TOPIC I:

INTRODUCTION TO FINANCIAL MANAGEMENT

CONTENTS

Definition to finance Roles of financial manager Basic forms of business organization Goals of the firm Financial markets and institution

DEFINITION OF FINANCE

Activities that earn and use of capital – collecting, using and managing

Concern with the maintenance & creation of economic value or wealth

Focuses on the decision making toward creating wealth

FIVE FOUNDATIONAL PRINCIPLES OF FINANCE

1. Cash flow is what matters2. Money has a time value3. Risk requires a reward4. Market prices are generally right5. Conflicts of interest cause agency problems

Principle 1: Cash flow is what matters

Accounting profits are not equal to cash flows. It is possible for a firm to generate accounting profits but not have cash or to generate cash flows but not report accounting profits in the books.

Cash flow, and not profits, drive the value of a business.

We must determine incremental cash flows when making financial decisions. Incremental cash flow is the difference between

the projected cash flows if the project is selected, versus what they will be, if the project is not selected.

Principle 2:Money has a time value

A dollar received today is worth more than a dollar received in the future. Since we can earn interest on money received

today, it is better to receive money earlier rather than later.

Principle 3:Risk requires a reward

We won’t take on additional risk unless we expect to be compensated with additional reward or return.

Investors expect to be compensated for “delaying consumption” and “taking on risk”. Thus investors expect a return when they put their savings in a

bank (i.e. delay consumption) and they expect to earn a higher rate of return on stocks relative to bank savings account (i.e. taking on risk)

Principle 4: Market prices are generally right

In an efficient market, the prices of all traded assets (such as stocks and bonds) at any instant in time fully reflect all available information.

Thus stock prices are a useful indicator of the value of the firm. Prices changes reflect changes in expected future cash flows. Good decisions will tend to increase the stock prices and vice versa.

Note there are inefficiencies in the market that may distort the prices.

Principle 5: Conflicts of interest cause agency problems

The separation of management and the ownership of the firm creates an agency problem. Managers may make decisions that are not consistent with the goal of maximizing shareholder wealth.

Agency conflict is reduced through monitoring (ex. Annual reports), compensation schemes (ex. stock options), and market mechanisms (ex. Takeovers)

ROLES OF FINANCIAL MANAGERS

Actively manages the financial affairs of any type of business, whether private or public, large or small, profit-seeking or not-for-profit.

Important roles in making decision in a company such as:› Where to invest? (Capital budgeting)› How to raise money to fund the investment? (Capital structure)› How to manage cash flows from daily operations? (Working capital)

The responsibilities of a financial managers including:› Planning and forecasting› Investment and financing decisions› Controlling and coordinating› Transaction in the financial markets› Risk management

The Role of a Financial Manager in a Firm

BASIC FORMS OF BUSINESS ORGANISATION

Business Forms

Sole Proprietorship Partnership Corporation

Sole proprietorship

Business owned by an individual Owner maintains title to assets and profits Unlimited liability Termination occurs on owner’s death or by owner’s

choice

Partnerships

Two or more persons come together as co-owners General Partnership: All partners are fully responsible

for liabilities incurred by the partnership. Limited Partnerships: One or more partners can have

limited liability, restricted to the amount of capital invested in the partnership. There must be at least one general partner with unlimited liability. Limited partners cannot participate in the management of the business and their names cannot appear in the name of the firm.

Corporation

Legally functions separate and apart from its owners Corporation can sue, be sued, purchase, sell, and own property

Owners (shareholders) dictate direction and policies of the corporation, oftentimes through elected board of directors.

Shareholder’s liability is restricted to amount of investment in company

Life of corporation does not depend on the owners … corporation continues to exist through easy transfer of ownership

Taxed separately

The trade-offs: Corporate Form

Benefits: Limited liability, Easy to transfer ownership, Easier to raise capital, Unlimited life (unless the firm goes through corporate restructuring such as mergers and bankruptcies)

Drawbacks: No secrecy of information, maybe delays in decision making, Greater regulation, double taxation.

WRMAS 17

GOALS OF THE FIRM

Maximize PROFIT

Maximize SHAREHOLDER WEALTH

Maximize PROFIT

Many people think the goal is to maximize profits.

However, profit maximization goal is unclear about the time frame over which profits are to be measured. Would this mean short-term profit, or long-term profit?

It is easy to manipulate the profits through various accounting policies.

Profit maximization goal ignores risk and timing of cash flows.

Maximize SHAREHOLDER WEALTH The goal of the firm is to create value for the firm’s owners

(shareholders) Maximize shareholder wealth. Shareholder wealth is measured by share prices. Thus, This is equivalent to saying the goal is to maximize the price

of common stock!

FINANCIAL MARKETS AND INSTITUTION Financial markets play a critical role in capitalist economy.

Financial markets help facilitate the transfer of funds from “saving surplus” units to “saving deficit” units i.e. transfer money from those who have the money to those who need it.

Three ways to transfer capital in the economy:

Money Market Vs. Capital Market

The 2 key financial markets are the MONEY MARKET and theCAPITAL MARKET. Money Market

› Market for short-term debt instruments (maturity < 1 year). Examples: Treasury bills (issued by federal government), commercial paper, negotiable CDs, bankers’ acceptances.

Capital Market› Market for long-term financial securities (maturity > 1 year).

Examples: Corporate Bonds, Common stocks, Treasury Bonds, term loans and financial leases.

Primary Market Vs. Secondary Market

Primary Market (initial issue)• Market in which new issues of a securities are sold to initial buyers.

This is the only time the issuing firm ever gets any money for the securities.

• Example: Google raised $1.76 billion through sale of shares to public in August 2004.

• Seasoned Equity Offering: Sale of additional shares by a company whose shares are already traded in the secondary market.

• Example: Google raised $4.18 billion in September 2005.

Secondary Market (subsequent trading)• Market in which previously issued securities are traded. The issuing

corporation does not get any money for stocks traded on the secondary market.

• Example: Trading among investors today of Google stocks.

Public Offering – Both individuals and institutional investors have the opportunity to purchase securities. The securities are initially sold by the managing investment bank firm. The issuing firm never actually meets the ultimate purchaser of securities.

Initial Public Offering – It is a type of public offering. The first time a company issues its stock.

Private Placement – The securities are offered and sold to a limited number of investors.