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Chapter 1
Financial Management
LEARNING OBJECTIVES (Slides 1-1 to 1-3)
1. Describe the cycle of money, the participants in the cycle, and the common objective of
borrowing and lending.
2. Distinguish the four main areas of finance and briefly explain the financial activities that
each encompasses.
3. Explain the different ways of classifying financial markets.
4. Discuss the three main categories of financial management.
5. Identify the main objective of the financial manager and how he or she might meet that
objective.
6. Explain how the finance manager interacts with both internal and external players.
7. Delineate the three main legal categories of business organizations and their respective
advantages and disadvantages.
8. Illustrate agency theory and the principal-agent problem.
9. Define issues in corporate governance and business ethics.
10. Explain why studying finance improves your employability.
IN A NUTSHELL
Given that a large number of business students tend to be “terrified” of taking their first (and
possibly, their only) course in finance, the topics, concepts, and issues presented in this chapter
provide an excellent opportunity for the instructor to “break the ice” and dispel the
premonitions and prejudices that cloud students’ interest in the subject. The chapter is
organized into 10 sections beginning with the definition of finance and financial management.
Next, the process known as the “cycle of money” is defined, and the role of financial
intermediaries such as commercial and investment banks, in the smooth operation of this cycle,
is discussed.
After presenting the similarities, differences, advantages, and disadvantages of the various
forms of business organizations (i.e., sole proprietorship, partnerships, and corporations), the
author discusses the main responsibilities of a financial manager and the main goal of financial
management, which is to maximize the value of the equity of the company.
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The complexity of the responsibility of financial management is introduced by presenting the
various stakeholders whose interests must be balanced by the financial manager. The author
then explains the relationship of the officers of a company to the owners of the company
through a model called agency theory and discusses the areas of conflict that often arise from
this relationship as well as the mechanisms by which these conflicts can be minimized. Finally,
he touches on some of the issues concerning how corporations govern their activities and how
the government attempts to regulate and monitor these activities.
LECTURE OUTLINE
Definition of Finance: (Slide 1-4)
Finance is the art and science of managing wealth. It is about making decisions regarding what
Definition of Financial Management: (Slide 1-5)
Financial management is generally defined as those activities that create or preserve the
1.1 The Cycle of Money (Slide 1-6 to 1-8)
Financial intermediaries such as investment and commercial banks assist in the movement of
money, from lenders to borrowers and back again. This process is termed the cycle of money
and its main objective is to make all the participants better off (see Figure 1.1.).
Example
A mutual fund issues shares, which are bought by individuals who save and invest part of their
paychecks. The pooled funds are invested by the mutual fund company in shares that are issued
Chapter 1 ◼ Financial Management 5
Besides the company officers, the employees, customers, suppliers, and business clients make
up a much greater collection of players who are involved in the creating and maintaining the
wealth of the company. So, financial managers have to interact with various internal as well as
external stakeholders in their quest for shareholder wealth maximization.
Completed learning objective 6: Explain how the finance manager interacts with both
internal and external players.
1.7 The Legal Forms of Business (Slides 1-16 to 1-19)
The three main forms of business organizations are sole proprietorships, partnerships, and
corporations; the advantages and disadvantages of each form are shown in the following table:
Type of Business
Organization
Advantages
Disadvantages
Sole Proprietorship
1. Simplest and easiest form of
business.
2. Least amount of legal
documentation.
3. Least regulated.
4. Owner keeps all profits
1. Owner pays personal tax rate
on profits.
2. Obligations of the business are
sole responsibility of owner,
and personal assets may be
necessary to pay obligations
(personal and business assets
commingled).
3. Business entity limited to life
of owner.
4. Access to outside funding of
business can be limited.
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Type of Business
Organization
Advantages
Disadvantages
Partnership
1. Agreements between partners
may be easily formed.
2. Involves more individuals as
owners and therefore usually
more expertise.
3. Larger amount of capital
usually available to the
business (compared to
proprietorship).
1. Assets of general partners are
commingled with assets of the
business.
2. Profits treated as personal
income for tax purposes.
3. Difficult to transfer ownership.
Corporation
1. Business is legal separate
entity from owners.
2. Owners have limited liability
to obligations of the business.
3. Easy to transfer ownership.
4. Usually greater access to
capital for business.
5. Profits may be taxed at capital
gains rate for owners.
1. Most difficult business
operation to form due to
charters and other legal
documents.
2. Double taxation of company
profits, first at the company
and then at the owners when
distributed.
3. Often the most regulated form
of business.
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Hybrid Corporations such as Limited Liability Corporations (LLCs) and S Corporations,
combine the limited liability advantage of a corporation with the personal taxation of business
income feature of a partnership, thereby providing the owners (members) the best of both
worlds!
Not-For-Profit Corporations are formed by businesses that engage in charitable, educational,
Completed learning objective 7: Delineate the three main legal categories of business
organizations and their respective advantages and disadvantages.
1.8 The Financial Management Setting:
The Agency Model (Slide 1-20)
The relationship between the owners (principals) of a corporation and the managers (agents)
who are appointed by the owners to run the corporation is termed an agency relationship. The
very nature of such a relationship is fraught with opportunities for conflict (agency conflict)
because owners want higher stock prices while managers, who are empowered to make the key
operating decisions, can often stray away from their main goal of maximizing shareholder
wealth and grant themselves excessive perks, or high salaries, or pad their offices with luxurious
carpets, much to the dismay of the shareholders.
problems and ways to align agents with the interests of the principals. Costs to align the agents
above a straight effort contract or ensure performance at the contracted level are agency costs.
Completed learning objective 8: Illustrate agency theory and the principal-agent problem
1.9 Corporate Governance and Business Ethics (Slide 1-21)
Corporate governance deals with how a company conducts its business and implements controls
to ensure proper procedures and ethical behavior. Most companies and managers go about the
business in a fair and honest manner; however, occasionally some managers get involved in
The Sarbanes-Oxley Act, enacted in 2002, requires among other things, that
• The CEO and CFO attest to the fairness of the financial reports.
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• The company maintains an effective internal control structure around financial
reporting.
• The company and its auditors assess the effectiveness of the controls over the most
recent fiscal year.
Completed learning objective 9: Review issues in corporate governance and business ethics.
1.10 Why Study Finance? (Slide 1-22)
By studying finance one can understand how and why financial decisions are made in large and
small companies. This knowledge can help individuals increase their own compensations as well
as improve their contributions to the success of the companies that they work for. Studying
finance can also help us understand the trade-offs we face in making personal financial choices
and help us to select the most appropriate action.
The Putting Finance to Work box helps us gain some more insight into how studying finance
can help our professional development.
Questions
1. What is the cycle of money? Who participates in the cycle of money? What is the objective
of a financial transaction?
The cycle of money is the movement of funds from a lender to a borrower and back to the
lender.
2. Construct an example of the cycle of money, identify all the players involved, and identify
their individual benefits from participating in the cycle of money.
Example One: An individual opens a savings account at a local commercial bank with a $200
Example Two: An individual deposits his monthly paycheck in a checking account. The bank
checking account.
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© 2018 Pearson Education, Inc.
marketing the bond, and the funds from the sale of the bond are delivered to the city minus
a fee from the investment banker. The city uses the funds to build new facilities at the
airport, such as a new parking lot. Once finished, the fees received from parking are used to
payback the buyer of the bond with interest.
3. What are the four areas of finance? Give an example of a financial activity that would fall
into each area.
Corporate finance—the financial activities that support the operations of a business. A
company. A typical financial activity is the changing of currency from one country to another
country.
4. What is the difference between the primary market and the secondary market?
5. What is the general definition of the financial management function? Give an example of
a financial management function that an individual might perform.
The financial management function is generally defined as the activities that create or
6. List a capital budgeting decision, a capital structure decision, and a working capital
management decision a business might make.
Here are three examples of financial decisions that a business might make:
1. The company chooses a new product to introduce into the market (capital budgeting).
management).
7. List the advantages and disadvantages of the three different types of business
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© 2018 Pearson Education, Inc.
A conflict could involve an employee being required to work overtime. The employee wants
sufficient lead time on overtime work while the supervisor assigns the work whenever the
situation arises. The employee is disgruntled when working overtime and does not produce
quality work. The cost of this is rework on some of the production items.
Solution: A policy on overtime and selection for overtime should be worked out between
the supervisor and all employees subject to selection for overtime.
11. Employees at the Jackson Hole Corporation typically take forty-five minutes for lunch
when the allocated time is only 30 minutes. Employees are encouraged to eat at the
company cafeteria located in the middle of the company facilities. Most employees
choose to eat their lunch in the cafeteria. Is there an agency cost here? If so, how can
management eliminate or reduce this agency cost?
The first issue is why do employees take 45 minutes for lunch? The 45 minutes may be the
natural time required to go through the line, purchase a lunch, and then eat the lunch at an
additional employees added to the cafeteria staff to speed up the process is an agency cost.
Another possibility is to extend the work day by 15 minutes. The cost to negotiate a new
Prepping for Exams
1. c.
2. b.
3. a.
4. b.
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Solutions to Mini-Case Questions
Richards’ Tree Farm Grows Up
This case requires students to review the major financial decisions faced by any business and the
advantages and disadvantages of various forms of business organization with emphasis on
incorporation. It introduces the agency problem and ethical decisions, using examples that will
be familiar to most students.
1. Major financial management decisions involve capital budgeting, capital structure, and
working capital management. Give an example of each that relates to Richards’ Tree Farm.
Capital Budgeting: Whether they know it or not, when the Richards decide to purchase any
Capital Structure: The Richards had to decide whether to finance these purchases with their
Working Capital: The Richards always have inventories of trees at various stages of maturity
and available for sale. They sell to commercial clients on credit and purchase supplies used
capital accounts such as cash, inventory, accounts receivable, and accounts payable.
2. Should the Richards form a regular corporation or choose one of the hybrid forms?
Whichever form they use, they intend to distribute ownership equally among Jake, his
wife, and their two children so that each party will own 25% of the shares. Consider the
tax consequences of their decision.
The major advantage to incorporating is the separation of personal income and assets from
business income and assets. Either a regular corporation or one of the alternative forms (LLC
or Subchapter S) will accomplish this goal. The distribution of shares more or less assures
could be taxed once at the corporate level, and again when it is distributed as dividends. By
taking appropriate salaries from the business, however, they might be able to have lower
Chapter 1 ◼ Financial Management 13
marginal rates on both personal and business income. If they use dividends as a means of
sharing wealth with their children, double taxation could be an issue.
3. How does incorporating affect the family’s overall risk exposure?
In theory, at least, any problems with the business will leave the Richards liable only for the
4. How does incorporating affect the ability of the business to expand?
Although incorporating a relatively small business would not automatically give it easy
access to the capital markets, the Richards might be able to obtain additional equity by
5. Jake is concerned that if the business gets much bigger or if he should just decide to slow
down and enjoy life a little more, he will need to hire professional management and
possibly lose control over key business decisions. Are his concerns justified?
Corporations do create the possibility of separating ownership and management, but as
6. Jake occasionally hires day workers, who may or may not be in the United States legally.
What are his legal and ethical obligations with respect to this decision?
Jake has a clear legal and ethical responsibility to verify the immigration status of all
7. The Richards are deeply concerned with environmental issues and know that the best
practices for pesticide and fertilizer usage increase production costs. Will incorporating
affect their ability to give up a small amount of profit in exchange for protecting the
environment?
Again, as long as the Richards maintain a controlling interest in the firm, they can establish
they become minority shareholders or simply stop playing an active role in the management
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of the business, profit pressures could make it difficult to follow best environmental
practices. At times, best practices, such as avoiding unnecessary pesticide applications, can
actually lower costs. Some customers may also be willing to pay a higher price for
responsibly farmed crops.
8. How does incorporating affect the Richards’ ability to transfer ownership of the tree farm
to their children?
Incorporating creates many convenient options for transferring ownership of the business.
The Richards can gradually sell or give their children increasing numbers of shares as they
9. Suppose this business has an opportunity to become much larger at some point in the
future. How might it obtain more equity funding and perhaps create considerable wealth
for the Richards family in the process?
A handful of similar businesses are publicly traded on NASDAQ (which will be discussed in
more detail in Chapter 7 on stocks), so it is possible to imagine that by acquiring other