Definition to finance
Roles of financial manager
Basic forms of business organization
Goals of the firm
Financial markets and institution
Activities that earn and use of capital – collecting,
using and managing
Concern with the maintenance & creation of
economic value or wealth
Focuses on the decision making toward creating
Cash flow is what matters
Money has a time value
Risk requires a reward
Market prices are generally right
Conflicts of interest cause agency problems
Accounting profits are not equal to cash flows. It is
possible for a firm to generate accounting profits
but not have cash or to generate cash flows but not
report accounting profits in the books.
Cash flow, and not profits, drive the value of a
We must determine incremental cash flows when
making financial decisions.
Incremental cash flow is the difference between
the projected cash flows if the project is selected,
versus what they will be, if the project is not
A dollar received today is worth more than a dollar
received in the future.
Since we can earn interest on money received
today, it is better to receive money earlier rather
We won’t take on additional risk unless we expect to be
compensated with additional reward or return.
Investors expect to be compensated for “delaying
consumption” and “taking on risk”.
Thus investors expect a return when they put their savings in a
bank (i.e. delay consumption) and they expect to earn a higher
rate of return on stocks relative to bank savings account (i.e.
taking on risk)
In an efficient market, the prices of all traded assets
(such as stocks and bonds) at any instant in time
fully reflect all available information.
Thus stock prices are a useful indicator of the value
of the firm. Prices changes reflect changes in
expected future cash flows. Good decisions will tend
to increase the stock prices and vice versa.
Note there are inefficiencies in the market that may
distort the prices.
The separation of management and the ownership
of the firm creates an agency problem. Managers
may make decisions that are not consistent with the
goal of maximizing shareholder wealth.
Agency conflict is reduced through monitoring
(ex. Annual reports), compensation schemes
(ex. stock options), and market mechanisms
Actively manages the financial affairs of any type of business, whether
private or public, large or small, profit-seeking or not-for-profit.
Important roles in making decision in a company such as:
› Where to invest? (Capital budgeting)
› How to raise money to fund the investment? (Capital structure)
› How to manage cash flows from daily operations? (Working capital)
The responsibilities of a financial managers including:
› Planning and forecasting
› Investment and financing decisions
› Controlling and coordinating
› Transaction in the financial markets
› Risk management
Business owned by an individual
Owner maintains title to assets and profits
Termination occurs on owner’s death or by owner’s
Two or more persons come together as co-owners
General Partnership: All partners are fully
responsible for liabilities incurred by the
Limited Partnerships: One or more partners can
have limited liability, restricted to the amount of
capital invested in the partnership. There must be at
least one general partner with unlimited liability.
Limited partners cannot participate in the
management of the business and their names
cannot appear in the name of the firm.
Legally functions separate and apart from its owners
Corporation can sue, be sued, purchase, sell, and own property
Owners (shareholders) dictate direction and policies of the
corporation, oftentimes through elected board of directors.
Shareholder’s liability is restricted to amount of investment
Life of corporation does not depend on the owners …
corporation continues to exist through easy transfer of
Benefits: Limited liability, Easy to transfer
ownership, Easier to raise capital, Unlimited life
(unless the firm goes through corporate
restructuring such as mergers and bankruptcies)
Drawbacks: No secrecy of information, maybe
delays in decision making, Greater regulation,
Many people think the goal is to maximize profits.
However, profit maximization goal is unclear about
the time frame over which profits are to be
measured. Would this mean short-term profit, or
It is easy to manipulate the profits through various
Profit maximization goal ignores risk and timing of
The goal of the firm is to create value for the firm’s owners
(shareholders) Maximize shareholder wealth.
Shareholder wealth is measured by share prices. Thus,
This is equivalent to saying the goal is to maximize the price
of common stock!
Financial markets play a critical role in capitalist economy.
Financial markets help facilitate the transfer of funds from “saving
surplus” units to “saving deficit” units i.e. transfer money from
those who have the money to those who need it.
Three ways to transfer capital in the economy:
The 2 key financial markets are the MONEY MARKET and the
› Market for short-term debt instruments (maturity < 1 year).
Examples: Treasury bills (issued by federal government),
commercial paper, negotiable CDs, bankers’ acceptances.
› Market for long-term financial securities (maturity > 1 year).
Examples: Corporate Bonds, Common stocks, Treasury
Bonds, term loans and financial leases.
Primary Market (initial issue)
• Market in which new issues of a securities are sold to initial buyers. This
is the only time the issuing firm ever gets any money for the securities.
• Example: Google raised $1.76 billion through sale of shares to public in
• Seasoned Equity Offering: Sale of additional shares by a company
whose shares are already traded in the secondary market.
• Example: Google raised $4.18 billion in September 2005.
Secondary Market (subsequent trading)
• Market in which previously issued securities are traded. The issuing
corporation does not get any money for stocks traded on the secondary
• Example: Trading among investors today of Google stocks.
Public Offering – Both individuals and institutional
investors have the opportunity to purchase securities.
The securities are initially sold by the managing
investment bank firm. The issuing firm never actually
meets the ultimate purchaser of securities.
Initial Public Offering – It is a type of public offering.
The first time a company issues its stock.
Private Placement – The securities are offered and sold
to a limited number of investors.