Chapter 1 Foundation  Holder owns a piece of the company,

What is Finance? entitled to share of the firms profits.

 Dividends or retained earnings to enhance
 Art and science of prospects for growth
handling money  2 sources of cash flows: (1) dividends (2)
 Management of money eventual selling price of the share.
4. Bonds represent a debt relationship
Two areas:  Buying a bond is lending money

 Investments and financial markets Companies issue financial assets to raise money to
 Financial management of companies buy real assets used in running the business.

The financial system involves the flow of money Financial assets are purchased by people to earn
and paper between the two. income they don’t currently need.
Stock or bond is also called security.
What are financial assets?
A person buying a financial asset is investing,
therefore called an investor.
Money, debt security and equity securities are financial
assets. Investments in financial assets can be made directly
by buying shares in a mutual fund.
 Both debt and equity securities represent claims
against the assets and future earnings of the  A mutual fund pools the contributions of
corporation. many investors and employs a professional
 Debt and equity securities are financial assets of manager to select securities that match a
the investors who own them, and, at the same particular set of investment goals.
time, these securities appear on the liabilities
and stockholders’ equity side of the issuing
company’s balance sheet. What are financial markets?
 Where financial assets are issued by
Financial assets are income not currently needed. companies and purchased by investors
 A framework or organization in which
1. Real Assets – an object that provides a service
people can buy and sell securities in
(cars, house).
accordance with well-defined rules and
 Real assets derive their value because
regulations (ex. stock market)
they provide services of some kind.
 Financial markets are the vehicles through
2. Financial Assets – a legal document
which financial assets are bought, sold, and
representing an income claim.
traded. Financial markets are generally
 Owners have claims to certain future classified as money or capital markets and
cash flows. primary or secondary markets.
 Stocks or bonds (ownership or debt)
 Most financial assets are either stocks or
bonds, and their claim to future income
is based on debt/equity.
What is a stockbroker?
A medium; licensed to trade securities on behalf of
investors.
3. Stock represents an ownership interest.
 Investors buy and sell the same financial assets finance. They report to the president of the
among themselves; they are most of the company. “Financial management” is what the CFO
transactions. and the finance department do.
Business Decisions – financial management also
refers to the financial input that goes into general
A security is issued by a company only once, but
business decisions.
it may be traded among investors many times
thereafter. Oversight – is looking over everyone’s shoulder to
make sure they’re using money effectively.
“market” describes the combined actions of
Oversight responsibility.
investors acting within the marketplace.
The link between company management and
Financial management answers:
investments comes from the relationship between
1. How to raise money price and expected financial results. Everything
2. What to do with it? firms and their managers do is watch the market and
has an impact on investor’s perception of future
Market Companies performance and risk. Those perceptions determine
the prices of stocks and bonds.
Investors Financial
“All about future performance”
evaluate and managements of
firms raise and Accounting is a system of record-keeping designed
buy stocks to portray a firm’s operations to the world in a fair
Financing means raisingspend
moneymoney
to acquire or to do and unbiased way. The records are used periodically
something. to produce financial statements.
- Leased financed. Treasury department – raise money, analyze
- Debt financed (bond, borrow) results, handle relationships with outsiders such as
- Equity financed (stock, selling) banks, shareholders and representatives of the
investment community.
 “Field of Finance” is concerned on both raising
money and its providers. Finance department – consists of the accounting
department handled by a controller and the treasury
 “Modern Finance” includes goals and activities, department handled by a treasurer. Both reports to
concerned with the notion of risk in investing. It the CFO.
also involves the roles and function of financial  Treasury functions are called
within firms. finance.
 Controller functions are called
 “Portfolios” are where investors put together a accounting.
group of securities.
CFO
Treasurer Controller
Cash is King! Finance concentrates on cash flow.
Financial management – the management and
control of money and money-related operations Important Notes:
within the business. It also involves finance
 Depreciation expense lowers the profit.
departments.
 Financial transactions are recorded within
Chief Financial Officer (CFO) – executive in the structure of accounting systems.
charge of finance, also called vice president of
 Accounting is the language of finance  The tax system considers them as
partnerships. They are called “pass-
What is financial theory? (In economics) it is the
through”, they pass profit through owners
body of thought that is studied and continually
and are taxed only at personal rates; can be
developed by highly trained experts
large but owned by few people.
Forms of business organization:
In economics, the goal of the firm is to maximize
 Sole partnership (can be partnership) profits.
 Partnership
The appropriate managerial goal is to maximize
 Corporation
shareholder wealth equivalent to maximizing the
 C type
price of the company stock.
 S type Small
 LLC Shareholder wealth maximization is a practical goal
1. Proprietorship for corporate management.
 Simple
Terminologies:
 Taxed as personal income.
 Raise money (loan, family, friends,  Conflict of Interest – when something that
bank) benefits one group takes away from another.
 Difficulty in raising money  Agency problem – onerous conflict of interest
 “Collateral” – loan banked by asset.  Agency relationship – a person hires another
2. Corporation and gives him or her decision-making authority
 Legal process of incorporation over something. There should be decision-
 A corporation is a separate legal entity making authority.
subject to a corporate tax on whatever it  Prerequisites or perks
earns. The leftover after-tax belongs to  Agency costs – ensure to control agency to
the corporation. avoid agency problems.
 Although the entrepreneur owns the  Security analysis – estimating the value of a
business, he needs to declare dividend particular stock.
before getting the money.
This “dividend” is taxable to the
individual. Stakeholders or Constituencies – are interested
 Double taxation of earnings is a major is groups where each has a stake or vested interest in
a major financial disadvantage of the way the firm is operated.
traditional corporate form.
 Ease of raising money by selling stocks Management – has a special position among
is an advantage. stakeholder groups; they have little accountability to
stockholder group.
Corporation has double taxation:
 If ownership is widely dispersed that no one
1. Tax of the corporation holds more than 1% or 2% of the company,
2. Tax of individuals stockholders have limited influence because
Personal guarantees – side agreements that make no one can muster enough power to force a
owners personally responsible for repayment. change in the management team.
 Top managers become entrenched in
LLC and S-type Corp –are corporations that have positions controlling vast company
limited liability and earnings are not subject to resources and are able to use those resources
corporate income tax. Personal rates only (Tax of for their own benefit rather than for the
individuals). LLC and S-type corporations let small; benefit of shareholders.
businesses avoid double taxation.
The ownership of a widely held company is
dispersed so no one has enough control to influence
management.
Agency Problem
The special position of management in widely held
companies leads to a particularly onerous conflict of
interest known as the agency problem.
 Agency problem – is the conflict of interest
between stockholders and management.
An agency relationship is created when a person
hires another and gives him or her decision-making
authority over something.
 Example: if Smith hires Jones to run his
business, Jones is the agent of smith, who is
a principal. If Smith hires Jones to sweep
the floor, no agency relationship is created
because no decision-making authority is
involved.
The agency relationship creates an opportunity for
abuse by the agent who has no control over the
assets of the principal.
Corporate managers are the agents of the firm’s
stockholders.

Abuse of agency is when corporate managers

(agent) receive excessive compensation. The
conflict is with stockholders because the excessive
payment is company profit which belongs to them.
Another form is using company assets for personal
use.
A creditor is anyone owed money by a business,
including