Chapter 1: An Overview of Financial Management and the Financial Environment
Financial management involves planning, organizing, and controlling financial
resources to achieve a company’s objectives. It is crucial for business success and
economic stability.
Key aspects of financial management:

Investment Decisions – Determining where to allocate resources for maximum
return.

Financing Decisions – Deciding the best way to raise funds (debt vs. equity).

Dividend Policy – Choosing how much profit to return to shareholders versus
reinvesting in the business.
The financial environment includes:

Markets – Where financial assets like stocks and bonds are traded.

Institutions – Banks, investment firms, and other financial entities that
facilitate money movement.
1.1 The Five-Minute MBA
An MBA education prepares managers to run successful businesses. All successful
companies share two main characteristics:
1. They identify, create, and deliver valuable products/services that attract
customers.
2. They sell at prices that cover costs and generate profits, compensating owners
and creditors for their investments.
Key attributes of successful companies:

Skilled workforce – Talented leaders, managers, and employees.

Strong external relationships – Good relationships with suppliers and
customers.

Sufficient capital – Enough funding to grow and operate effectively.
Finance plays a crucial role in helping companies balance growth, profitability, and
sustainability.
1.2 The Corporate Life Cycle
Companies evolve through different stages:
1. Startup (Proprietorship/Partnership) – Owned by individuals or small groups.
2. Growth (Private Corporation) – Expands operations and requires more capital.
3. Maturity (Public Corporation) – Stocks are publicly traded on exchanges.
4. Decline or Renewal – The business must innovate or face decline.
Business Structures

Proprietorship – Easy to start, full control, unlimited personal liability.

Partnership – Shared ownership, but personal liability risks exist.

Corporation – Limited liability, easier fundraising, but subject to
regulations.
1.3 Say Hello to the Global Economic Crisis!
The 2008 financial crisis was caused by excessive borrowing and risky investments.
When investments failed, consequences included:

Bankruptcies – Many financial institutions collapsed.

Credit Crunch – Banks stopped lending money.

Economic Downturn – Businesses and consumers cut spending, leading to job
losses.
This crisis highlighted the importance of responsible financial management and risk
assessment.

Bankruptcies of major financial institutions

Credit freezes – Banks stopped lending money.

Recession and job losses.
Governments had to intervene with bailouts and regulations to stabilize the economy.
1.4 Columbus Was Wrong—the World Is Flat! And Hot, and Crowded!
Globalization has intensified competition and removed trade barriers. Companies now:

Companies must innovate to stay competitive.

Global supply chains allow businesses to operate across multiple countries.

Environmental and energy challenges require sustainable business strategies.
1.5 The Primary Objective of the Corporation: Value Maximization
A business’s goal is to maximize shareholder wealth by increasing stock value.
However, true value creation considers:

Long-term sustainability over short-term gains.

Ethical behavior and social responsibility alongside profitability.
Intrinsic Value vs. Market Price

Intrinsic Value – A stock’s real worth, based on future cash flows and
risks.

Market Price – The current price, which may not reflect intrinsic value due
to speculation.
Over time, market prices tend to align with intrinsic value.
1.6 Ethics for Individuals and Businesses
Ethical business practices build trust and sustainability.
Key ethical principles:

Transparency – Honest financial reporting.

Fairness – Treating investors, employees, and customers fairly.

Accountability – Holding executives responsible for financial decisions.
1.7 Corporate Scandals and Maximizing Stock Price
Unethical practices such as fraud and stock price manipulation (e.g., Enron) damage a
company’s reputation and investors’ trust.
Regulatory responses:

Sarbanes-Oxley Act – Introduced stricter financial reporting rules.

Corporate governance reforms – Increased transparency and accountability.

Proper corporate governance is essential.

Regulations like Sarbanes-Oxley Act were introduced to prevent fraud.

Companies must balance profit goals with ethical responsibilities.
1.8 An Overview of the Capital Allocation Process
Capital moves in three ways:
1. Direct Transfers – Investors fund companies directly.
2. Investment Banks – Middlemen who help companies raise capital.
3. Financial Intermediaries – Banks, mutual funds, and institutions invest money
on behalf of clients.
Businesses, governments, and individuals often require capital for growth, infrastructure, and
personal expenses. Fortunately, savers—individuals and firms with surplus income—help supply
these funds. Most individuals act as both borrowers and lenders, while nonfinancial corporations
and governments are generally net borrowers. Financial institutions, such as banks, facilitate
capital movement by raising and lending money.
Capital transfers occur in three ways:
1. Direct Transfers – Businesses or governments sell securities directly to
savers.
2. Investment Banks – Underwriters like Goldman Sachs purchase securities from
companies and resell them to investors.
3. Financial Intermediaries – Institutions like banks and mutual funds collect
funds from savers and lend them to businesses.
Additionally, corporate scandals have demonstrated the dangers of short-term stock price
manipulation. Poorly designed incentives led managers to unethical behavior, ultimately harming
long-term value. Lessons from these cases emphasize the importance of ethical management,
proper incentives, and sustainable business practices.
1.9 Financial Securities
Firms raise money through:

Stocks – Represent ownership in a company.

Bonds – Loans given to companies/governments, repaid with interest.
Investors trade these financial securities in markets to generate profits.
1.10 The Cost of Money
Interest rates depend on:
The interaction of the providers’ supply and the users’ demand determines the cost (or
price) of money, which is the rate users pay to providers. For debt, we call this price the
interest rate. For equity, we call it the cost of equity, and it consists of the dividends and
capital gains stockholders expect.


Production Opportunities – Businesses borrow to expand.

Time Preference for Consumption – People decide to save or spend.

Risk – Higher risk leads to higher interest rates.

Inflation – Reduces money’s value over time.
1.11 Financial Institutions
Types of financial institutions:

Commercial Banks – Accept deposits, provide loans.

Investment Banks – Help companies raise money.

Insurance Companies – Manage risk. Protect against financial risks.

Mutual Funds & Pension Funds – Invest for long-term returns. Pool investor
money to buy stocks and bonds.
1.12 Financial Markets
Financial markets are where stocks, bonds, and financial instruments are traded
Types of Financial Markets
1. Money Markets – Short-term, highly liquid securities.
2. Capital Markets – Long-term stocks and bonds.
3. Primary Markets – New securities (e.g., IPOs).
4. Secondary Markets – Existing securities traded among investors.
5. Foreign Exchange Markets – Currency trading.
6. Derivative Markets – Trading financial contracts like options and futures.
1.13 Investment Funds
Investment funds pool money from investors to buy securities.
Types of Investment Funds
1. Mutual Funds – Professionally managed portfolios.
2. Exchange-Traded Funds (ETFs) – Trade like stocks but track indices.
3. Hedge Funds – High-risk strategies for wealthy investors.
4. Pension Funds – Retirement savings funds.
5. Private Equity Funds – Invest in private companies and startups.
6. Venture Capital Funds – Provide early-stage funding for high-growth startups.
1.14 Trading Procedures in Financial Markets

Brokers – Facilitate transactions between buyers and sellers.

Dealers – Buy and sell securities from their inventory. Places like NYSE and
NASDAQ where trading happens.

Electronic Trading Platforms – Automated trading of stocks and derivatives.
Online systems for buying/selling stocks.
1.15 Trading Procedures in Financial Markets
Financial markets facilitate the buying and selling of securities. The secondary
market, where most trading happens, can be classified based on location and method
of matching orders.
Physical Location vs. Electronic Networks

Physical Exchanges: These markets have a centralized trading floor where
traders meet in person (e.g., New York Stock Exchange, Tokyo Stock Exchange).

Electronic Networks: These markets operate via computer and telephone
networks. Traders never meet physically, making these markets less
transparent. Examples include Nasdaq and U.S. Treasury bond markets.
Methods of Matching Buy and Sell Orders
1. Open Outcry Auctions: Traders shout and use hand signals to execute trades
(e.g., Chicago Board of Trade).
2. Dealer Markets: Market makers (dealers) hold an inventory of stocks and quote
prices at which they are willing to buy or sell. Examples include Nasdaq and
London SEAQ.
3. Electronic Communication Networks (ECNs): Participants post orders to buy and
sell. The ECN automatically matches orders. Examples include Instinet (owned
by Nasdaq) and Archipelago (owned by NYSE).
Importance: These trading methods affect market efficiency, liquidity, and
transaction transparency.
1.16 Types of Stock Market Transactions
Stock market transactions are classified into three categories:
1. Initial Public Offerings (IPOs) – A company sells shares to the public for
the first time, transitioning from private to public ownership.
2. Seasoned Equity Offerings (SEOs) – A company issues additional shares after
its IPO to raise more capital.
3. Secondary Market Transactions – Investors trade previously issued stocks. The
company does not receive money from these transactions.
Recent IPO Trends:

2007: 1,711 IPOs raised $279 billion.

2008: Only 662 IPOs raised $77 billion due to the financial crisis.

Visa’s IPO: Raised over $19 billion, making it the largest IPO at the time.
IPOs can generate quick gains but also experience long-term declines. For instance,
some stocks surged on the first trading day but lost value later.
1.17 Rational Exuberance?
This concept refers to irrational market behavior, where stock prices rise
excessively due to investor excitement, leading to overvaluation.

Example: In 1999, the Nasdaq was trading at 3,000. Investors believed it was
overvalued, but it surged to 5,000 before crashing to 1,300.

John Maynard Keynes' View: Markets can stay irrational longer than investors
can remain solvent.
Bottom Line: Stock prices generally reflect intrinsic value, but major shifts can
create temporary bubbles.
1.18 The Secondary Stock Markets
Once stocks are issued in the primary market, they are traded in the secondary
market. The two leading U.S. secondary stock markets are:
1. New York Stock Exchange (NYSE): A physical exchange with strict listing
requirements.
2. Nasdaq: A dealer-based market where stocks are traded electronically.
Importance of Secondary Markets:

Provide liquidity, allowing investors to buy and sell stocks easily.

Help companies raise additional capital by making shares more attractive to
investors.
Types of Secondary Markets:
1. Physical Stock Exchanges: Stocks are traded in a centralized location (NYSE,
AMEX).
2. Dealer Markets: Dealers hold stock inventories and execute trades (Nasdaq).
3. Bulletin Boards & Over-the-Counter (OTC) Markets: Small companies trade with
fewer regulations.
Companies aim to be listed in active secondary markets before launching an IPO.
1.19 Measuring the Market
Stock market performance is measured using indices that track overall trends.
Major Market Indices:

S&P 500: Tracks 500 large U.S. companies.

Dow Jones Industrial Average (DJIA): Measures 30 significant U.S. companies.

Nasdaq Composite: Focuses on technology and growth stocks.
These indices help investors analyze market trends and make informed decisions.
1.20 Stock Market Returns
Investors earn returns through capital gains and dividends.
1. Capital Gains: Profit from selling stocks at a higher price than the purchase
price.
2. Dividends: Payments from company profits to shareholders.
Risk vs. Return:

High-risk stocks can generate high returns but also come with higher chances
of loss.

Diversification helps reduce investment risk.
1.21 The Global Economic Crisis
The 2008 financial crisis revealed weaknesses in the global financial system.
Causes of the Crisis:
1. Excessive borrowing: Governments, businesses, and individuals took on too much
debt.
2. Risky investments: Banks invested in subprime mortgages and complex financial
instruments.
3. Market collapse: Defaults led to a credit crunch, causing banks to fail and
stock markets to crash.
Impact:

Job losses, business closures, and government bailouts.

Strengthened financial regulations like Dodd-Frank Act to prevent future
crises.
1.22 The Big Picture
Successful financial management contributes to economic growth, stability, and
wealth creation.
Key Takeaways:

Businesses must maximize intrinsic value while maintaining ethical standards.

Investors should focus on long-term market trends rather than short-term
speculation.

Government regulations play a crucial role in maintaining market integrity and
preventing financial crises.
Intrinsic Value vs. Market Price
Intrinsic value represents a stock’s true worth based on expected future cash flows
and risk.

Market Price: The current trading price of a stock.

Intrinsic Value: The estimated true value of a stock based on its financial
health and future growth potential.
Market equilibrium occurs when market price ≈ intrinsic value. However, during
market bubbles and crashes, these values can deviate.
Why It Matters:
Investors and managers should focus on intrinsic value rather than short-term price
fluctuations. Overvalued stocks will eventually correct downward, while undervalued
stocks will rise over time.
ENRON’S SCANDAL!!!
The Enron Scandal was one of the biggest corporate fraud cases in history. It
exposed widespread accounting fraud, corruption, and unethical business practices,
leading to the collapse of Enron Corporation in 2001.
📌 What Was Enron?

Enron Corporation was an American energy and commodities trading company based
in Houston, Texas.

Before its collapse, it was one of the largest companies in the U.S., known
for its innovative business strategies and rapid growth.

It was ranked 7th on the Fortune 500 list in 2000, with reported revenues of
over $100 billion.
📌 What Went Wrong? (The Fraud & Accounting Scandal)
Enron executives manipulated financial statements to make the company appear more
profitable than it really was. They did this through:
1. Mark-to-Market Accounting (Fake Profits)

Instead of reporting actual profits, Enron used a controversial accounting
method called mark-to-market accounting.

This allowed Enron to record projected future earnings from deals as if they
were real profits (even if the deals never made money).

As a result, Enron inflated its earnings and misled investors.
2. Special Purpose Entities (Hiding Debt)

Enron created hundreds of fake companies (called Special Purpose Entities, or
SPEs) to hide its debt and losses.

These entities were used to borrow money and buy Enron’s poor-performing
assets, keeping debt off Enron’s balance sheet.

This made Enron look financially strong while it was actually drowning in
debt.
3. Insider Trading and Executive Corruption

While Enron executives knew the company was failing, they encouraged employees
and investors to buy more Enron stock.

CEO Jeffrey Skilling, Chairman Kenneth Lay, and CFO Andrew Fastow sold their
personal shares for millions of dollars before the stock price crashed.

Meanwhile, employees lost their retirement savings, as their pensions were
tied to Enron stock.
📌 The Collapse of Enron

October 2001: Enron reported massive losses ($618 million) and revealed that
billions in debt had been hidden.

Stock Price Plunge: Enron’s stock price fell from $90 per share to less than
$1 within weeks.

December 2, 2001: Enron declared bankruptcy, becoming the largest corporate
bankruptcy in U.S. history at the time.
📌 Consequences of the Scandal
For Enron Executives:

Jeffrey Skilling (CEO): Sentenced to 24 years in prison for fraud and insider
trading. Later reduced to 14 years.

Kenneth Lay (Chairman): Convicted of fraud but died of a heart attack before
sentencing.

Andrew Fastow (CFO): Served 6 years in prison for creating the fraudulent
financial schemes.
For Employees and Investors:

Over 20,000 Enron employees lost their jobs and life savings.

Investors lost billions as the company’s stock became worthless.
For Accounting Firm (Arthur Andersen):

Arthur Andersen, Enron’s accounting firm, was found guilty of obstructing
justice for destroying financial documents.

The firm was shut down, costing 85,000 employees their jobs.
For U.S. Laws and Regulations:

The U.S. government passed the Sarbanes-Oxley Act (SOX) in 2002, which
introduced:
o
Stricter corporate financial reporting rules
o
Harsh penalties for corporate fraud
o
More oversight on accounting firms
📌 Key Lessons from the Enron Scandal
✅ Transparency and honest financial reporting are essential for businesses.
✅ Corporate greed and unethical behavior can destroy companies and economies.
✅ Strict financial regulations are needed to prevent fraud.
✅ Investors should be cautious of companies that report “too good to be true”
profits.
📌 Final Summary
The Enron Scandal was a wake-up call for the corporate world. It showed the dangers
of fraudulent accounting, executive corruption, and weak financial regulations. The
case changed corporate governance laws and remains one of the biggest business
scandals in history.
Summary of Financial Markets and Their Types
1. Physical vs. Financial Asset Markets
o
Physical (Tangible) Asset Markets: Trade real goods like wheat, cars,
real estate, computers, and machinery.
o
Financial Asset Markets: Deal with stocks, bonds, mortgages,
derivatives, and other financial instruments.
2. Spot vs. Futures Markets
o
Spot Markets: Assets are bought and delivered immediately (or within a
few days).
o
Futures Markets: Contracts for assets to be delivered at a future date
(e.g., in 6 months or a year).
3. Money vs. Capital Markets
o
Money Markets: Trade short-term, highly liquid debt securities
(maturity <1 year).
o
Capital Markets: Deal with stocks and long-term debt (maturity >1
year).
o
Examples: The New York Stock Exchange (NYSE) is a capital market.
o
Debt Market Terms:

Short-term: <1 year

Intermediate-term: 1-5 years

Long-term: >5 years
4. Mortgage vs. Consumer Credit Markets
o
Mortgage Markets: Loans for homes, farms, commercial, and industrial
real estate.
o
Consumer Credit Markets: Loans for cars, appliances, education, and
personal expenses.
5. Geographic Markets
o
Financial markets exist at global, national, regional, and local
levels.
o
Companies may borrow and lend globally or be limited to local markets.
6. Primary vs. Secondary Markets
o
Primary Markets: Where companies raise new capital by selling
securities (e.g., Microsoft’s Initial Public Offering (IPO) in 1986).
o
Secondary Markets: Where existing securities (stocks, bonds) are bought
and sold among investors (e.g., NYSE trading of AT&T stock).
o
Key Difference: In the primary market, the company gets the money; in
the secondary market, the company does not receive any funds.
7. Private vs. Public Markets
o
Private Markets: Direct transactions between two parties (e.g., bank
loans, private debt placements). These are customized but less liquid.
o
Public Markets: Securities traded on organized exchanges (e.g., stocks,
corporate bonds). These are standardized and more liquid but less
flexible.
Key Takeaways:

Different markets serve different financial needs (e.g., short-term vs. longterm, local vs. global).

Investors and companies choose markets based on liquidity, risk, and
financial goals.

Primary markets help businesses raise capital, while secondary markets
provide liquidity for investors.