Introduction to Financial
Management
Financial Management
Outline
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Meaning of Financial Management
Meaning of Corporate Finance
Significance of Financial Management
Forms of Business Organization
Goal of a Firm and Corporate Form of
Organization
What motivates Management to act in
shareholders’ best interests?
Meaning of Corporate Finance
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Corporate finance can be defined as a body
of knowledge that deals with the following
three issues:
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What long-term strategic investments a firm should
undertake?
What long-term strategic financing alternatives that a firm
should use to raise capital to finance its long-term strategic
investments?
How much short-term cash flow does a company need to
ensure smooth day-to-day operations of the firm?
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Long-term strategic investments decisions are also
known as the capital budgeting decisions of the firm.
Long-terms strategic financing decisions involve a
decision on mix of debt and equity financing for the
company and are known as capital structure
decisions.
Dividend policy decisions also fall into this category.
Management of short-term cash flows relates to
working capital management.
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Thus, we can define corporate finance as a
study of the principles, policies, and
institutions that shape corporate financial
decisions
Why Financial Management is an
Important?
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Coordinated corporate decision-making
financial implications of virtually all business
decisions and non-financial executives must know
enough finance to work these implications into their
own specialized analyses.
Lack of understanding of basic principles of finance
may have disastrous implications for a firm.
Forms of Business Organization
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Individual Ownership
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One individual owns the business
No legal distinction between the business and the
owner
All assets belong to the owner and all loans and
liabilities are the responsibility of the owner
Partnership
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Two or more partners own the business
Partners are jointly and severally responsible for
all loans and liabilities of the firm
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Corporate form of Organization
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Shareholders own the firm
Common stockholders true owners/residual
owners
Company is a separate legal entity, distinct from
its owners
Shareholder cannot be sued to recover any
loans/liabilities of the firm
Goal of Firm in a Corporate Form of
Organization
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Separation of ownership from management in a company form of
organization
Owners (shareholders) elect the management (board of
directors)
Management is in an agency relationship to shareholders
Given that management is managing the firm on behalf of the
shareholders, what should be the goal of a firm?
 Should it be maximization of sales revenue?
 Should it be minimization of costs?
 Should it be maximization of employee welfare?
 Should it be maximization of society welfare?
 Should it be customer satisfaction?
Goal of a Firm?
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The overall goal should be maximization of
owners’ welfare
It also means maximization of shareholder
wealth
Shareholder wealth is maximized through
market price per share maximization
It is also consistent with maximization of
profits at a given level of risk
How to Ensure the Management Acts
in Shareholders’ Interest?
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Managerial Incentives
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Performance-based Incentive Plans
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Executive Stock Option Plans
Performance Shares
Direct Intervention by Shareholders
The Threat of Firing
The Threat of Hostile Takeover
Performance-based incentive Plans
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Types of Incentive Plans
 Stock Options
 Performance Shares
Stock options allow management to purchase pre-designated
number of shares at some time in the future at a predetermined
price.
The stock options will have value only if the market price of the
stock rises above the exercise price of the option. This serves as
an incentive to the management to take actions that would
ensure growth of stock price through comparison with
competitors.
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Performance shares are shares of stock given to executives
on the basis of performance as defined by objective
measures such as earnings per share, return on assets,
return on equity, and so forth. Managerial performance may
also be judged in a relative sense
Other methods of motivating top management:
 Kodak requires its top executives to invest one to four
times the base salary in Kodak shares
 GM requires top executives to hold GM common stock
equivalent in market value to the manager’s annual
salary
 Xeros, Union Carbide, and Hershey Foods also
require top executives to invest in the common stock
of the firm
Direct Intervention by Shareholders
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Direct intervention more easy now with
institutional ownership of shares
Shareholders being the ultimate owners can
force management to act in their best
interests or risk losing the job
Threat of Firing
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Of course, shareholders can remove the
existing management by voting them and
with institutional investors this threat has
become a reality.
American Express, Goodyear, GM, IBM,
Apple have lost their CEOs at some point due
to shareholders’ unhappiness
Threat of Hostile Takeover
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Hostile takeover is a takeover of a firm against the
wishes of existing management.
Hostile takeovers are most likely to occur when a
firm’s stock is undervalued relative to its potential
due to poor management.
RJR Nabisco was the target of hostile takeover by
KKR group
IBM initial bid for Lotus Development Corporate was
hostile
Can management prevent hostile takeovers? Poison
Pills