Chapter 1 -- An Overview of Financial Management
What is finance: cash flows between capital markets and firm’s operations
The goal of a firm
Forms of business organization
Intrinsic value and market price of a stock
Important business trends
Business ethics
Agency problem
Career opportunities in finance
What is finance: cash flows between capital markets and firm’s operations
(2) (1)
Firm’s Capital
Operation Financial (4a) Markets
(Real Assets) Managers (Financial
(3) (4b) Assets)
(1) Cash raised by selling financial assets in financial markets
(2) Cash invested in firm’s operations and used to purchase real assets
(3) Cash generated from firm’s operations
(4a) Cash reinvested in firms’ operations
(4b) Cash returned to investors
Financing decisions vs. investment decisions: raising money vs. allocating money
Activity (1) is a financing decision
Activity (2) is an investment decision
Activities (4a) and (4b) are financing decisions
The role of a financial manager
Forecasting and planning of firms’ financial needs
Making financing and investment decisions
Coordinating with other departments/divisions
Dealing with financial markets
Managing risks
1
, Finance within an organization: importance of finance
Finance includes three areas
(1) Financial management: corporate finance, which deals with decisions related
to how much and what types of assets a firm needs to acquire, how a firm should
raise capital to purchase assets, and how a firm should do to maximize its
shareholders wealth - the focus of this class
(2) Capital markets: study of financial markets and institutions, which deals with
interest rates, stocks, bonds, government securities, and other marketable
securities. It also covers Federal Reserve System and its policies.
(3) Investments: study of security analysis, portfolio theory, market analysis, and
behavioral finance
The goal of a firm
To maximize shareholder’s wealth (or firm’s long-run value)
Why not profit or EPS maximization?
Profit maximization usually ignores timing and risk of cash flows
EPS sometimes can be manipulated or misleading
2
, Forms of business organization
Proprietorship: an unincorporated business owned by one individual
Advantages:
Easy and inexpensive to form
Subject to less government regulations
Lower income taxes
Disadvantages:
Unlimited personal liability
Limited lifetime of business
Difficult to raise capital
Partnership: an unincorporated business owned by two or more people
Advantages vs. disadvantages: similar to those of proprietorship, in general
Corporation: legal entity created by a state
Advantages:
Limited liability
Easy to transfer the ownership
Unlimited lifetime of business
Easy to raise capital
Disadvantages:
Double taxation (at both corporate and individual levels)
Cost of reporting
S Corporation: allows small business to be taxed as proprietorship or partnership
Restrictions: no more than 100 shareholders; for small and privately owned firms
Limited Liability Company (LLC) and Limited Liability Partnership (LLP):
Hybrid between a partnership and a corporation - limited liability but taxed as
partnership
LLPs are used in professional fields of accounting, law, and architecture while
LLCs are used by other businesses
Intrinsic value and market price of a stock
Intrinsic value is an estimate of a stock’s “fair” value (how much a stock should
be worth)
Market price is the actual price of a stock, which is determined by the demand and
supply of the stock in the market
3
, Determinants of intrinsic value and stock price
Intrinsic value is supposed to be estimated using the “true” or accurate risk and
return data. However, since sometimes the “true” or accurate data is not directly
observable, the intrinsic value cannot be measured precisely.
Market value is based on perceived risk and return data. Since the perceived risk
and return may not be equal to the “true” risk and return, the market value can be
mispriced as well.
Stock in equilibrium: when a stock’s market price is equal to its intrinsic value the
stock is in equilibrium
Stock market in equilibrium: when all the stocks in the market are in equilibrium
(i.e. for each stock in the market, the market price is equal to its intrinsic value)
then the market is in equilibrium
4
What is finance: cash flows between capital markets and firm’s operations
The goal of a firm
Forms of business organization
Intrinsic value and market price of a stock
Important business trends
Business ethics
Agency problem
Career opportunities in finance
What is finance: cash flows between capital markets and firm’s operations
(2) (1)
Firm’s Capital
Operation Financial (4a) Markets
(Real Assets) Managers (Financial
(3) (4b) Assets)
(1) Cash raised by selling financial assets in financial markets
(2) Cash invested in firm’s operations and used to purchase real assets
(3) Cash generated from firm’s operations
(4a) Cash reinvested in firms’ operations
(4b) Cash returned to investors
Financing decisions vs. investment decisions: raising money vs. allocating money
Activity (1) is a financing decision
Activity (2) is an investment decision
Activities (4a) and (4b) are financing decisions
The role of a financial manager
Forecasting and planning of firms’ financial needs
Making financing and investment decisions
Coordinating with other departments/divisions
Dealing with financial markets
Managing risks
1
, Finance within an organization: importance of finance
Finance includes three areas
(1) Financial management: corporate finance, which deals with decisions related
to how much and what types of assets a firm needs to acquire, how a firm should
raise capital to purchase assets, and how a firm should do to maximize its
shareholders wealth - the focus of this class
(2) Capital markets: study of financial markets and institutions, which deals with
interest rates, stocks, bonds, government securities, and other marketable
securities. It also covers Federal Reserve System and its policies.
(3) Investments: study of security analysis, portfolio theory, market analysis, and
behavioral finance
The goal of a firm
To maximize shareholder’s wealth (or firm’s long-run value)
Why not profit or EPS maximization?
Profit maximization usually ignores timing and risk of cash flows
EPS sometimes can be manipulated or misleading
2
, Forms of business organization
Proprietorship: an unincorporated business owned by one individual
Advantages:
Easy and inexpensive to form
Subject to less government regulations
Lower income taxes
Disadvantages:
Unlimited personal liability
Limited lifetime of business
Difficult to raise capital
Partnership: an unincorporated business owned by two or more people
Advantages vs. disadvantages: similar to those of proprietorship, in general
Corporation: legal entity created by a state
Advantages:
Limited liability
Easy to transfer the ownership
Unlimited lifetime of business
Easy to raise capital
Disadvantages:
Double taxation (at both corporate and individual levels)
Cost of reporting
S Corporation: allows small business to be taxed as proprietorship or partnership
Restrictions: no more than 100 shareholders; for small and privately owned firms
Limited Liability Company (LLC) and Limited Liability Partnership (LLP):
Hybrid between a partnership and a corporation - limited liability but taxed as
partnership
LLPs are used in professional fields of accounting, law, and architecture while
LLCs are used by other businesses
Intrinsic value and market price of a stock
Intrinsic value is an estimate of a stock’s “fair” value (how much a stock should
be worth)
Market price is the actual price of a stock, which is determined by the demand and
supply of the stock in the market
3
, Determinants of intrinsic value and stock price
Intrinsic value is supposed to be estimated using the “true” or accurate risk and
return data. However, since sometimes the “true” or accurate data is not directly
observable, the intrinsic value cannot be measured precisely.
Market value is based on perceived risk and return data. Since the perceived risk
and return may not be equal to the “true” risk and return, the market value can be
mispriced as well.
Stock in equilibrium: when a stock’s market price is equal to its intrinsic value the
stock is in equilibrium
Stock market in equilibrium: when all the stocks in the market are in equilibrium
(i.e. for each stock in the market, the market price is equal to its intrinsic value)
then the market is in equilibrium
4
