Chapter 1

Introduction to Financial
Management
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

1-2

Forms of Business
Organization

Proprietorship
Partnership
Corporation

1-3

Proprietorships and
Partnerships

Advantages

Ease of formation
Subject to few regulations
No corporate income taxes

Disadvantages

Difficult to raise capital

Unlimited liability
Limited life
1-4

Corporation

Advantages

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

Disadvantages

Double taxation
Cost of set-up and report filing
1-5

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 companys prospects.

1-6

Stock Prices and Intrinsic Value

In equilibrium, a stocks price should

equal its true or intrinsic value.

Intrinsic value is a long-run concept.

To the extent that investor perceptions
are incorrect, a stocks 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.

1-7

Determinants of Intrinsic Values

and Stock Prices
Managerial Actions, the Economic
Environment, Taxes, and the Political
Climate
True
Risk

Perceived
Investor
Returns

Stocks
Intrinsic
Value

Perceived
Risk

Stocks
Market Price
Market Equilibrium:
Intrinsic Value = Stock
Price

1-8

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.
1-9

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
1-10

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.
1-11