Chapter 1: An Overview Of Financial Management And Finance

Chapter 1 An Overview Of Financial Management And The Financial Envir

Assume that you recently graduated and have just reported to work as an investment advisor at the brokerage firm of Balik and Kiefer Inc. One of the firm’s clients is Michelle DellaTorre, a professional tennis player who has just come to the United States from Chile. DellaTorre is a highly ranked tennis player who would like to start a company to produce and market apparel she designs. She also expects to invest substantial amounts of money through Balik and Kiefer. DellaTorre is very bright, and she would like to understand in general terms what will happen to her money.

Your boss has developed the following set of questions you must answer to explain the U.S. financial system to DellaTorre:

1. Why is corporate finance important to all managers?
2. Describe the organizational forms a company might have as it evolves from a start-up to a major corporation. List the advantages and disadvantages of each form.
3. How do corporations go public and continue to grow? What are agency problems? What is corporate governance?
4. What should be the primary objective of managers?
   • Do firms have any responsibilities to society at large?
   • Is stock price maximization good or bad for society?
   • Should firms behave ethically?
5. What three aspects of cash flows affect the value of any investment?
6. What are free cash flows?
7. What is the weighted average cost of capital?
8. How do free cash flows and the weighted average cost of capital interact to determine a firm’s value?
9. Who are the providers (savers) and users (borrowers) of capital? How is capital transferred between savers and borrowers?
10. What do we call the cost that a borrower must pay to use debt capital? What two components make up the cost of using equity capital? What are the four most fundamental factors that affect the cost of money, or the general level of interest rates, in the economy?
11. What are some economic conditions that affect the cost of money?
12. What are financial securities? Describe some financial instruments.
13. List some financial institutions.
14. What are some different types of markets?
15. Along what two dimensions can we classify trading procedures?
16. What are the differences between market orders and limit orders?
17. Explain the differences among dealer-broker networks, alternative trading systems, and registered stock exchanges.
18. Briefly explain mortgage securitization and how it contributed to the global economic crisis.

Paper For Above instruction

Financial management serves as the backbone of any enterprise, guiding how companies acquire and allocate resources to maximize value for shareholders. It is pivotal for managers across all levels to understand financial principles because their decisions directly influence a firm’s profitability and sustainability. By understanding the core concepts of corporate finance, managers can better assess investment opportunities, manage costs, and strategize for growth amidst an evolving economic landscape.

Organizational forms of companies develop progressively, from sole proprietorships to multinational corporations. Initially, entrepreneurs might opt for sole proprietorships or partnerships due to ease of setup and lower regulatory requirements. These forms have benefits such as simplicity and direct control but are often limited in raising capital and are subject to unlimited liability. As firms expand, they typically transition into corporations— either private or public— which can raise funds more efficiently via stock issuance, though they are subject to complex regulatory requirements and potential agency problems.

Going public involves a corporation issuing shares on stock exchanges and complying with regulatory disclosures to attract investors and facilitate growth. However, this expansion introduces agency problems—conflicts of interest between managers and shareholders—and emphasizes the importance of effective corporate governance mechanisms that align managerial actions with shareholder interests.

The primary objective of managers is often debated, but widely accepted is the maximization of stockholder wealth, which theoretically aligns corporate actions with shareholder interests. However, firms also have societal responsibilities, and ethical behavior is increasingly recognized as fundamental to sustainable success. Societal impacts are especially relevant in discussions about corporate social responsibility and environmental sustainability, which can influence reputation and long-term profitability.

Investment valuation hinges on cash flows—specifically, the aspects that determine their present value. Free cash flow—the cash generated by a firm after accounting for necessary investments—is a key indicator in valuation models. The weighted average cost of capital (WACC) reflects the average rate a firm must pay to finance its operations through debt and equity, serving as a discount rate for valuation purposes.

The interaction between free cash flows and WACC reveals a firm’s value: higher free cash flows or lower cost of capital increase firm valuation. Capital is transferred between savers—such as individuals, institutions, and pension funds—and borrowers, including corporations and governments, through financial markets. These markets facilitate the flow of capital via financial securities like bonds, stocks, derivatives, and other instruments.

The cost that a borrower pays to use debt capital is termed the interest rate or yield, determined by factors like credit risk, prevailing interest rates, and economic conditions. The cost of equity combines dividend yields and potential capital gains, influenced by market risk premiums, interest rates, company-specific risk, and overall economic stability. The fundamental factors affecting interest rates include inflation expectations, monetary policy, economic growth, and the supply and demand for credit.

Economic conditions such as inflation, unemployment levels, and GDP growth significantly influence the cost of money. Financial securities encompass various instruments—stocks, bonds, options, and derivatives—that enable investors to manage risk and seek returns. Financial institutions such as commercial banks, investment banks, mutual funds, pension funds, and insurance companies facilitate the deployment of capital efficiently across sectors.

Markets can be classified as primary, where new securities are issued, and secondary, where existing securities are traded. Trading procedures are characterized along two dimensions: order type (market vs. limit orders) and trading venue—such as dealer networks, brokerages, or electronic trading platforms.

Market orders execute immediately at the best available price, while limit orders set specific price thresholds for buying or selling. Dealer-broker networks involve intermediaries who buy and sell securities, whereas alternative trading systems provide electronic platforms outside traditional exchanges. Registered stock exchanges are formal marketplaces that regulate trading activities, such as NYSE or NASDAQ.

Mortgage securitization aggregates mortgage loans into securities sold to investors, providing liquidity to lenders and facilitating credit expansion. However, during the 2007–2008 global financial crisis, overreliance on complex mortgage-backed securities and flawed risk assessments contributed to widespread financial instability and the subsequent economic downturn. Proper regulation and risk management are crucial in preventing recurrence of such crises.

References

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