Introduction to Financial Management - Chapter 1

mutual funds

a means of pooling money that is then invested by a portfolio manager

four basic areas of finance

1. Corporate finance (or business finance) 2. Investments 3. Financial Institutions 4. International Finance

forms of business organization

1. Sole proprietorship 2. partnership: general and limited 3. Corporation: S-Corp and limited liability company

What does OTC stand for? What is the large OTC market for stocks called?

Dealer markets in stocks and long-term debt are called over-the-counter (OTC) markets. Most trading in debt securities takes place over the counter. The expression over the counter refers to days of old when securities were literally bought and sold at counters in offices around the country. Today, a significant fraction of the market for stocks and almost all of the market for long-term debt have no central location; the many dealers are connected electronically.

working capital managment

How do we manage the day-to-day finances of the firm?

capital structure

How should we pay for our assets? Should we use debt or equity?

primary market

Refers to the original sale of securities by governments and corporations.

What is the largest auction market in the United States?

The equity shares of most of the large firms in the United States trade in organized auction markets. The largest such market is the New York Stock Exchange (NYSE), which accounts for more than 85 percent of all the shares traded in auction markets. Other auction exchanges include the American Stock Exchange (AMEX) and regional exchanges such as the Chicago Stock Exchange.

capital budgeting

What long-term investments or projects should the business take on?

Financial Management Decisions

1. What long-term investments should the firm take on? Capital Budgeting 2. Where will we get the long-term financing to pay for the investments? Capital Structure 3. How will we manage the everyday financial activities of the firm? Working Capital Management

What is the goal of financial management?

1. maximize the current value per share of the company's existing stock 2. maximize the market value of the existing owners' equity * maximize the value of the company and stock - why? because it rewards the owners

Investments

Broadly speaking, the investments area deals with financial assets such as stocks and bonds

What incentives do managers in large corporations have to maximize share value?

Management will frequently have a significant economic incentive to increase share value for two reasons. First, managerial compensation, particularly at the top, is usually tied to financial performance in general and oftentimes to share value in particular. For example, managers are frequently given the option to buy stock at a fixed price. The more the stock is worth, the more valuable is this option. The second incentive managers have relates to job prospects. Better performers within the firm will tend to get promoted. More generally, those managers who are successful in pursuing stockholder goals will be in greater demand in the labor market and thus command higher salaries.

stakeholder

Someone other than a stockholder or creditor who potentially has a claim on the cash flows of the firm.

what is the role of the financial manager?

The financial management function is usually associated with a top officer of the firm, often called the chief financial officer (CFO) or vice president of finance. * Treasurer: oversees cash managment, credit managment, capital expenditures, and financial planning. * Controller: oversees taxes, cost accounting, financial accounting, and data processing. The financial manager in a corporation makes decisions for the stockholders of the firm.

What is corporate or business finance?

The process of making a company more valuable in the long-run

agency relationship

The relationship between stockholders and management. Such a relationship exists whenever someone (the principal) hires another (the agent) to represent his or her interest.

financial institutions

are basically businesses that deal primarily in financial matters such as: * banks, commercial and investment, credit unions, savings and loans * Insurance companies * Brokerage firms

secondary makets

are those in which securities are bought and sold after the original sale

What is the difference between a general and a limited partnership?

In a general partnership, all the partners share in gains or losses, and all have unlimited liability for all partnership debts, not just some particular share. The way partnership gains (and losses) are divided is described in the partnership agreement. This agreement can be an informal oral agreement, such as "let's start a lawn mowing business," or a lengthy, formal written document. In a limited partnership, one or more general partners will run the business and have unlimited liability, but there will be one or more limited partners who do not actively participate in the business. A limited partner's liability for business debts is limited to the amount that partner contributes to the partnership. This form of organization is common in real estate ventures, for example.

Besides wanting to pass this class, why do you need to understand finance?

Perhaps the most important reason to know finance is that you will have to make financial decisions that will be very important to you personally. Today, for example, when you go to work for almost any type of company, you will be asked to decide how you want to invest your retirement funds. We'll see in a later chapter that what you choose to do can make an enormous difference in your future financial well-being. On a different note, is it your dream to start your own business? Good luck if you don't understand basic finance before you start; you'll end up learning it the hard way. Want to know how big your student loan payments are going to be before you take out that next loan? Maybe not, but we'll show you how to calculate them anyway.

What are agency problems and how do they arise? What are agency costs?

The possibility of conflict of interest between the owners and management of a firm. For example, you might hire someone (an agent) to sell a car that you own while you are away at school. In all such relationships, there is a possibility of conflict of interest between the principal and the agent. To see how management and stockholder interests might differ, imagine that a corporation is considering a new investment. The new investment is expected to favorably impact the stock price, but it is also a relatively risky venture. The owners of the firm will wish to take the investment (because the share value will rise), but management may not because there is the possibility that things will turn out badly and management jobs will be lost. If management does not take the investment, then the stockholders may lose a valuable opportunity. This is one example of an agency cost.

Why is the corporate form superior when it comes to raising cash?

The relative ease of transferring ownership, the limited liability for business debts, and the unlimited life of the business are the reasons why the corporate form is superior when it comes to raising cash. If a corporation needs new equity, it can sell new shares of stock and attract new investors. The number of owners can be huge; larger corporations have many thousands or even millions of stockholders.

What is a dealer market? How do dealer and auction markets differ?

There are two kinds of secondary markets: auction markets and dealer markets. Dealers buy and sell for themselves, at their own risk. A car dealer, for example, buys and sells automobiles. In contrast, brokers and agents match buyers and sellers, but they do not actually own the commodity that is bought or sold. A real estate agent, for example, does not normally buy and sell houses. Dealer markets in stocks and long-term debt are called over-the-counter (OTC) markets. Most trading in debt securities takes place over the counter. The expression over the counter refers to days of old when securities were literally bought and sold at counters in offices around the country. Today, a significant fraction of the market for stocks and almost all of the market for long-term debt have no central location; the many dealers are connected electronically. Auction markets differ from dealer markets in two ways. First, an auction market, or exchange, has a physical location (like Wall Street). Second, in a dealer market, most of the buying and selling is done by the dealer. The primary purpose of an auction market, on the other hand, is to match those who wish to sell with those who wish to buy. Dealers play a limited role.

What are some shortcomings of the goal of profit maximization?

There is ambiguity in the criterion, and there is conflict in the short-run versus long-run type of decisions. Profit maximization would probably be the most commonly cited business goal, but this is not a very precise objective. Do we mean profits this year? If so, then actions such as deferring maintenance, letting inventories run down, and other short-run, cost-cutting measures will tend to increase profits now, but these activities aren't necessarily desirable. The goal of maximizing profits may refer to some sort of "long-run" or "average" profits, but it's unclear exactly what this means. First, do we mean something like accounting net income or earnings per share? As we will see, these numbers may have little to do with what is good or bad for the firm. Second, what do we mean by the long run? As a famous economist once remarked: "In the long run, we're all dead!" More to the point, this goal doesn't tell us the appropriate trade-off between current and future profits.

Into what category of financial management does cash management fall?

Working Capital Management - The term working capital refers to a firm's short-term assets, such as inventory, and its short-term liabilities, such as money owed to suppliers. Managing the firm's working capital is a day-to-day activity that ensures the firm has sufficient resources to continue its operations and avoid costly interruptions. This involves a number of activities related to the firm's receipt and disbursement of cash. Some questions about working capital that must be answered are the following: (1) How much cash and inventory should we keep on hand? (2) Should we sell on credit to our customers? (3) How will we obtain any needed short-term financing? If we borrow in the short term, how and where should we do it?