Financial Management

Lecture # 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

Financial Ledger Posting

Statements
Accounting
Cycle
Adjusted Trial Trial
Balance Balance

Periodical
Adjustments
 Business Environment, Accounting and Financial Statements

Business Environment Business Strategy

Labor Markets Scope of Business:
Business
Capital Markets • Degree of Diversification
Activities
Product Markets: • Type of Diversification
Operating
• Suppliers Competitive Positioning:
Investment
• Customers • Cost Leadership
Financing
• Competitors • Differentiation
Business Regulations Key Success Factors &
Risks
Accounting Environment Accounting
Capital Market Structure System Accounting Strategy
Contracting & Governance Measure & Report Choice of:
Accounting Conventions & Economic • Accounting Policies
Regulations Consequences of • Accounting Estimates
Tax & Financial Accounting Business
• Reporting Formats
Linkage Activities
• Supplementary
Independent Auditing Disclosures
Legal System for
Accounting Disputes
Financial
Statements