FM Chapter 1: An overview of Financial Management

Learning structure:
1. Describe how finance is related to the overall business
- Point out that finance prepares students for jobs in different fields of
business
- Discuss the difference forms of business organisations
2. For corporations, management’s goal should be to maximise shareholder wealth 
maximise the value of stock (true, long run value, not current stock price).
3. How firms must provide the right incentives for managers to focus on long run value
maximisation.

What is Finance?
 Finance need knowledge of both accounting and economics.
 Finance within an organisation:

 Finance is generally divided into 3 areas: Financial management, Capital markets,

Investments
1. Financial management (aka corporate finance)
- Focuses on decisions relating to how much and what type of assets to
acquire
- How to raise the capital needed to purchase assets
- How to run the firm to maximise its value
2. Capital markets
 - Relates to the market where interest rates, along with stock and bond
prices, are determined
- Financial institutions that supply capital to businesses
3. Investments
- Relate to decisions concerning stocks and bonds
- Include activities: (1) Security analysis deals with finding the proper values
of individual securities (2) Portfolio theory (3) Market analysis

Forms of Business Organisation

1. Proprietorships
2. Partnerships
3. Corporations
4. Limited liability companies (LLCs) and limited liability partnerships (LLPs)

 Proprietorships
Advantages Disadvantages
1) Easily and inexpensively formed 1) Unlimited personal liability for the
2) Subject to fewer regulations business’ debts, and can lose
3) Subject to lower income taxes more than the amount of money
than are corporations invested in the company (might
invest $10,000 to start a business
but be sued for $1million if one of
your employees runs over
someone with a car)
2) The life of business is limited to
the life of the individual that
created it  to bring in new
equity, investors require a change
in the structure of business
3) Because of the first 2 points,
proprietorship have difficulty
obtaining large sums of capital 
hence usually is small business

 Partnership
- A legal arrangement between 2 or more people who decide to do business
together
- Firm’s income is allocated on a pro rata basis to the partners and is taxed on
an individual basis  allows firms to avoid the corporate income tax
- But all of the partners are subject to unlimited personal liability  if a
partnership goes bankrupt and any partner is unable to meet his pro rata
share of the firm’s liabilities, the remaining partners have to make good on
the unsatisfied claim.
 - Hence, difficult to raise large amount of capital
 Corporation
- A legal entity created by a state, and it is separate and distinct from its
owners and managers this separation limits stockholders’ losses to the
amount they invested in the firm  the corporation can lose all of its
money but its owners can lose only the find s they invested in the company
- Unlimited lives, easier to transfer shares of stock in corporation than one’s
interest in an unincorporated business
- Therefore, easier to raise large sum of capitals  operate large business
- Disadvantages: Most corporations’ earnings are subject to double taxation
 the corporations’ earnings are taxed and then after tax earnings are paid
out as dividends  taxed again as personal income to the stockholders
 S corporations: tax the corporation as if they were partnerships,
hence exempted from corporate income tax (but to qualify, a firm can
have no more than 100 stockholders)  larger corporations are
known as C corporations (When S sell stock to public, they become C)

 Limited liability companies (LLCs) and limited liability partnerships (LLPs)

- LLCs: Hybrid between partnership and corporation (used for business)
- LLPs: Similar to that of LLCs but are used for professional firms in
accounting, law and architecture
- Both have limited liability like corporations but are taxed like partnerships
What are some reasons why the value of a business other than a small one is generally
maximised when it is organised as a corporation?

Balancing shareholder value and the interests of society

 The primary goal of a corporation should be to maximise its owners’ value, but a
proprietor’s goal might be quite different.
- E.g., Amber Plus Trading, 要开店就开店
- But if you are a CEO of a large corporation, and most of the stock is owned
shareholders who purchased it because they were looking for an investment
that would help them to retire. The shareholders elected a board of
directors, which then selected you to run the company  you are working
on behalf of these shareholders, need to enhance shareholder value
Intrinsic values, stock prices, and executive compensation
 Stock prices are based on cash flows expected in future years, not just in the current
year.  stock price maximisation requires us to take a long-run view of operations.
 A growing number of companies have used stock and stock options (stock-based
compensation) as a key part of executive pay  so that managers think more like
stockholders

 Intrinsic value: an estimate of a stock’s “true” value based on accurate risk and return
data. Can be estimated but not measured precisely.
- Management’s goal should be to take actions designed to maximise the
firm’s intrinsic value, not its current market price
- Though maximising the intrinsic value will maximise the average price over
the long run not necessarily the current price at each point in time
- E.g., management makes an investment that lowers profit for the current
year but raises the expected future profits  if investors are not aware of
the true situation, the stock price may decrease by the low current profit
even though the intrinsic value was raised
o Therefore, management should provide information that helps
investors to better estimate the firm’s intrinsic value (s that stock
price closer to equilibrium)  but cannot give too much info that
helps the competitors
 Market price: the stock value based on perceived but possibly incorrect information as
seen by the marginal investor (an investor whose views determine the actual stock
price)
 Equilibrium: the actual market price equals the intrinsic value  when equilibrium
exists, there is no pressure for a change in the stock’s price

 Actual stock prices are easy to determine (can be found on the Internet and are
published in newspaper everyday)  but intrinsic values are estimates, and different
analysis with different data
 To distinguish between successful and unsuccessful investors: estimating intrinsic values
(security analysis)
 1. The intrinsic value rises because the firm retains and reinvests earnings each year 
increase profit.
2. In 2006, jumped dramatically as R&D breakthrough raised management’s estimate of future
profits before investors had this information.
** the actual stock price tends to move up and down with the estimated intrinsic value 
but investor optimism and pessimism, along with imperfect knowledge about the true
intrinsic value tends to lead to a deviation between actual prices and intrinsic values

Important Business trends

1. Globalisation of business
- Obtain real-time data on the sales of items in different outlets in different
countries
2. Ever-improving information technology (IT)
- Collect massive amount of data and using it to take much of the guesswork out of
financial decisions
- Draw on the historical results from thousands of other stores to predict results at
the proposed site  lowers the risk of investing in new stores
3. Corporate governance/the way the top managers operate and interface with stockholders
- In the past, chairperson of the board of director was almost always the CEO 
decide who would be elected to the board  made it impossible for stockholders
to replace poor management team
- Today, active investors who control huge pool of capitals are constantly looking for
underperforming firm and will quickly pounce on laggards, take control and replace
the managers.
- New rules: companies with a stock market value greater than $75 million to have
their shareholders vote regarding approval/disapproval of top management’s pay
at least once every 3 years
Business ethics

 Can be measured by the tendency of its employees to adhere to laws, regulations and moral
standards relating to product safety and quality, fair employment practices…
 What Companies are doing:
- Written codes of ethical behaviour
- Conduct training programmes
 Consequences of ethical behaviour
- Example: Misleading accounting practices (overstated profit)  executives busy
selling their stock while recommending the stock to employees and outside
investors  the executives reaped millions before the stock declined and
employees were left “holding the bag”
- Go jail, fined, bankrupt, bad reputation  lose faith, turn away from stock market
(difficult for business to get capital)

Conflict between managers, stockholders, and bondholders

1. Managers VS Stockholders
- Managers might want to maximise their personal wealth than their stockholders’,
hence their will pay themselves excessive wealth.
- Good executive compensation plans can motivate managers to act in their
stockholders’ best interests.
 Reasonable compensation packages
 Firing managers who don’t perform well
 The threat of hostile takeovers
 Compensation plans should: be sufficient to attract and retain abled managers,
consistent over time, managers are rewarded on the basis of the stock’s
performance over the long run (not the stock’s price on an option exercise date,
so that managers have incentive to keep the stock price high over time)
 When intrinsic value can be measured in an objective and verifiable manner,
performance pay can be based on changes in intrinsic value. But because it is
not observable, compensation must be based on the stock’s market price (but
the price used should be an average over time rather than on a specific date)
- Stockholders can intervene directly with managers
 Majority of stock is owned by institutional investors (insurance company,
pension funds, hedge funds…) who are ready to step in and take over
underperforming firms
- How institutional money managers exercise influence over firm’s operations
1. Speak with managers and make suggestions about how the business should be
run.
2. Any shareholder who has owned $2000 of a company’s stock for one year can
sponsor a proposal that may be voted on at the annual stockholders’ meeting
(although the proposal is non-binding, the results will be heard by the top
management)
3. If a firm’s stock is undervalued, corporate raiders (who targets a corporate for
take-over because it is undervalued) will see it as a bargain and will attempt to
capture the firm in a hostile takeover (the acquisition of a company over
 opposition of its management) and target’s executive will be fired (所以 manager
会怕)

*managers should try to maximise their stock’s intrinsic value and then communicate effectively
with stockholders.  so that intrinsic value is high and the actual stock price to remain close to the
intrinsic value over time.

2. Stockholders vs Bondholders
 Bondholders generally receive fixed payment regardless of how well the company does,
while stockholder do better when the company does better  conflict

Example: A company has the chance to make an investment that will result in a profit of $10 billion
if it is successful but the company will be worthless and go bankrupt if the investment is
unsuccessful.

The firm has bonds that pay an 8% annual interest rate and have value of $1000 per bond and stock
that sells for $10 per share. If the investment is successful, the price of the stock will jump to $2000
per share, but the value of bonds will remain just $1000 per bond. The probability of success is 50%

 The expected stock price is = 0.5($2000) + 0.5($0) = $1000

 Expected percentage gain on stock = ($1000-$10)/$10 x 100% = 9900%

- Looks wonderful from the stockholders’ standpoint but lousy for the bondholders
(bondholders will lose their entire investment if it fails)

 Another conflict is over the use of additional debt

- The more debt a firm uses to finance a given amount of assets, the riskier the firm
is.

Example: A firm has $100 million of assets and finances them with $5 million of bonds and $95
million of common stock, things have to go terribly bad before bondholders suffer a loss. But, if the
firm uses $95 million of bonds and $5 million of stock, the stockholders suffer a loss even if the value
of the assets declines only slightly.

- Hence, bondholders attempt to protect themselves by including covenants

(agreement) in the bond agreement that limit firms’ use of additional debt and
constrain managers’ actions in other ways.

*the stock’s “true” long-run value is more closely related to its intrinsic value rather than its current
price.