Financial ManagementLecture # 01

Introduction to Finance

By: Faisal Dhedhi

Organizing a Business

SOLE PROPRIETOR: Sole owner of a business which has no partners and no shareholders. The proprietor is personally liable for all the firm’s obligations.

PARTNERSHIP: Business owned by two or more persons who are personally responsible for all its liabilities.

Limited Partner: Member of a limited partnership not personally liable for the debts of the partnership.

General Partner: Member of a partnership with unlimited liability for the debts of the parternship.

CORPORATION: Business owned by stockholders who are not personally liable for the business’s liabilities.

LIMITED LIABILITY: The owners of the corporation are not personally responsible for its obligations.

To summarize, the corporation is a distinct, permanent legal entity. Its advantages are limited liability and the ease with which ownership and management can be separated. These advantages are especially important for large firms. The disadvantage of corporate organization is double taxation.

Hybrid form of Business Organization Businesses do not always fit into these neat categories. Some are hybrids of the three basic types: proprietorships, partnerships, and corporations. In many states a firm can also be set up as a limited liability partnership (LLP) or, equivalently, a limited liability company (LLC). These are partnerships in which all partners have limited liability. This form of business organization combines the tax ad-vantage of partnership with the limited liability advantage of incorporation. However, it still does not suit the largest firms, for which widespread share ownership and separation of ownership and management are essential. Another variation on the theme is the professional corporation (PC), which is commonly used by doctors, lawyers, and accountants. In this case, the business has limited liability, but the professionals can still be sued personally for malpractice, even if the malpractice occurs in their role as employees of the corporation.

Self-Test 1:

Which form of business organization might best suit the following?

a) A consulting firm with several senior consultants and support staff.

b) A house painting company owned and operated by a college student who hires some friends for occasional help.

c) A paper goods company with sales of $100 million and 2,000 employees.

Characteristics of Business Organization:

The Role of Financial manager:

REAL ASSETS: Assets used to produce goods and services.FINANCIAL ASSETS: Claims to the income generated by real

assets. Also called securities.FINANCIAL MARKETS: Markets in which financial assets are

traded.The flow chart suggests that the financial manager faces two basic problems. First, how much money should the firm invest, and what specific assets should the firm in-vest in? This is the firm’s investment, or capital budgeting, decision. Second, how should the cash required for an investment be raised? This is the financing decision.

CAPITAL BUDGETINGDECISION: Decision as to which real assets the firm should acquire.

FINANCING DECISION: Decision as to how to raise the money to pay for investments in real assets.

CAPITAL STRUCTURE: Firm’s mix of long-term financing. CAPITAL MARKETS: Markets for long-term financing.Self-Test 2: Are the following capital budgeting or financing

decisions?a) Intel decides to spend $500 million to develop a new

microprocessor.b) Volkswagen decides to raise 350 million euros through a

bank loan.c) Exxon constructs a pipeline to bring natural gas on

shore from the Gulf of Mexico.d) Pierre Lapin sells shares to finance expansion of his

newly formed securities trading firm.e) Novartis buys a license to produce and sell a new drug

developed by a biotech company.f) Merck issues new shares to help pay for the purchase of

Medco, a pharmaceutical distribution company.

Financial Institutions:

Most firms are too small to raise funds by selling stocks or bonds directly to investors. When these companies need to raise funds to help pay for a capital investment, the only choice is to borrow money from a financial intermediary like a bank or insurance company. The financial intermediary, in turn, raises funds, often in small amounts, from individual households. For example, a bank raises funds when customers deposit money into their bank accounts. The bank can then lend this money to borrowers. The bank saves borrowers and lenders from finding and negotiating with each other directly. For example, a firm that wishes to borrow $2.5 million could in principle try to arrange loans from many individuals: However, it is far more convenient and efficient for a bank, which has ongoing relations with thousands of depositors, to raise the funds from them, and then lend the money to the company

Financial Markets:As firms grow, their need for capital can expand dramatically. At some point, the firm may find that “cutting out the middle-man” and raising funds directly from investors is advantageous. At this point, it is ready to sell new financial assets, such as shares of stock, to the public. The first time the firm sells shares to the general public is called the initial public offering, or IPO. The corporation, which until now was privately owned, is said to “go public.”

PRIMARY MARKET: Market for the sale of new securities by corporations.

SECONDARY MARKET: Market in which already issued securities are traded among investors.

There is also a thriving over the- counter (OTC) market in securities. The over-the-counter market is not a centralized exchange like the NYSE but a network of security dealers who use an electronic system known as NASDAQ6 to quote prices at which they will buy and sell shares. While shares of stock may be traded either on exchanges or over-the-counter, almost all corporate debt is traded over-the-counter, if it is traded at all. United States government debt is also traded over-the-counter.

Who is the Financial Manager?

The treasurer is usually the person most directly responsible for looking after the firm’s cash, raising new capital, and maintaining relationships with banks and other investors who hold the firm’s securities.Larger corporations usually also have a controller, who prepares the financial statements, manages the firm’s internal accounting, and looks after its tax affairs. The largest firms usually appoint a chief financial officer (CFO) to oversee both the treasurer’s and the controller’s work. The CFO is deeply involved in financial policymaking and corporate planning. Often he or she will have general responsibilities beyond strictly financial issues.

Goals of the Corporation:SHAREHOLDERS WANT MANAGERS TO MAXIMIZE MARKET VALUE: A smart and effective financial manager makes decisions which increase the current value of the company’s shares and the wealth of its stockholders. That increased wealth can then be put to whatever purposes the shareholders want. They can give their money to charity or spend it in glitzy night clubs; they can save it or spend it now. Whatever their personal tastes or objectives, they can all do more when their shares are worthmore.profit maximization is not a well-defined corporate objective. Here are three reasons:

1. “Maximizing profits” leaves open the question of “which year’s profits?” The company may be able to increase current profits by cutting back on maintenance or staff training, but shareholders may not welcome this if profits are damaged in future years.

2. A company may be able to increase future profits by cutting this year’s dividend and investing the freed-up cash in the firm. That is not in the shareholders’ best interest if the company earns only a very low rate of return on the extra investment.

3. Different accountants may calculate profits in different ways. So you may find that a decision that improves profits using one set of accounting rules may reduce them using another.

The Accounting Cycle

Journal Entry

Ledger Posting

Trial Balance

Adjusted Trial Balance

Periodical Adjustments

Financial Statements Accounting

Cycle

Business Environment, Accounting and Financial Statements

Business EnvironmentLabor Markets

Capital Markets

Product Markets:• Suppliers• Customers• Competitors

Business Regulations

Business StrategyScope of Business:• Degree of Diversification• Type of Diversification

Competitive Positioning:• Cost Leadership• Differentiation

Key Success Factors & Risks

Accounting EnvironmentCapital Market Structure

Contracting & Governance

Accounting Conventions & Regulations

Tax & Financial Accounting Linkage

Independent Auditing

Legal System for Accounting Disputes

Accounting StrategyChoice of:• Accounting Policies• Accounting Estimates• Reporting Formats• Supplementary

Disclosures

Business Activities

Operating

Investment

Financing

Accounting System

Measure & Report Economic

Consequences of Business Activities

Financial Statements