Chapter 1

An Overview of
Financial Management

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 An Overview of Financial Management

• Forms of Business Organization

• Creating Value for Investors

• Stockholder-Manager Conflicts

• Stockholder-Debtholder Conflicts

• Balancing Interests of Shareholders and Society

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Finance Within the Organization

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 Forms of Business Organization

Proprietorship Partnership Corporation

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 Proprietorships and Partnerships

• Advantages
• Ease of formation
• Subject to few regulations
• No corporate income taxes
• Disadvantages
• Difficult to raise capital
• Unlimited liability
• Limited life
• Often set up through LLCs/LLPs.
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 Corporation

Advantages Disadvantages

Unlimited life Double taxation

Easy transfer of ownership Cost of setup and report filing

Limited liability

Ease of raising capital

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 Stock Prices and Intrinsic Value

• In equilibrium, a stock’s price should equal its “true” or intrinsic value.

• Intrinsic value is a long-run concept.

• To the extent that investor perceptions are incorrect, a stock’s price in the short
run may deviate from its intrinsic value.

• Ideally, managers should avoid actions that reduce intrinsic value, even if those
decisions increase the stock price in the short run.

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Determinants of Intrinsic Values and Stock
Prices

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 Stockholder-Manager Conflicts

• Managers are naturally inclined to act in their own best interests (which are not
always the same as the interest of stockholders).

• But the following factors affect managerial behavior:

• Managerial compensation packages

• Direct intervention by shareholders

• The threat of firing

• The threat of takeover

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 Stockholder-Debtholder Conflicts

• Stockholders are more likely to prefer riskier projects, because they receive
more of the upside if the project succeeds. By contrast, bondholders receive
fixed payments and are more interested in limiting risk.

• Bondholders are particularly concerned about the use of additional debt.

• Bondholders attempt to protect themselves by including covenants in bond

agreements that limit the use of additional debt and constrain managers’
actions.

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 Balancing Shareholder Interests and Society
Interests
• The primary financial goal of management is shareholder wealth maximization,
which translates to maximizing stock price.
• Value of any asset is present value of cash flow stream to owners.

• Most significant decisions are evaluated in terms of their financial consequences.

• Stock prices change over time as conditions change and as investors obtain new
information about a company’s prospects.

• Managers recognize that being socially responsible is not inconsistent with

maximizing shareholder value.

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