Business Organization and Financial markets Some basic concepts Financial management: Lecture 2

Business Organization and Financial markets

Some basic concepts

Financial management: Lecture 2


Today’s agenda

Understand the types and features of business organizations

Understand the goal of corporation and agency problem

Understand financial markets and their functions Understand the concept of the cost of capital and

the time value of money

Organize a business

Types of Business Organizations• Sole Proprietorships

• A business owned and run by one individual

• Partnerships• A business owned by two or more people

• Corporations• A business organized as a separate legal entity

owned by stockholders.


Organize a business


Sole Proprietorship Partnership Corporation

Who owns the business?

The manager Partners Stockholders

Are managers and owners separate?

No No Usually

What is the owner's liability?

Unlimited Unlimited Limited

Are the owner and business taxed

separately?No No Yes

Organize a business


Sole Proprietorships

Corporations

Partnerships

Limited Liability

Corporate tax on profits +

Personal tax on dividends

Unlimited Liability

Personal tax on profits

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Who is The Financial Manager?

Chief Financial Officer

Treasurer Controller

Financial managers

Chief Financial Officer (CFO)• Oversees the treasurer and controller and sets

overall financial strategy. Treasurer

• Responsible for financing, cash management, and relationships with banks and other financial institutions.

Controller• Responsible for budgeting, accounting, and taxes.


The goal of corporation

The financial managers are supposed to maximize shareholders’ wealth or maximize stock prices


Agency problems

Managers, acting as agents for stockholders, may act in their own interests rather than maximizing shareholders’ value.

This conflict of interest between shareholders and managers causes the agency problem.


Career In Finance


Career Annual SalaryCommercial Banking

Loan Officer $ 90,000 +Department Manager $ 200,000 +

Corporate FinanceFinancial Analyst $ 61-78,000Credit Manager $ 73-92,000Chief Financial Officer $ 222-367,000

Investment Banking (bulge bracket)First Year Analyst $ 90-180,000First Year Associate $ 200-350,000Assistant Vice President $ 300-900,000Director/Principal $ 500k - 2 milManaging Director/Partner $ 600k - 30 milDepartment Head $ 1 mil - 70 mil


Financial

Manager

Firm's

operations

Investors

(1) Investors buy shares with cash

(1)

(2)Cash is invested

(2)

(3) Operations generates cash

(3)

(4a) Cash reinvested

(4a)

(4b) Cash returned to investors

(4b)

Financial markets and investors

Real assets

(timberland)

(stockholders save and invest in closely held firm.)

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Corporation

Investment in real assets

Investorsworldwide

Financial markets

Stock marketsFixed-income marketsMoney marketsMarkets for Commodities Foreign exchange Derivatives

Financial Intermediaries

Mutual Funds Pension funds

Financial Institutions

Banks Insurance companies

Reinvestment

Financial Markets

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Total U.S. Financing

27.1

12.6

0.3822.3

28.3

1.4 HouseholdsRest of worldBanksInsurance CosPension FundsMutual FundsOther

% Holdings of Corporate Equities (Qtr 3, 2007)


Financial markets

A financial market • Securities are issued and traded

The classification of the financial market• By seasoning of claim

• Primary market

• Secondary market

• By nature of market• Debt market

• Equity market


Financial markets (continue)

• By maturity of claim• Money market

• Capital market


The functions of financial markets

1. Conducting exchange

2. Providing liquidity

3. Pooling money to fund large corporations

4. Transferring money across time and distance

5. Risk management (hedge, diversify)

6. Providing information

7. Providing efficient allocation of money


Conducting exchange

What does it mean ? Examples


Providing liquidity

What does this mean? Examples


Pooling money to fund large corporation investments



Transferring money across time and distance



Risk management



Providing information



Providing efficient allocation of money



The cost of capital

The cost of capital is a very important concept in capital budgeting.

It links investment opportunities in financial markets and investment opportunities in real assets markets.


What is the cost of capital?

Cash

Investment opportunity (real

asset)Firm Shareholder

Investment opportunities

(financial assets)

Invest Alternative: pay dividend to shareholders

Shareholders invest for themselves

Cost of capital

Cost of capital sometimes is also called • The opportunity cost of your money

• The interest rate

• The discount rate

It is defined as the expected return required by investors for the same risky project in financial markets.


Documents

Business Organization and Financial markets Some basic concepts Financial management: Lecture 2