Chap-1, An Overview of Financial Management and the Financial Environment' 2015

8/19/2019 Chap-1, An Overview of Financial Management and the Financial Environment' 2015

1/9

1

1-1

1

Financial Management (13th edt)By E.F. Bringham and M.C. Ehrhardt

An Overview of FinancialManagement and the Financial

Environment

1-2

What Is Finance?

Finance is the art and science of managing

money Science? In some situations, its fundamental

concepts, principles, theories, and models can beapplied universally to make decisions

Art? In some situations, precise models cannot becreated/used, rather intuition or insight orcreativity is used to make decisions

1-3

What Is Finance?

At the personal level, finance is concernedwith individuals‟ decisions about:

How much of their earnings they spend

How much they save

How they invest their savings

In a business context, finance involves:

How firms raise money from investors

How firms invest money in to earn profits

How firms decide whether to reinvest profits in thebusiness or distribute them back to investors.

1-4

What Is Corporate or ManagerialFinance?

An important area of finance that deals with

The sources of funding,

The capital structure of firms,

The tools and analysis used to allocate financialresources, and

The actions taken to maximize the firm‟s value

to the shareholders

Continued…

1-5

What Is Corporate or Managerial

Finance?

Is concerned with the duties of the financialmanager working in a business

Helps financial managers administer the

financial affairs of all types of businesses

Tasks include:

Developing a financial plan

Evaluating proposed large expenditures

Raising money to finance the firm‟s operations

Extending credit to customer

1-6

Finance VS Economics & Accounting

Finance grew out of Economics and AccountingEconomics Accounting Finance

Provides structurefor decision makingand suggests thatasset‟s value is

based on its abilityto generate CFs

now and in thefuture

Deals with collectionand presentation offinancial data andmeasures firm‟s

performance

Deals with evaluatingaccounting statement,developing additional data,and making decisions basedon associated risk and returnand makes plans for CFs to

maintain firm‟s solvency

May be positive or

normative

Is backward looking and

deals with historicaldata

Is forward looking and makes

analysis and decisions aboutfuture


2/92

1-7

Finance Within the Organization

Board of Directors

Chief Executive Officer (CEO)

Chief Operating Officer (COO)

Marketing, Production, HumanResources, and Other Operating

Departments

Chief Financial Officer (CFO)

Accounting, Treasury, Credit,Legal, Capital Budgeting, and

Investor Relations

1-8

Four Golden Rules of Finance

If it don‟t jingle, it don‟t count

Risk is the possibility that bad or good things

may happen

The greater the risk, the greater the expected

reward

A $1 today is worth more than a $1 tomorrow

1-9

Basic Forms of Business Organization

Sole Proprietorship

Owned by one person

Operated for personal profit

Unlimited liability

Partnerships (general and limited)

Owned by two or more people

Operated for joint profit

Liable personally and collectively

Run by partnership deedContinued…

1-10

Basic Forms of Business Organization

Corporations

“Legal entity” created by law

Mandatory registration

Legally functions separate and apart from itsowners

Owners‟ liability is limited to the amount of theirinvestment

Owners hold common stock, and ownership can betransferred

1-11

Proprietorships and Partnerships

Advantages

Ease of formation

Subject to few regulations

No corporate income taxes

Disadvantages

Difficult to raise capital

Unlimited liability

Limited life

1-12

Corporation

Advantages

Limited Liability

Permanency

Transferability of

ownership

Better access to capitalmarkets

Disadvantages

Double taxation

Cost of set-up andreport filing

Separation of ownersfrom management


3/93

1-13

Separation of Ownership andControl

Board of Directors

Management

Assets

Debt

Equity

S h a r e h o l d e r s

D e b t h o l d e r s

1-14

Partnership Vs. Corporations

Corporation PartnershipLiquidity Shares can easily be

exchanged.

Subject to substantialrestrictions.

Voting Rights Usually each sharegets one vote

General Partner is incharge; limitedpartners may have

some voting rights.Taxation Double Partners pay taxes

on distributions.Reinvestment and

dividend payout

Broad latitude All NCF is distributedto partners.

Liability Limited liability General partners mayhave unlimited liability.Limited partners enjoylimited liability.

Continuity Perpetual life Limited life

1-15

Becoming a Public Corporation andGrowing Afterwards

Initial public offering (IPO) of stock

Raises cash

Allows founders and pre-IPO investors to

“harvest” some of their wealth

Subsequent issues of debt and equity

1-16

Agency Problems, Agency Costs andCorporate Governance

Agency problem arises when managers act intheir own interests and not on behalf of owners

Agency costs arise from agency problems thatare borne by shareholders and represent a loss ofshareholder wealth

Corporate governance is the set of rules thatcontrol a company‟s behavior towards its directors,

managers, employees, shareholders, creditors,customers, competitors, and community

Can help control agency problems

1-17

Types of Agency Problems

Type-I agency problem: The conflict of interestsbetween managers and stockholders (the „classic‟agency problem)

Type-II agency problem: When controllingstockholders (families) have an incentive to extractprivate benefits of control at the expense of minoritystockholders

Type-III agency problem: Stockholders throughmanagers could take actions to maximize stock pricethat are detrimental to creditors

1-18

Mitigating Agency Problems

Factors affecting managerial behavior:

The role of board of directors*

Managerial compensation packages

Direct intervention by shareholders

The threat of firing

The threat of takeover

Audited financial statements

Corporate governance code (soft laws)


4/94

1-19

The Balance-Sheet Model of the Firm

Continued…1-20


Continued…

1-21


Continued…1-22


1-23

Financial Management Decisions

Capital budgeting What LT investments should we engage in?

Where, when & how to make LT investments?

Capital structure How should we pay for our assets?

Should we use debt or equity or both?

From which source should we raise capital?

Working capital management How do we manage the day-to-day CFs?

Continued…1-24

Financial Management Decisions

Risk Management What financial risks should we take on or hedge

out

Capital Analysis What is something worth?

How can we create value for the firm?


5/95

1-25

Capital Allocation Process

Transfers of capital between savers and users

Direct transfers--businesses issue securities likecommercial papers directly to savers

Indirect transfers--through investment bankinghouse (ICB, IDLC) which underwrites the issue

Indirect transfers--through a financialintermediary where individual deposits money inbanks and banks make commercial loans to firms

1-26

Cash Flows Between the Firm andFinancial Markets

1-27

Types of Securities

Financial securities are simply pieces of paper withcontractual provisions that entitle their owners tospecific rights and claims on specific CFs or values

Debt instruments typically have specified payments anda specified maturity (capital market security, moneymarket security)

Equity instruments are a claim upon a residual value

Derivatives are securities whose values depend on thevalues of some other traded assets (e.g. options, futures,forward, etc.)

1-28

Types of Financial Markets

Physical asset markets (called “real” assetmarkets) are markets for such products as wheat,autos, real estate, computers, and machinery

Financial asset markets deal with stocks, bonds,notes, mortgages, derivatives, and other financialinstruments

Spot markets are the markets where assets arebought or sold for „on-the-spot‟ delivery (literally,within a few days)

Futures markets are the markets where assets arebought or sold for delivery at some future date, suchas 6 months or a year into the future

Continued…

1-29


Money markets are the markets for ST, highly liquiddebt securities (banker‟s acceptance, commercialpaper) with a maturity of less than 1 year

Capital markets are the markets for corporatestocks and debt maturing more than a year in thefuture

Mortgage markets deal with loans on residential,agricultural, commercial, and industrial real estate

Consumer credit markets involve loans for autos,appliances, education, vacations, and so on

Continued…1-30


Primary markets are the markets in which theoriginal security is directly sold to the public by theissuer (corporation/government) with the help ofinvestment banking houses

IPO market is a subset of the primary market. Herefirms “go public” by offering shares to the public forthe first time

Secondary markets are the markets in whichexisting, already outstanding securities are tradedamong investors

Private markets are markets where transactions areworked out directly between two parties


6/96

1-31

The Primary objective of theCorporation

Which one?

Survive?

Avoid financial distress and bankruptcy?

Beat the competition?

Maximize sales or market share?

Maintain steady earnings growth?

Minimize costs?

Maximize profit!!!Maximize profit!!!

Does this mean we should do anything andeverything to maximize profit?

Continued…1-32

Decision rule for managers: Only take actionsthat are expected to increase the share price.

Fig: Financial decisions maximizing stock price


Continued…

1-33


Investment Year 1 Year 2 Year 3 Total (years 1-3)

Rotor 1.40$ 1.00$ 0.40$ 2.80$

Valve 0.60$ 1.00$ 1.40$ 3.00$

Earnings per share (EPS)

Which Investment is Preferred?

Profit maximization may not lead to the highest possible

stock price for at least three reasons:

1. Timing is important —the receipt of funds sooner is preferred

2. Profits do not necessarily result in CFs available to stockholders

3. Profit maximization fails to account for risk

Continued…

1-34


„SHAREHOLDER WEALTH MAXIMIZATION‟

The same as:

Maximizing „market price of stock‟≡

Maximizing „intrinsic value of stock‟≡

Maximizing „value of the equity‟ ≡

Maximizing „value of the firm‟

Continued…

1-35

Why best goal?

A comprehensive goal for the firm, its managers,and employees

This goal can be explored through EVA

This goal avoids actions that prove to bedetrimental to stakeholders

This goal meets triple bottom line

Economic (generating monetary value)

Social (the impact of business on people inside and outside)

Environmental (the total impact on natural environment)


Continued… 1-36

Stock Prices and Intrinsic Value

In equilibrium, a stock‟s price should equal its

“true” or intrinsic value

Intrinsic value is a long-run concept

To the extent that investor perceptions are incorrect, a

stock‟s price in the short run may deviate from itsintrinsic value

Ideally, managers should avoid actions that

reduce intrinsic value, even if those decisions

increase the stock price in the short run


7/97

1-37

Determinants of Intrinsic Values andStock Prices

1-37

“True” InvestorReturns

“True”Risk

“Perceived”Investor Returns

“Perceived”Risk

Managerial Actions, the EconomicEnvironment, Taxes, and the Political Climate

Stock‟sIntrinsic Value

Stock‟sMarket Price

Market Equilibrium:Intrinsic Value = Stock Price

1-38

Is Stock Price Maximization the Sameas Profit Maximization?

No, despite a generally high correlationamongst stock price, EPS, and CFs

Current stock price depends on current as well asfuture earnings and CFs

Some actions may cause earnings to increase, yet

cause the stock price to decrease and vice-versa

1-39

The Goal of Non-Business Firm

To maximize the interests (benefits) ofstakeholders given a set of resources

The goal of a university:

Quality education for the students

Good management for the university

Right contribution to the society and to the country

Financially healthy condition

1-40

Three Basic Questions

Do firms have any responsibilities to societyat large? YES! Shareholders are alsomembers of society

Should firms behave ethically? YES!

Is stock price maximization good or bad for

the society, employees, and customers? YES, Good!

1-41

Stock Price Maximization IncreasesSocial Welfare

To a large extent, the owners of stock are society When a manager takes actions to maximize the stock price, this

improves the quality of life for most citizens as they are shareholders

Consumer benefits Stock price maximization requires eff icient, low-cost businesses that

produce high-quality goods and services at the lowest possible cost.

Employees benefits Companies that successfully increase stock prices also grow and add

more employees, thus benefiting society

Consumer welfare is higher in capitalist free market economies than

in communist economies

1-42

Three Aspects of CFs Affecting AnInvestment‟s Value

Amount of expected CFs (bigger is better)

Timing of the CF stream (sooner is better)

Risk of the CFs (less risk is better)


8/98

1-43

The Big Picture: The Determinants ofIntrinsic Value Using FCF and WACC

Value = + + +FCF1 FCF2 FCF∞

(1 + WACC)1 (1+WACC)∞(1 + WACC)2

Free cash flow

(FCF)

Market interest rates

Firm’s business risk Market risk aversion

Firm’s debt/equity mixCost of debt

Cost of equity

Weighted average

cost of capital(WACC)

Operating costsand taxes

Required investmentsin operating capital

−

=

…

SalesRevenue

−

1-44

FCF The cash available for distribution to all investors after

meeting all expenses and making required investment inoperations to support growth

WACC

The minimum return a company needs to earn to satisfy allof its investors, including stockholders, bondholders, andpreferred stockholders (from investor‟s perspective)

The cost of capital for the firm as a whole (from the firm‟sperspective)

Determined by the capital structure, interest rates, the firm‟srisk, and attitude toward risk

Determinants of a Firm‟s Value

1-45

Equity capital of $50,000 and the required rate of return is12%.

Preferred stock of $10,000 and preferred dividend is 6%.

Bank loan of $20,000 @ 15% interest and tax rate is 40%.

Bonds of $20,000 @ 10% interest and tax rate is 40%.

Calculation of WACC

Funds(1)

Amount(2)

Weight(3)

Rate(4)

WACC(5)=(3)×(4) × (1-t)

Equity $50,000 0.5 0.12 0.5×0.12=0.060

Pref Stock $10,000 0.1 0.06 0.2×.15×(1-0.4) =0.006

Bank Loan $20,000 0.2 0.15 0.2×.15×(1-0.4) =0.018

Bonds $20,000 0.2 0.10 0.2×.10×(1-0.4) =0.012

Total $50,000 1.0 0.096

1-46

The Cost of Money or Fund

For debt, it is the interest rate

For equity, it is the cost of equity consisting of

the dividends and capital gains stockholders

expect

1-47

Factors Affecting the Cost of Money

Production opportunities (the ability to turn

capital into benefits)

Time preferences for consumption (as

opposed to saving for future consumption)

Risk of return

Expected inflation

1-48

Economic Conditions and Policies Affecting the Cost of Money

The policy of central bank

How „open market operations‟ influence the price of T-bills, loanable fund and interest rate

Inverse relation between T-bill‟s price and interest rate

A low interest rates stimulates economy by allowing firms to

borrow fund at a low cost for new projects

The national budget deficit or surplus

Government borrowing by issuing new T-bills

The same impact

Continued…


9/9

1-49


The level of business activities

Interest rates and inflation rise prior to a recession and

fall afterwardsDuring recession: Consumer demand slows, keeping companies from increasing

prices, which reduces price inflation

Companies also cut back on hiring, which reduces wage inflation

Less disposable income causes consumers to reduce theirpurchases of homes and automobiles, reducing consumer

demand for loans

Companies reduce investments in new operations, which reducetheir demand for funds

The cumulative effect is downward pressure on inflation and

interest ratesContinued…

1-50


International trade deficits or surpluses.

Trade deficit is financed by debt

Increased borrowing drives up interest rates

International investors are willing to hold country debtif and only if the risk-adjusted rate paid on this debt iscompetitive

If the trade deficit is large relative to the size of theoverall economy, it will hinder the central bank‟s abilityto reduce interest rates and combat a recession

Continued…

1-51


International country risk

A particular country‟s economic, political, and socialenvironment can increase the cost of money that isinvested abroad

Exchange Rate Risk

The value of an investment depends on what happensto exchange rates.

This is known as exchange rate risk.

Chap-1, An Overview of Financial Management and the Financial Environment' 2015

Documents

Transcript of Chap-1, An Overview of Financial Management and the Financial Environment' 2015