1 Chapter 1 – Introduction to Financial Management

1.1 What is Finance?

Finance is all about managing money to achieve the best results while weighing the risks. It’s a broad field that applies to almost every part of life. Here are a few key areas where finance plays a role:

• • Corporate Finance: Businesses use finance to decide how to invest, fund projects, and reward shareholders. For example, a company might decide whether to build a new factory or pay off debt.
  • Banking: Banks rely on finance to manage loans, set interest rates, and evaluate risks before lending money.
  • Personal Finance: Individuals use finance to make budgets, save for big goals like retirement, and make decisions about spending and investing.

No matter the area, the goal is the same: manage money effectively while keeping risks in check.

1.1.1 Commercial Banking/Financial Institutions

Financial institutions like banks, credit unions, and insurance companies play a big role in managing money and connecting borrowers with lenders. They handle:

• • Managing risks and evaluating returns.
  • Helping money grow over time (e.g., through interest).
  • Facilitating loans, payments, and financial transactions.

We’ll touch on some of these topics, such as balancing risks and rewards and how money changes value over time. While banking isn’t our main focus, understanding how it fits into the bigger picture of finance is essential.

1.1.2 Understanding the Financial Cycle

Finance is also about how money flows in the economy. The financial cycle connects individuals, businesses, and financial institutions in a continuous loop:

1. 1. Individuals save money by depositing it in banks.
   2. Banks lend this money to businesses, fueling growth.
   3. Businesses repay loans with interest, which helps banks provide more loans.

1.1.3 Investments

When most people think of finance, they picture investments like the stock market. This field involves managing financial products like stocks, bonds, and mutual funds, with a focus on:

• • Balancing risks and rewards.
  • Diversifying investments to reduce risk.
  • Aligning investments with individual goals.

Key Careers in Investments: Roles like stock analyst, portfolio manager, and trader are exciting but competitive, offering high rewards for those who excel.

1.1.4 Personal Finance

Personal finance is about managing your own money to achieve your goals. This includes:

• • Planning for retirement.
  • Creating a budget for big purchases like a car or house.
  • Protecting yourself with insurance.

While this course doesn’t focus solely on personal finance, many concepts we’ll cover—like how money changes value over time—apply directly to personal decisions. If you want to dive deeper into personal finance, consider taking another class at foothill, Business 45 personal finance with me! This course focuses on practical strategies and personal experiences to help you manage your money effectively.

1.1.5 Corporate Finance

Corporate finance focuses on how businesses manage money. This includes:

• • Raising money (through stocks, bonds, or loans).
  • Deciding how to spend money (e.g., investing in new products or facilities).
  • Managing cash flow to keep the business running smoothly.

Amazon’s rapid growth is a great example of effective corporate finance. From raising capital through bonds to investing in innovations like cloud computing, Amazon’s financial decisions have fueled its expansion into one of the world’s largest companies. By carefully balancing risks and returns, Amazon demonstrates how corporate finance drives success.

1.1.6 Financial Manager’s Role in a Business

Financial managers are like the navigators of a company, guiding it toward success by making smart money decisions. Their job focuses on three main areas:

• • Investment Decisions:

This means choosing where the company’s money should go. Should it launch a new product, expand into a new market, or invest in cutting-edge technology? For example, a coffee chain might decide to open stores in a new city based on expected customer demand.

• • Financing Decisions:

This involves figuring out how to get the money needed for those big plans. Should the company borrow through loans, issue stocks, or reinvest its own profits? Each option has trade-offs in terms of cost and control.

• • Managing Cash Flow:

Financial managers make sure there’s enough cash to keep the business running smoothly. This includes keeping track of payments coming in from customers and making sure suppliers, employees, and lenders are paid on time.

1.2 Forms of Business Organization

When starting a business, choosing the right structure is a big decision. There are three main types of business organizations: sole proprietorships, partnerships, and corporations. Each has its pros and cons, so understanding how they work is crucial.

While this course focuses primarily on corporations, let’s take a quick look at all three to build a solid foundation.

1.2.1 Sole Proprietorship

A sole proprietorship is the simplest and most common type of business ownership. It’s run by one person, and there’s no legal distinction between the owner and the business.

Key Features:

• • Full Control: The owner makes all the decisions—no partners or boards to consult.
  • Personal Liability: The owner is personally responsible for all debts and legal issues. If the business owes money, the owner’s personal assets (like a car or house) are at risk.
  • Pass-Through Taxation: Business profits are taxed as part of the owner’s personal income.

Advantages:

• • Easy to set up and manage.
  • The owner keeps all the profits.
  • Simple tax structure.

Disadvantages:

• • Unlimited liability—your personal assets are on the line.
  • Harder to raise money, as banks may be hesitant to lend to a sole proprietor.
  • The business ends if the owner leaves or passes away.

Example:

Imagine a freelance graphic designer running a sole proprietorship. They manage everything themselves, from client relations to invoices. While this gives them flexibility, it also means they’re responsible for any debts if the business struggles.

1.2.2 Partnership

A partnership involves two or more people sharing ownership. Each partner contributes to the business and shares its profits and losses.

Types of Partnerships:

1. • General Partnership: All partners are equally involved in management and share liability.
   • Limited Partnership (LP): Some partners manage the business and take on liability, while others only invest capital and have limited liability.
   • Limited Liability Partnership (LLP): All partners enjoy limited liability, protecting them from personal responsibility for business debts.

Advantages:

• • Shared responsibilities and resources.
  • Easier to raise funds compared to sole proprietorships.
  • Pass-through taxation—profits are taxed only at the individual level.

Disadvantages:

• • Conflicts between partners can arise.
  • In general partnerships, each partner is personally liable for the business’s debts.
  • The business may dissolve if a partner leaves, unless there’s an agreement in place.

Example:

Think of a small law firm run as an LLP. Each partner brings their own expertise and shares the workload. If one partner leaves, the firm can continue without significant disruption, thanks to the LLP structure.

1.2.3 Corporation

A corporation is a separate legal entity from its owners. It can enter contracts, own property, and even sue or be sued.

Key Features:

• • Limited Liability: Shareholders are only responsible for the money they invest.
  • Separate Legal Entity: The corporation exists independently of its owners, ensuring continuity even if ownership changes.
  • Corporate Taxation: Profits may be taxed twice—first as corporate income and again as dividends paid to shareholders.

Advantages:

• • Easier to raise capital by selling stocks or issuing bonds.
  • Limited liability protects shareholders’ personal assets.
  • Continuity—the business doesn’t end if an owner leaves.

Disadvantages:

• • Double taxation on profits and dividends.
  • Higher costs and more regulations compared to other structures.

Example:

Snap Inc., the company behind Snapchat, went public in 2017. By selling shares, it raised billions of dollars to fund growth, even though it hadn’t yet turned a profit.

1.2.4 Limited Liability Company (LLC)

An LLC blends features of partnerships and corporations, offering flexibility and liability protection.

Key Features:

• • Limited Liability: Owners’ personal assets are protected from business debts.
  • Pass-Through Taxation: Profits are taxed only at the individual level, avoiding double taxation.
  • Flexible Management: Owners can run the business themselves or hire managers.

Advantages:

• • Combines liability protection with tax simplicity.
  • Fewer formalities than corporations.
  • Owners can choose how to manage the business.

Disadvantages:

• • Rules and fees vary by state, adding complexity.
  • Owners may face self-employment taxes.

1. 1. Sole Proprietorship

• • Liability: Unlimited Personal Liability
  • Taxation: Pass-Through (Personal Income Tax)
  • Control: Full Control
  • Complexity: Low
  • Lifespan: Ends with Owner

1. 2. Partnership

• • Liability: Shared or Limited Liability
  • Taxation: Pass-Through (Personal Income Tax)
  • Control: Shared Control
  • Complexity: Moderate
  • Lifespan: Ends with Partner’s Departure (unless specified)

1. 3. Corporation

• • Liability: Limited Liability for Shareholders
  • Taxation: Double Taxation (Corporate & Personal)
  • Control: Board of Directors
  • Complexity: High
  • Lifespan: Perpetual

1. 4. LLC (Limited Liability Company)

• • Liability: Limited Liability for Members
  • Taxation: Pass-Through or Corporate Taxation
  • Control: Flexible (Member or Manager Controlled)
  • Complexity: Moderate
  • Lifespan: Perpetual (if specified in agreement)

1.3 Stocks vs. Bonds

When companies need money, they typically turn to two main sources: stocks and bonds. These financial tools allow businesses to raise capital, but they work very differently. Let’s break them down.

1.3.1 Stocks

Stocks represent ownership in a company. When you buy a stock, you purchase a small part of that company, making you a shareholder. Large corporations can have millions or billions of shares outstanding, so even if you own 100 shares, your ownership is a small fraction. For example, consider the share counts of some prominent companies in early 2023:

• • • Apple Inc. had around 15.8 billion shares outstanding
    • Ford Motor Company had about 4 billion shares
    • Domino’s Pizza had approximately 36 million shares

As a shareholder, you benefit in two main ways:

1. 1. Dividends: If the company earns profits, it may share a portion with you as a dividend. Not all companies pay dividends, as some reinvest profits into growth instead.
   2. Capital Gains: If the company grows and its stock price rises, you can sell your shares for more than you paid, earning a profit.

Key Characteristics of Stocks:

• • Variable Returns: Stock returns depend on the company’s performance and market conditions, so they can fluctuate.
  • Higher Risk, Higher Reward: Stocks are riskier than bonds because their value can change based on market forces, but they offer the potential for significant gains.
  • No Maturity Date: Unlike bonds, stocks don’t expire. You own them indefinitely unless you sell or the company ceases to exist.

Additional Features:

• • Companies often reinvest profits into new products, research, or reducing debt, which can drive future growth and raise the stock price.
  • Some companies may buy back shares, reducing the total number of shares in circulation and increasing the value of each remaining share.

1.3.2 Bonds

Bonds are a form of debt financing. When you buy a bond, you’re essentially lending money to the company or government that issued it. In return, they agree to pay you back with interest.

Key Characteristics of Bonds:

• • Fixed Returns: Bonds usually provide predictable payments (called coupons) and return the principal amount when they mature.
  • Lower Risk, Lower Reward: Bonds are less risky than stocks but generally offer lower returns.
  • Defined Maturity Date: Bonds have a set end date when the borrower repays the principal.

Stocks and bonds are essential tools for raising money, and they each have their place in a well-rounded financial plan. Understanding the differences helps investors and businesses make smarter decisions about how to grow and manage their money.

Key Differences Between Stocks and Bonds:

• • Ownership vs. Loan: Stocks represent ownership in a company, while bonds are loans to the issuer.
  • Risk and Return: Stocks are riskier but offer higher potential rewards. Bonds are safer but typically provide lower returns.
  • Time Horizon: Stocks have no set maturity date, while bonds have fixed terms.
  • Payments: Stock returns come from dividends and capital gains, whereas bonds provide fixed interest payments and principal repayment.

1.4 Goal of the Financial Manager

The financial manager’s role is to make decisions that maximize the company’s value for its shareholders. Think of the financial manager as the strategic decision-maker for the company’s money. This involves three primary responsibilities:

1. 1. Investment Decisions: Where should the company’s money go? Should it invest in new products, expand into new markets, or buy equipment? For example, a financial manager at Tesla might evaluate the costs and benefits of building another Gigafactory.
   2. Financing Decisions: How does the company get the money it needs? Should it borrow through loans, sell shares, or reinvest its profits? Each option comes with trade-offs, like debt obligations or diluted ownership for shareholders.
   3. Managing Cash Flow: Can the company pay its bills and meet its obligations on time? Financial managers ensure there’s enough cash on hand to cover expenses, whether that’s payroll, supplier payments, or debt repayments.

The Big Picture: Maximizing Shareholder Wealth

The financial manager’s ultimate goal is to maximize shareholder wealth, which means increasing the company’s value. To achieve this, they focus on three key factors:

• • Magnitude of Cash Flows: How much money the business generates. Bigger is better.
  • Timeliness of Cash Flows: When the money comes in. Cash sooner is worth more than cash later.
  • Riskiness of Cash Flows: The uncertainty of cash flows. Lower risk is typically preferred, but sometimes taking on risk is necessary for growth.

Why Focus on Cash Flows?

Financial managers prioritize cash flows because:

1. 1. Cash is essential: A business that can’t pay its bills won’t survive, no matter how profitable it looks on paper.
   2. Earnings can be misleading: Accounting practices can manipulate earnings, but cash flow tells a clearer story.
   3. Time matters: Money today is worth more than money tomorrow, thanks to the time value of money.

In Every Department

The financial manager’s role isn’t isolated. Every department contributes to the goal of maximizing value. For instance:

• • Marketing campaigns boost revenue.
  • Operations improve cost efficiency.
  • HR builds a strong workforce.

While the financial manager oversees the numbers, the entire company works together to achieve long-term success.

1.5 Risk Aversion

Risk aversion is the tendency to prefer safer options over riskier ones, even when the riskier choice might offer a higher reward. It’s a core concept in finance because it explains how people make decisions about money, from small personal choices to large corporate investments.

For example:

• • An investor might choose a government bond with a guaranteed 3% return over a stock with an uncertain return that could range from -10% to +10%.
  • A company might delay launching a risky new product until it has more market data, even if early entry could mean bigger profits.

Risk aversion doesn’t mean avoiding risk entirely—it means people and businesses want to be compensated for taking risks. This compensation often comes in the form of higher potential returns.

Why Does Risk Aversion Matter?

Understanding risk aversion is crucial because it shapes:

• • Investment Decisions: Safer investments like bonds are designed for risk-averse individuals, while risk-tolerant investors may lean toward stocks or cryptocurrency.
  • Corporate Strategies: Companies weigh risks when deciding where to invest, balancing potential rewards with the likelihood of failure.

We’ll explore this balance in much greater detail in a later chapter: Risk and Return, where you’ll learn:

• • How risk and expected returns are linked.
  • Ways to measure risk using tools like standard deviation.
  • Strategies like diversification that help manage risk while maximizing returns.

For now, think of risk aversion as a foundational idea that helps explain why people make the financial choices they do—and why risk and reward are always connected.

1.6 Social Responsibility and Ethics

Finance isn’t just about numbers and profits—it’s also about doing the right thing. Businesses operate within communities, and their decisions can have far-reaching effects on people, the environment, and society as a whole. This is where social responsibility and ethics come into play.

1.6.1 Social Responsibility

Social responsibility means that businesses should contribute positively to society. This can involve:

• • Supporting education through scholarships or donations.
  • Protecting the environment by reducing waste or using sustainable materials.
  • Investing in community programs or charitable causes.

Being socially responsible helps businesses build trust and loyalty with customers, employees, and investors. For instance, a company known for ethical practices may attract more customers, boosting its profitability in the long run.

1.6.2 Ethics

Ethics in finance is about making decisions that are fair, honest, and aligned with moral principles. Examples include:

• • Treating employees fairly and ensuring safe working conditions.
  • Honoring commitments to customers and suppliers.
  • Following not just the letter of the law, but its spirit.

In finance, ethical behavior builds a company’s reputation and ensures long-term success. Cutting corners might deliver short-term gains, but unethical practices often lead to scandals, fines, or even bankruptcy.

1.6.3 Why Does it Matter in Finance?

Social responsibility and ethics align with the financial manager’s goal of maximizing shareholder wealth. While these practices may involve costs, they can lead to significant long-term benefits, such as:

• • Enhanced brand reputation.
  • Increased customer loyalty.
  • Better relationships with investors and employees.

Evidence of Positive Impact:

A comprehensive study by Margolis et al. (2009) analyzed 251 studies examining the relationship between social responsibility and firm performance. The findings include:

• • • An overall mean correlation of 0.13, showing a positive relationship.
    • 28% of the studies revealed a statistically significant, positive relationship.
    • 59% indicated no measurable impact.
    • Only 2% showed a statistically negative relationship.

These results suggest that ethical and socially responsible behavior tends to either benefit firms financially or has no substantial negative impact. In essence, companies that engage in responsible behavior may experience increased shareholder wealth, or at the very least, no noticeable financial detriment.

Companies highly rated for their commitment to social responsibility often excel in building trust and loyalty among consumers and investors. For example, firms featured on the Business Ethics List of 100 Best Corporate Citizens showcase the positive impact of integrating ethical practices into their business models.

How This Relates to Maximizing Value

Social responsibility and ethical behavior contribute to a company’s value by building goodwill and trust. While the primary goal of a business is to generate profits, companies that ignore ethics or social responsibility often face backlash—from customers, employees, or regulators—which can hurt their financial performance.

A Broader Perspective

We’ll explore these ideas further throughout the course, but for now, remember:

•Ethics and responsibility are integral to sustainable financial success.

•Businesses that prioritize these principles often perform better in the long run.

1.7 International Issues

In today’s global economy, businesses can no longer focus solely on their domestic markets. Engaging with international customers, suppliers, and investors has become essential for maximizing firm value. This section highlights the importance of thinking globally in finance.

1.7.1 The Global Marketplace

The world is interconnected, offering businesses opportunities to expand their reach beyond national borders. Consider these facts:

• • The U.S. population represents only about 4% of the global population, meaning 96% of potential customers live outside the United States.
  • Similarly, around 75% of global GDP occurs outside the U.S., offering enormous opportunities for growth.

Companies that ignore international markets limit their potential for expansion and risk being left behind by global competitors.

1.7.2 Expanding Opportunities

Operating internationally can significantly impact a company’s financial performance:

• • Increased Cash Flows: Selling products or services in foreign markets opens up new revenue streams.
  • Diversified Risk: By operating in multiple countries, businesses reduce their dependence on any single market, making them more resilient to local economic downturns.

However, international operations also come with challenges, such as:

• • Political instability in certain regions.
  • Currency exchange rate fluctuations.
  • Cultural and regulatory differences.

1.7.3 Real-World Example: S&P 500 Companies

For companies in the S&P 500, around 40-50% of revenue comes from international markets. Take Coca-Cola, for example:

• • The brand is sold in over 200 countries, and much of its revenue comes from outside the U.S.
  • This global presence not only increases revenue but also spreads risk, as poor sales in one region can be offset by strong sales elsewhere.

1.7.4 Balancing Risks and Rewards

While international markets offer growth opportunities, they also introduce additional risks that financial managers must navigate. For example:

• • Currency Risks: A weakening foreign currency could reduce the value of overseas profits when converted back to U.S. dollars.
  • Political Risks: Instability in certain countries could disrupt operations.

Managing these risks requires careful planning, including hedging strategies and thorough market research.

1.7.5 Connecting Back to the Goal of Finance

Expanding internationally aligns with the financial manager’s primary goal of maximizing shareholder wealth by:

• • Increasing the magnitude of cash flows through larger markets.
  • Improving the timeliness of cash flows by accessing regions with favorable economic conditions.
  • Reducing the riskiness of cash flows through diversification.

Looking Ahead

As you progress through this course, you’ll see how international finance ties into key topics like exchange rates, global markets, and managing risk. A global perspective is no longer optional—it’s a necessity for success in today’s financial world.