Ch.1 Overview of Financial


Nov 10, 2013 (4 years and 8 months ago)


Ch.1 Overview of Financial
Management and Financial

1. Types of Business Organization:

1) Sole proprietorship

2) Partnership

3) Corporations

4) Hybrid

1) Sole proprietorship


Easily and inexpensively formed

Subject to few government regulations

Avoid corporate income tax


Unlimited personal liability

Limited to the life of the individual who create

Difficult to obtain large sums of capital

2) Partnership

more than one owner.



Easy and inexpensive to set up



Unlimited liability


Limited life


Difficult to transfer ownership

Limited partnership has limited partners and general
partners. Limited partners do not involve in management
and can lose only his or her investment whereas general
partners involve in management and have unlimited
liabilities. In both regular and limited partnerships, at least,
one partner is liable for debts of the partnership. E.g.)
Limited Liability Company or Limited Liability Partnership

3) Corporations

Separation of owners from management.


Unlimited life

Easy transferability of ownership

Limited liabilities


Double taxations: corporate and individual levels

More time consuming documentation and reports:
charter and a set of bylaws

Different types:

Professional Corporation (PC) or Professional
Association (PA). Though Corporation, it does
not allow to relieve professional liability (e.g.
malpractice of doctors, lawyers,

S Corporation: small size business and 100
owners. Taxed like a proprietorship.

2. Growing and managing a Corporation

Agency problem: conflict of interest between
management and shareholders

Corporate governance in order to address
agency problem. Here corporate governance
is a set of rules that control company’s
behavior towards its directors, managers,
hareholders, creditors,
customers, competitors, and community.

3. Primary Objective of Corporation

Stock holders elect directors who then hire
managers to run a corporation

Goal of management is to maximize the
fundamental or intrinsic price
of common
stock rather than the market price.

Maximizing stock price also benefit social
welfare: (1) owners of stock are society, (2)
Consumer benefit resulting from high quality
and low cost, and (3) employees benefit, .

(1) Managerial actions to maximize
shareholder wealth

Firm value is determined by a company’s
ability to generate free cash flows (FCF) now
and in the future. The improvement of FCF will
improve the intrinsic value of a firm.

FCF = sale revenue

operating costs

operating taxes

required new investments in
operating capital.




Here WACC is weighted average cost of capital

4. An overview of the Capital
Allocation Process

1) Direct Transfers

2) Indirect Transfers though Investment
Bankers underwriting the security issues.

3) Indirect Transfer through a Financial
Intermediary such as banks and funds.

Figure 1

5. Financial Securities

1) Major Financial Instruments (Table 1

2) The process of securitization



S&L, banks or specialized mortgage
originating firms originate mortgage and sell
them to investment banks. The investment
bundle them into packages and then use
these package as collateral for bonds sold to
pension funds, insurance and other investors.

Congress facilitated this process by creating two
owned but government sponsored entities

Federal National Mortgage Association (Fannie Mae) and
Federal Home Loan Mortgage Corporation (Freddie Mac)
which have a small amount of equity and a huge amounts
of debt.

Since then, S&L and banks originate and pool mortgage and
then sell them to Fannie Mae which uses them as collateral
in order to sell bonds.

This process (1) increases lendable funds, (2) transfer of risk
of mortgage to Fannie Mae, and (3) increases liquidity for
holders of the debts.

This process benefit investors (lenders) through

bundled mortgage and an improved return.

6. Cost of money

Raised capital is not free.

For debt, borrowers have to pay interest.

For equity, firms have to pay dividends.

4 fundamental factors affecting the cost of money:

1) Production opportunities: The returns available within an economy
from investments in productive assets

(2) Time preferences for consumption: The preferences of consumers
for current consumption as opposed to saving for future consumption.

(3) Risk: The chance that an investment will provide a lower or
negative return

(4) Inflation: The amount by which prices increase over time

Economic conditions and policies that affect the cost of

(1) Federal
reserve policy

FED controls money supply by:


open market operation


discount rate


reserve requirement

(2) Federal
deficit: The larger the deficit, the higher the

(3) Business activity

(4) Foreign
trade balance (deficit or surplus): The larger
the trade deficit, the more we must borrow and this
will drives up the interest

(5) International country risk

7. Financial Institutions

Investment banks: an organization that
underwrites and distributes new investment
securities and helps businesses obtain financing.

Commercial bank: the traditional department
store of finance serving a variety of savers and

Financial services corporation: a firm that offers a
wide range of financial services, including
investment banking, brokerage operations,
insurance, and commercial banking.

Credit union: cooperative association whose members’
savings are loaned only to other members.

Pension funds: retirement funds. Primarily investing in
bonds, stocks, mortgages, and real estate.

Life insurance companies: take premium and invest in
bonds, stocks,

Mutual funds: organizations that pool investor funds to
purchase financial instruments and thus reduce risk
through diversification.


Money market funds: investment in low
securities and allow investors to write checks against
their accounts.

Exchange Traded Funds (ETFs): similar to mutual
funds. ETFs funds buy a portfolio of stocks of
certain type and then sell their own shares to the

Hedge funds: similar to mutual funds.


Mutual funds are registered and regulated by
SEC but hedge funds are largely unregistered.


Minimum investment requirement ( $1 million).

Private Equity Companies: they buy and then
manage entire firms.

8. Financial Markets

1) Physical
asset markets: goods, tangible assets,
real assets markets

Financial markets: claims on real assets (financial

2) Spot and futures markets: assets are bought or
sold for “ on the spot” or for delivery at some
future date.

3) Money markets: financial markets for short term
and high liquid debt securities.

Capital Market: financial markets for intermediate
or long term bonds and stocks.

4) Primary Markets: markets in which corporations
raise capital by issuing new securities.

Secondary market: markets in which existing,
already outstanding, securities are traded. Ex)

5) Private market: The market where transactions
are worked out directly between two parties. Ex)
bank loan or private debt placement

Public market: The market where standardized
contracts are traded on organized exchange. Ex)
issuing securities or public debts

9. Trading Procedure

Two basic types of stock markets

Physical location exchange: NYSE, AMEX and regional stock

Electronic dealer
based markets:
, over the counter and
electronic communication networks (ECNs)

Matching buy and sell orders:

Outcry: meet and communicate with shout and hand signals.

Dealers market: list bid and ask quotes and then contact a specific
dealer to match.

Electronic communication network (ECN): post buy and sell prices
and then ECN automatically match with close prices.
) Instinet
and Archipelago.

3) Types of stock market transactions:


oing public and seasoned equity offering.

10. Secondary stock market

1) New York Stock Exchange

Privately held firm owned by members and merged with
Archipelago. The merged one also has Pacific Exchange.

The NYSE group merged with Euronext in 2007 and became NYSE

organization having tangible physical locations that conduct
auction markets in designated (“listed”) securities.

More than 300 members
in NYSE had seats giving rights to trade on
the exchange.
The trading license is also leased. Most
of the larger
investment banks operate brokerage
departments or members with
the leased trading licenses.

2) National Association of Securities Dealers (NASD) or

regulatory body that licenses brokers and oversees
trading practices.

Its own listing requirement.

More than 400 dealers making a market, generating
good liquidity.


OTC Bulletin Board, which lists quotes
for stocks that are registered with the SEC but are not
listed on any exchange because of small size or less


operates Pink Sheet which provides quotes on
company that are not registered with SEC.

11. Stock market performance

Figure 1

The Global Economic

Assignment 1: Summarize page 36 to 42