Chapter 1
Introduction to Financial
Management
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This chapter introduces the following topics:
1.1 Why study finance?
1.2 Major Concerns in Financial Management
1.3 A Corporation and The Goal of Its Financial
Management
1.4 Cash Flows do matter
1.5 The Agency Problems and Their Solution
1.6 How Blockchain Is Changing Finance
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1.1 Why Study Finance?
• Individuals are taking charge of their personal finances
with decisions such as:
1. When to start saving and how much to save for
retirement?
2. Whether a car loan or lease is more advantageous?
3. Whether a particular stock is a good investment?
4. How to evaluate the terms of a home mortgage ?
• In your business career, you may face such questions such
as:
1.
2.
3.
4.
5.
Should your firm launch a new product?
Which supplier should your firm choose?
Should your firm produce a part or outsource production?
Should your firm issue new stock or borrow money instead?
How can you raise money for your start-up firm?
1.2 Major Concerns in Financial
Management
1.The Investment Decision => Real Assets
2.The Financing Decision => Financial Assets
3.The Risk Management Decision both
• to raise the rate of return on real assets and
• to abate the cost of capital on financial assets issued by the
corporation.
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Investment, Financing, and the Risk Management
Decisions
Are the following capital budgeting or financing decisions?
1. Huawei decides to spend ¥1.2 billion to develop a
new cell phone Mate 7.
2. Rosneft borrows RUB800 million from bond
investors.
3. Foxconn Technology Group issues 100 million
shares to buy a small technology company.
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The Balance Sheet displays the main Financial
decisions made by the corporation
Total Value of Assets:
Total Firm Value to
Investors:
Current Debts
Current Assets
Long-Term Debt
Fixed Assets
1 Tangible
2 Intangible
Shareholders’ Equity
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• The Balance Sheet exhibits the major concerns in financial
management:
1. What long-term investments should the corporation choose?
－－Capital Budgeting ( Investment Decision)
2. How should the corporation raise funds for the selected
investments? －－Capital Structure ( Financing Decision)
3. How should current assets and debts be managed? －－
Working Capital ( Short-Term Investment and Financing
Decision)
Note that, all the concerns involve the risk management which is
not revealed in balance sheet.
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Capital Budgeting—The Investment Decision
Current Debt
Current Assets
Fixed Assets
1 Tangible
2 Intangible
Long-Term
Debt
What longterm
investments
should the
corporation
choose?
Equity
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Capital Structure– The Financing Decision
Current Debt
Current Assets
Fixed Assets
1 Tangible
2 Intangible
How should
the corporation
raise funds for
the selected
investments?
Long-Term
Debt
Equity
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Short- Term Investment and Financing Decisions
Current Assets
Fixed Assets
1 Tangible
2 Intangible
Net
Working
Capital
How should
current assets &
debt be
managed?
Current Debt
Long-Term
Debt
Equity
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1.3 A Corporation and The Goal of Its
Financial Management
• A corporation is a legal entity that has been incorporated
through a registration process established through
legislation. Incorporated entities have legal rights and
liabilities that are distinct from their employees and
shareholders.
• Most jurisdictions allow the creation of new corporations
through registration. In addition to legal personality,
registered corporations tend to have limited liabilities, be
owned by shareholders who can transfer their shares to
others, and controlled by a board of directors who are
elected by the shareholders.
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Benefits of the Corporation
• Limited liability
• Infinite lifespan
• Ease of raising capital
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Drawbacks of the Corporation
• Corporations face the problem of double taxation
• Improper corporate structures may lead to “Agency
Problems”
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Goals of The Corporation
• Shareholders want wealth maximization
• Wealth maximization vs. profit maximization:
• Pitfall: Profits from which period?
• Pitfall: Cutting dividends to increase cash reserves
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1.4 Cash Flow do matter
• If a corporation is to prosper, it must:
• Invest in assets that generate more cash than they cost
－－capital budgeting (Investment decision)
• Issue financial securities that raise more cash than
they cost－－Capital structure (Financing decision)
• A successful corporation generates more cash than it uses.
• Cash Flow ≠ Accounting. Do not confuse cash flow and
accounting income
• Non-Cash expense example: Depreciation
• Non-Cash revenue example: Sales on Account
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The Conceptual Flow of Cash: Cash flows between
the Firm and Financial Market
Ultimately, the firm
must be a cash
generator.
The cash flows from the
firm must exceed the
cash flows from the
financial markets.
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The Ethics of Maximizing Value
• Does value maximization justify unethical behavior?
• Examples:
1. Enron
2. WorldCom
3. Bernard Madoff
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Example 1:Enron Corporation (former New York Stock
Exchange ticker symbol ENE)
• An American energy, commodities, and services company based in
Houston, Texas.
• Before its bankruptcy on December 2, 2001, Enron was one of the world's
major electricity, natural gas , communications, and pulp and
paper companies, with claimed revenues of nearly $111 billion during
2000.
• Fortune named Enron "America's Most Innovative Company" for six
consecutive years.
• At the end of 2001, its reported financial condition was sustained
substantially by an accounting fraud, known as the Enron scandal.
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• Enron has since become a well-known example of willful corporate
fraud and corruption.
• The scandal brought into question the accounting practices of many
corporations in the United States and led to the creation of
the Sarbanes –Oxley Act of 2002. The act took its name from its
two sponsors—Sen. Paul S. Sarbanes and Rep. Michael G. Oxley.
• The scandal caused the dissolution of the Arthur
Andersen accounting firm.
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Sarbanes –Oxley Act
• The Sarbanes-Oxley Act of 2002 (SOX)is a law the U.S.
Congress passed on July 30, 2022 to protect investors from
fraudulent financial reporting by corporations.
• SOX mandated strict reforms to existing securities regulations
and imposed tough new penalties on lawbreakers.
• SOX came in response to financial scandals in the early 2000s
involving publicly traded companies such as Enron
Corporation, Tyco International plc, and WorldCom. The highprofile frauds shook investor confidence in the trustworthiness
of corporate financial statements and led many to demand an
overhaul of decades-old regulatory standards.
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Example 2: WorldCom Scandal (2002)
Company: Telecommunications company; now MCI, Inc.
•What happened: Inflated assets by $11 billion, resulting in 30,000 lost jobs and
$180 billion in losses for investors.
•Main player: CEO Bernie Ebbers
•How he did it: Underreported line costs by capitalizing rather than expensing and
inflated revenues with fake accounting entries.
•How he got caught: WorldCom's internal auditing department uncovered $3.8
billion of fraud.
•Penalties: CFO was fired, controller resigned, and the company filed for
bankruptcy. Ebbers sentenced to 25 years for fraud, conspiracy and filing false
documents with regulators.
•Fun fact: Within weeks of the scandal, Congress passed the Sarbanes-Oxley Act,
introducing the most sweeping set of new business regulations since the 1930s.
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Example 3: Bernie Madoff Scandal (2008)
• Bernard L. Madoff Investment Securities LLC was a Wall Street
investment firm founded by Madoff.
• What happened: Tricked investors out of $64.8 billion through the largest
Ponzi scheme in history.
• Main players: Bernie Madoff, his accountant, David Friehling, and Frank
DiPascalli.
• How they did it: Investors were paid returns out of their own money or
that of other investors rather than from profits.
• How they got caught: Madoff told his sons about his scheme and they
reported him to the SEC. He was arrested the next day.
• Penalties: 150 years in prison for Madoff + $170 billion restitution.
Prison time for Friehling and DiPascalli.
• Fun fact: Madoff's fraud was revealed just months after the 2008 U.S.
financial collapse.
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1.5 The Agency Problems and Their Solutions
• Agency relationship
• Principal hires an agent to represent his/her interest
• Stockholders (principals) hire managers (agents) to run the
company
• Agency problem
• Conflict of interest between principal and agent
• The managers may act in their own interests rather than
maximizing value
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Agency Cost
• An agency cost is the cost to a “principal" (an
organization, a person or a group of persons), when the
principal hires an “agent" to act on its behalf.
• Because the two parties have different interests and the
agent has more information, the principal cannot ensure
that its agent always acts in the principals' best interests.
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The costs consist of two main sources
I. The costs inherently associated with using an agent (e.g., the risk that
agents will use organizational resource for their own benefit) and
II. The costs of techniques used to mitigate the problems associated with
using an agent—
1.gathering more information on what the agent is doing (e.g., the costs
of producing financial statement), and has done, or
2.employing mechanisms to align the interests of the agent with those of
the principal (e.g. compensating executives with equity payment such
as stock option).
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Examples
• This cost includes that undertaken by shareholders (the
principal), when corporate management (the agent)
acquires other firms to expand its power, or spends
money on wasteful pet projects, instead of maximizing
the firm value.
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• The classic case of agency cost is the professional manager—
specifically the CEO—with only a small stake in ownership, having
interests differing from those of firm's owners.
• Instead of making the company more efficient and profitable, the
CEO may :
1.increase the size of the corporation, rather than the size of its profits,
which usually increases the executives' prestige, perquisites,
compensation, etc, but at the expense of the efficiency and the value
of the firm;
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2.not fire subordinates whose mediocrity or even
incompetence may be outweighed by their value as yesmen or golf partners;
3.retain large amounts of cash. While wasteful, it gives the
management independence from capital markets;
4.venture onto fraud. Management may even manipulate
financial figures to optimize bonuses and stock options.
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Agency Problem Solutions
1. Compensation plans
•
Incentives can be used to align management and stockholder
interests. The incentives need to be structured carefully to
make sure that the management achieve stockholders’
intended goal
2. Board of Directors
◦
In response to Enron, WorldCOm, and other corporate
scandals, the U.S. Congress promulgated the Sarbanes-Oxley
Act of 2002(SOX). SOX requires corporations place more
independent directors on the board. More than half of all
directors are now independent.
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Board meet in sessions without the CEO present. SOX requires
CFOs to sign off personally on the corporation’s accounting
procedures and results.
3. Blockholders
Blockholders are those who hold more than 5% of the corporation’s
shares.
◦Institutional investors, such as pension funds and hedge funds, are
active in monitoring firm performance and propose changes to
corporate governance.
◦Many CEOs have been forced out recently. For example, CEOs of
AIG, Fannie Mae, Freddie Mac, GM, Lenovo, Peugeot Citroen,
Royal Bank of Scotland, Starbucks, and Versace.
Agency Problem Solutions
4. Takeovers
• The threat of a takeover may result in better management
5. Specialist Monitoring
• Specialists, including security analysts and banks , will
monitor the actions of the corporations, or review the
progress of the corporation receiving banks’ loans.
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6. Legal and Regulatory Requirements
• The CEOs and financial managers are required to act in the
interests of investors.
• The securities and Exchange Commission (SEC) set
accounting and reporting standards for listed corporations to
enhance consistency and transparency.
1.6 How Blockchain Is Changing
Finance
• Our global financial system moves trillions of dollars a day and
serves billions of people. But the system is rife with problems,
adding cost through fees and delays, creating friction through
redundant and onerous paperwork, and opening up
opportunities for fraud and crime.
• To wit, 45% of financial intermediaries, such as payment
networks, stock exchanges, and money transfer services, suffer
from economic crime every year; the number is 37% for the
entire economy, and only 20% and 27% for the professional
services and technology sectors, respectively. No wonder that
regulatory costs continue to climb and remain a top concern for
bankers.
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This all adds cost, with consumers ultimately bearing the burden.
It begs the question: Why is our financial system so inefficient?
• First, because it’s antiquated, a kludge of industrial technologies
and paper-based processes dressed up in a digital wrapper.
• Second, because it’s centralized, which makes it resistant to
change and vulnerable to systems failures and attacks.
• Third, it’s exclusionary, denying billions of people access to
basic financial tools. Bankers have largely dodged the sort of
creative destruction that, while messy, is critical to economic
vitality and progress. But the solution to this innovation logjam
has emerged: blockchain
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How Blockchain Works
Here are five basic principles underlying the technology.
1. Distributed Database
• Each party on a blockchain has access to the entire database and its
complete history. No single party controls the data or the
information.
• Every party can verify the records of its transaction partners
directly, without an intermediary.
2. Peer-to-Peer Transmission
• Communication occurs directly between peers instead of through a
central node. Each node stores and forwards information to all
other nodes.
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3. Transparency with Pseudonymity
• Every transaction and its associated value are visible
to anyone with access to the system.
• Each node, or user, on a blockchain has a unique 30plus-character alphanumeric address that identifies it.
• Users can choose to remain anonymous or provide
proof of their identity to others. Transactions occur
between blockchain addresses.
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4. Irreversibility of Records
• Once a transaction is entered in the database and the accounts
are updated, the records cannot be altered, because they’re
linked to every transaction record that came before them (hence
the term “chain”).
• Various computational algorithms and approaches are deployed
to ensure that the recording on the database is permanent,
chronologically ordered, and available to all others on the
network.
5. Computational Logic
• The digital nature of the ledger means that blockchain
transactions can be tied to computational logic and in essence
programmed. So users can set up algorithms and rules that
automatically trigger transactions between nodes.
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• Blockchain was originally developed as the technology behind
cryptocurrencies like Bitcoin.
• A vast, globally distributed ledger running on millions of devices, it is
capable of recording anything of value.
• Money, equities, bonds, titles, deeds, contracts, and virtually all other
kinds of assets can be moved and stored securely, privately, and from
peer to peer, because trust is established not by powerful
intermediaries like banks and governments, but by network consensus,
cryptography, collaboration, and clever code.
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• For the first time in human history, two or more parties, be they
businesses or individuals who may not even know each other,
can forge agreements, make transactions, and build value
without relying on intermediaries (such as banks, rating agencies,
and government bodies such as the U.S. Department of State)
to verify their identities, establish trust, or perform the critical
business logic — contracting, clearing, settling, and recordkeeping tasks that are foundational to all forms of commerce.
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