Introduction to Financial Management

Chapter 1

Forms of Business Organization Stock Prices and Shareholder

Value Intrinsic Values, Stock Prices, and

Executive Compensation Important Business Trends Conflicts Between Managers,

Stockholders, and Bondholders 1-1

Finance Within the Organization

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Forms of Business Organization Proprietorship Partnership Corporation

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Proprietorships and Partnerships Advantages

Ease of formation Subject to few regulations No corporate income taxes

Disadvantages Difficult to raise capital Unlimited liability Limited life

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Corporation Advantages

Unlimited life Easy transfer of ownership Limited liability Ease of raising capital

Disadvantages Double taxation Cost of set-up and report filing

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Stock Prices and Shareholder Value The primary financial goal of management

is shareholder wealth maximization, which translates to maximizing stock price. Value of any asset is present value of cash

flow stream to owners. Most significant decisions are evaluated in

terms of their financial consequences. Stock prices change over time as conditions

change and as investors obtain new information about a company’s prospects.

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Stock Prices and Intrinsic Value In equilibrium, a stock’s price should

equal its “true” or intrinsic value. Intrinsic value is a long-run concept. To the extent that investor perceptions

are incorrect, a stock’s price in the short run may deviate from its intrinsic value.

Ideally, managers should avoid actions that reduce intrinsic value, even if those decisions increase the stock price in the short run.

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Determinants of Intrinsic Values and Stock Prices

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“True” Risk

“Perceived” Investor Returns

“Perceived” Risk

Managerial Actions, the Economic Environment, Taxes, and the Political

Climate

Stock’s Intrinsic Value

Stock’s Market Price

Market Equilibrium:Intrinsic Value = Stock

Price

Some Important Business Trends Recent corporate scandals have

reinforced the importance of business ethics, and have spurred additional regulations and corporate oversight.

Increased globalization of business. The effects of ever-improving

information technology have had a profound effect on all aspects of business finance.

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Conflicts Between Managers and Stockholders Managers are naturally inclined to act in

their own best interests (which are not always the same as the interest of stockholders).

But the following factors affect managerial behavior: Managerial compensation packages Direct intervention by shareholders The threat of firing The threat of takeover

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Conflicts Between Stockholders and Bondholders Stockholders are more likely to prefer riskier

projects, because they receive more of the upside if the project succeeds. By contrast, bondholders receiving fixed payments are more interested in limiting risk.

Bondholders are particularly concerned about the use of additional debt.

Bondholders attempt to protect themselves by including covenants in bond agreements that limit the use of additional debt and constrain managers’ actions.

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