Chapter 1
An Overview of Financial Management
and the Financial Environment
Contents in Chapter
 The Corporate life cycle: Forms of business
organization
 The objective of the firm: Maximizing stockholder
wealth
 Determinants of fundamental value: Intrinsic value
 Financial securities, markets and institution
Attributes of successful companies
 Skilled people
 Strong relationship
 Enough funding
The Corporate Life Cycle
 Sole proprietorship
 Partnership
 Corporation
Starting Up as a Proprietorship
 Advantages Easy and inexpensive to start
 Relatively few government regulations
 No corporate income tax on profits
 Disadvantages  Limited to obtain the funding
 Unlimited personal liability
 Limited life
More Than One Owner: A Partnership
 A partnership has roughly the same pros and cons as a
sole proprietorship
Many Owners: A Corporation
 A legal entity created under state laws
 It is separate and distinct from its owners and managers
 Advantages Unlimited life
 Easy transfer of ownership
 Limited liability
 Disadvantages Double taxation
 Cost of set-up and time-consuming for report filling
--Could you give any discussion
relating to the double taxation?--
Growing a Corporation: Going Public
 Raises cash by selling their stock to the general public
 listed stock on stock exchange by registering
 Going public is called an initial public offering (IPO)
 Investment bank has a brokerage firm which employs
brokers on behalf of clients
 Subsequent issues of debt and equity
Primary Objective of the Firm
 The primary objective is shareholder wealth
maximization, which translates to maximizing the
fundamental stock price.
Stock Vs. Share
Managing a Corporation’s Value
What determines a corporation’s value?
“It is a company’s ability to generate cash flows
now and in the future.”
Free Cash Flow
• Free cash flows are the cash flow that are available
(or free) for distribution to all investors (stockholders
and creditors)
• FCF = Sales revenues - Operating costs - Operating
taxes - Required investments in new operating capital
Weighted Average Cost of Capital (WACC)
 WACC is the average rate of return required by all of
the company’s investors
 It is also called as discount rate
 It is a cost from company’s point of view
Weighted Average Cost of Capital (WACC) Cont.
WACC is affected by:
 Capital structure (the firm’s relative use of debt and
equity as sources of financing)
 Interest rates
 Risk of the firm
 Investors’ overall attitude toward risk
Determining a firm’s fundamental, or intrinsic, value
 Intrinsic value is the sum of all the future
expected free cash flows when converted into
today’s cash
Figure: Determinants of Intrinsic Value
An Overview of Financial Markets
Providers and users of cash into four groups:
 Individual,

Financial organizations (like banks and insurance companies),
 Non financial organizations (like Apple, Starbucks, and Ford), and
 Governments
Providers (Savers) and Users (borrowers)
The Capital Allocation Process
Getting Cash from Providers to Users: The Capital
Allocation Process
 Transfers of capital from providers to users take place
in three different ways
 Direct transfer
 Through an investment banking house
 Through a financial intermediary
Type of Claim on Future Cash Flows: Debt and
Equity
Debt
 Debt instruments typically have specified payments and a specified
maturity
 If debt matures in more than a year, it is called a capital market
security
 If the debt matures in less than a year, it is a money market security
Equity
 Equity instruments are a claim upon a residual value
 Stock has no maturity date, it is a capital market security.
Fundamental Factors That Affect the Required Rate
of Return (the Cost of Money)
 production opportunities,
 time preferences for consumption,
 risk, and
 Expected inflation
Economic Conditions and Policies That Affect the
Required Rate of Return (the Cost of Money)
• Federal Reserve Policy
• Budget deficits/ surplus
• Level of Business Activity (recession or boom)
• Foreign Trade Balance : deficits/surplus (level of imports to
export)
The Functions of Financial Institutions
Investment Banks and Brokerage Activities
 It helps companies raise capital
(1) advise corporations regarding the design and pricing
of new securities,
(2) buy these securities from the issuing corporation,
and
(3) resell them to investors.
Deposit-Taking Financial Intermediarie
• Savings and Loan Associations (S&Ls)
• Credit Unions
• Commercial banks
Investment Funds
• Mutual Funds (managing portfolios, and buying/ selling
securities)
• Hedge Funds
• Private equity fund
whereas hedge funds usually own many types of securities.
In contrast to a mutual fund, which might own a small
percentage of a publicly traded company’s stock, a private
equity fund typically purchases the entire company.
Life Insurance Companies and Pension Funds
• Life insurance companies take premiums, invest these
funds in stocks, bonds, real estate, and mortgages,
and then make payments to beneficiaries
• Life insurance companies also offer a variety of taxdeferred savings plans designed to provide retirement
benefits. Traditional pension funds are retirement
• Traditional pension funds are retirement plans funded
by corporations or government agencies
Financial Markets
• Physical Assets versus Financial Assets
• Time of Delivery: Spot (within a few days versus
Future (6 months or year)
• Maturity of Financial Asset: Short (money) versus
Long (capital)
• Primary Markets versus Secondary Markets
– new capital in primary market
– Existing securities in secondary market
Trading Procedures in the Secondary Markets
• Physical Location versus Electronic Network
• Matching Orders: Open Outcry Auctions, Dealer
Markets, and Automated Trading Platforms
– automated matching engine : part of a computer
system
– automated trading platform (entire system)
End!