are incorporated into
the overall goal of maximizing firm value
 When pursued in isolation, benign-sounding goals
will result in financial distress or failure

ACT3211 Financial Management

 Agency Theory
 When one party (the principal) hires another party (the
agent) to work for them, this is an agency relationship
and the agent is supposed to act in the principal’s best
interest.
 How does this apply to the firm?
 The stockholders (owners) don’t manage the firm. They hire
managers to operate the firm to maximize the value of their
investment.
 Often, the manager’s best interest does not align with
shareholder goals. This is known as an agency problem.
 Example: CEO buying corporate jet rather than flying
commercial.

ACT3211 Financial Management

Three approaches to minimizing this conflict of
interest
 Ignore it. If the amount of money is small enough such
perks might add value by enhancing productivity.
 Monitor the managers.
 Accountants
 Debt holders
 Align incentives by making the managers owners
 Equity stakes
 Stock options
 ESOPS

ACT3211 Financial Management

 Corporate Governance
The process of aligning managers’ incentives and
monitoring managers
Inside monitors: the Board of Directors
 Hires the CEO
 Evaluates management
 Designs compensation plans
Outside monitors
 Auditors
 Analysts
 Banks
 Credit rating agencies

ACT3211 Financial Management

 Ethics

Financial professionals manage other people’s

money
 Corporate managers
 Bankers
 Investment advisors
Professional associations place a strong emphasis on
ethical behavior
The corporate agency relationship can create ethical
dilemmas
 Stealing from firms = stealing from shareholders

ACT3211 Financial Management

 Financial Markets & Intermediaries

Financial markets and financial intermediaries

play an important role in facilitating the flow of
capital from investors to firms and back to
investors
Financial institutions acquire specialized expertise
and assets
 These firms often earn very high profits through the use of
these unique characteristics

ACT3211 Financial Management

Financial markets and financial intermediaries
play an important role in facilitating the flow of
capital from investors to firms and back to
investors
Financial institutions acquire specialized expertise
and assets
 These firms often earn very high profits through the use of
these unique characteristics

ACT3211 Financial Management

 Financial Management in Public, Private n
Commercial Organization
Area of Contrast Public Private Not for Profit Commercial

Ownership Usually government Private organization. Private corporation.

Legal Authority Through enabling legislation Through enabling legislation Through incorporation (state
and designation of tax status. and federal government
recognition, regulation, and
protection
Mandate Serve social welfare and Serve specific social welfare Realize maximum return on
commonwealth needs of all citizens. needs or leisure interests of a investment through service to
specific population most profitable market.

Source of funds Taxes, grants, donations , earned Grants, memberships, Investors, creditors, earned
income donations, fundraising income.
activities, earned income
Market Management Market limited to Market defined by particular Market composed of those who
geographic/political constituency. need. can pay. Define by merit
Market segmented on basis of need.
Might not compete

Success indicators Social change. Social changes. Financial Profitability. Growth. Return
viability on investment

Opportunities Tax exemption. Volunteers. Bulk Tax exemption. Volunteers. Entrepreneurship. Support for
purchasing and discounts. Public concern. eliminating financially
unsuccessful products
Challenges Public accountability and scrutiny. Relative uncertainty. Reliance Developing and maintaining
Changing political directions on gratuitous income and skills.
volunteers. Limited qualified
ACT3211 Financial Management staff. Inconsistent leadership
1-30