SCHOOL OF SLAVONIC AND EAST EUROPEAN

STUDIES

SESS3005: Topics in Financial Management

Week 1

Dr. Eugene Nivorozhkin

Introduction:

Finance and the

Financial System

Bodie, Merton, and Cleeton

Chapters 1 & 2

2

What is Finance?

• Finance is the study of how people allocate scarce resources over

time.

• Distinct from other resource allocation decisions in that the cost and

benefits of financial decisions are:

i. spread out over time; and

ii. uncertain.

• The basic tenet: the existence of the financial system facilitate the

satisfaction of people’s consumption preferences.

• The financial system: set of markets and other institutions used for

financial contracting and the exchange of assets and risks:

– markets for stocks, bonds and other financial instruments;

– financial intermediaries (banks, insurance companies);

– financial service firms (advisory firms);

– regulatory bodies.

3

Financial Decisions: Assets and Liability

• An asset is anything that has economic value,

such as a bank account, a real estate or a share

in a business adventure.

• Asset allocation is the choice of investment.

• Liability is what you owe.

• Net worth= Asset –Liability

4

Financial Decisions: Households

• Consumption and saving –how much to spend

and how much to save?

• Investment–where to invest the savings?

• Financing–when and how to use other people’s

money?

• Risk-management–how much risk should one

take, and how to control it?

5

Financial Decisions: Firms

• Strategic planning–evaluation of costs and benefits over

time to see what business the firm wants to be in.

• To operate firms need capital.– Physical capital–buildings, machines, intermediate inputs.

– Financial capital–stocks, bonds, loans.

• Capital budgeting process–plan of acquisition of assets

and training of personnel to operate each investment

project.

• Capital structure decisions –feasible financing plan for the

firm as a whole.– Determines the claims(fixed payments to bond holders, residuals to share

holders) and control(shareholders).

6

Example of Role of Finance: Business

Organisation

• Sole proprietorship: owned by an individual or a

family, with unlimited liability, i.e. the proprietor’s

other personal assets can be seized to pay debts.

• Partnership: ≥2owners

– limited partners –don’t manage the business

– general partners–unlimited liability

• Corporation: legal entity distinct from owners.

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Example of Role of Finance: Cont’d

• Advantages of Corporations

– Ownership can be transferred without disruption.

– Limited liability, i.e. owners are protected.

– Can appoint professional managers.

– Pooling of resources to achieve scale.

– Risk diversification for owners.

• But: may lead to conflict of interest.

– Managers should serve the best interests of the owners.

– But shareholders do not have the same info / expertise.

– Impractical when the number of shareholders is large.

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Example of Role of Finance: Cont’d

1. Defining goal: Shareholder-Wealth Maximisation

– Profit-maximisation entails ambiguities: multi-period production /

uncertainty.

– Share price is well defined and unambiguous.

– With well-functioning capital markets,

• Shareholders can risk-diversify ⇒only the share value matters.

• The market studies in detail the impact of managers’ decision on the

firm’s value.

2. Market Discipline

– Owners do not have the expertise / information.

– Information is a public good –no incentive to gather info.

– Takeover bidders supply market discipline.

• Thus the existence of a well-functioning stock market facilitate

the separation of ownership / management.9

The Flow of Funds

• Funds flow from surplus

units to deficit units through

markets, intermediaries, or

both.

• Intermediaries are the firms

whose primary business is

to provide financial services

and financial products:

– bank (currentaccounts, loans,

CDs …)

– investment company (mutual

funds …)

– insurance company (life

insurance …) 10

Key Financial Functions I

1. Transferring resources across time & space

– A Dutch household currently has excess funds.

– A Chinese business requires new investment funds now.

– Financial markets make this match.

– Flow of fund from low returns environment to high returns

environment “improves efficiency”.

2. Managing risk

– E.g. insurance companies specialise in risk transfer.

– Risks may be unbundled and repackaged using portfolios, financial

derivatives and guarantees.

3. Clearing and settling payments

– A financial system provides ways of clearing and settling payments

to facilitate the exchange of goods, services, and assets.

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Key Financial Functions II

4. Pooling resources and dividing ownership in large assets

– T-bills have a minimum face value of $10,000. Solution: money

market mutual fund.

– Developing a promising technology would expose a single firm to

too much risk. Solution: joint venture.

5. Providing information

– Provides price information that helps coordinate decentralised

decision-making.

– Quoted prices may be used to estimate the value of similar non-

quoted securities.

– Option prices may be used to determine the market’s assessment

of a stock’s risk.

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Key Financial Functions III

6. Dealing with incentive problems1. Moral hazard –asymmetric information on the action of the insuree

/ borrower.

– E.g. not looking after the business once the loan has been made.

– Solution: collateral on the loan.

2. Adverse selection – asymmetric information on the type of the

insuree / borrower.

– E.g. the less risky will not insure / borrow and the market will be

smaller.

7. Principal-agent problem– E.g. Shareholders and the managers, investors and the portfolio

manager.

– Solution: use the compensation scheme to align the interests of

managers and shareholders.13

Financial Markets

• By Basic Financial Assets:

– Debt: fixed income securities e.g. bonds, loans.

– Equity: common shares-residual claim on assets, with

limited liability.

– Derivatives: forwards, futures and options. Securities

that derive their value from other securities.

• By Maturity:

– Money Market• For short-term debt (less than one year).

– Capital Market• For long-term debt (more than one year) and equities.

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Interest Rates

• The promised rates of return e.g. mortgage rate,

commercial loan rate.

• Depend upon:

1. Unit of account–the medium in which the payments

are denominated. Usually a currency, but may be a

commodity such as gold, silver, a standard “basket” of

goods and services.

2. Maturity–length of time to principal repayment.

3. Default risk – possibility of some portion of the interest

of the principal not being repaid.

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Rates of Return on Risky Assets

• Many assets do not promise a rate of return

– Real estate

– Equity securities

– Works of art

• Return comes from:

• Any cash flows from the asset, such as dividends

• Capital gains

• Rate of return is calculated by,

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Fundamental Determinates of Rates of Return

• Expected productivity of capital goods

• Capital goods productivity uncertainty

– Leads to positive risk premium.

• Time preferences of people

– The greater the preference for current consumption

over future, the higher the rate of interest.

• Risk aversion

– The greater the degree of risk aversion of the

population, the higher the risk premium required.

• The following graphs show the returns of selected

securities and inflation.17

18

Security Returns

-60.00

-40.00

-20.00

0.00

20.00

40.00

60.00

1925 1930 1935 1940 1945 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995

Year

% R

etu

rn

Bills

Bonds

Stocks

Inflation

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Frequency of Returns

0

10

20

30

40

50

60

70

-50 -40 -30 -20 -10 0 10 20 30 40 50

Percent

Pro

ba

bility

Freq_BillsFreq_BondsFreq_StockFreq_Inflation

Inflation and Real Interest Rates

• NominalPrices & Rates

– Prices and rates expressed in terms of currency.

• RealPrices & Rates

– Prices and rates in terms of purchasing power–unit of

account is the standardisedbasket of consumption

goods (c.f. CPI).

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Financial Statements

Bodie, Merton, and Cleeton

Chapter 3

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Financial Statements

• Financial Statements are:

• 1.Balance sheet

• 2.Income statement

• 3.Cash flow statement

• Functions are:

– Provide information to the owners & creditors of a firm about the

current status and past performance.

– Provide a convenient way for owners & creditors to set

performance targets (e.g. ROE) & to impose restrictions on the

managers of the firm.

– Provide a convenient templates for financial planning.

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1. The Balance Sheet

• Summarises a firm’s assets, liabilities, and

owner’s equity at a point in time.

• Amounts measured at historical values and

historical exchange rates.

• Typically prepared according to GAAP (Generally

Accepted Accounting Principles or International

Financial Reporting Standards (IFRS).

• Exchange-listed companies must comply with the

adopted accounting rules.

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GPC Balance Sheet on December 31

25

26

GPC Income Statement

for Year Ending 2xx1

Sales revenues 200.0

Cost of goods sold (110.0)

*Gross margin 90.0

Gen sell, & admin exp (30.0)

*Operating income 60.0

Interest expense (21.0)

*Taxable income 39.0

Income tax (15.6)

*Net income 23.4

Allocation to divs (10.0)

*Chg retained earn 13.4

Summarises the

profitability of a

company during a

time period.

3. The Cash-Flow Statement

• Show the cash that flowed into and from a firm in

during a time period.– Focuses attention on a firm’s cash situation

– Unlike the balance sheet and income statement, cash flow

statements are independent of accounting methods

• E.g. management’s judgment on how to value inventories, or how quickly to

depreciate tangible assets and amortise intangible assets.

• N.B. Working Capital Management:– Working capital= current assets (inventories + acc. rec.) –current

liabilities (accrued expenses + acc. payable).

– Many businesses that fail do so because of poor management of

working capital, not poor profitability.

– One aim is then to reduce the Cash Cycle Time= Inventory period

+ receivable period - payables period.27

GPC Cash Flow Statement, for the Year

ending Dec 31, 2xx1

28

29

GPC Balance Sheet at Dec 31, 2xx1

2xx0 2xx1 Change

Assets

Cash & mkt'ble secs 100.0 120.0 20.0

Receivables 50.0 60.0 10.0

Inventories 150.0 180.0 30.0

*Current assets 300.0 360.0 60.0

Pp&e 400.0 490.0 90.0

Acc depreciation (100.0) (130.0) (30.0)

*Net pp&e 300.0 360.0 60.0

**Total Assets 600.0 720.0 120.0

Liabilities & Equity

Accounts payable 60.0 72.0 12.0

Short-term debt 90.0 184.6 94.6

*Current liabilities 150.0 256.6 106.6

Long-term debt 150.0 150.0 -

**Total liabilities 300.0 406.6 106.6

Paid-in capital 200.0 200.0 -

Retained earnings 100.0 113.4 13.4

*Shareholders equ 300.0 313.4 13.4

Liab + Shareholder 600.0 720.0 120.0

GPC Income Statement

for Year Ending 2xx1

Sales revenues 200.0

Cost of goods sold (110.0)

*Gross margin 90.0

Gen sell, & admin exp (30.0)

*Operating income 60.0

Interest expense (21.0)

*Taxable income 39.0

Income tax (15.6)

*Net income 23.4

Allocation to divs (10.0)

*Chg retained earn 13.4

GPC Cash Flow Statement, for

the Year ending Dec 31, 2xx0

Net income 23.4

+ Depreciation 30.0

- Increase in acc rec (10.0)

- Increase in invent (30.0)

+ Increase in acc pay 12.0

*Total cash from operations 25.4

- Invest in new ppe (90.0)

*Cash flow invest' activities (90.0)

-Div paid (10.0)

+ Inc short-term debt 94.6

*Cash flow from financing 84.6

**Chng cash & mkt securities 20.0

4. Notes to Financial Statements

• Explains accounting methods used

– E.g. depreciation methods

• Details of assets and liabilities

– E.g. Expiration dates for debts

• Details of equity structure

– Conditions attached to ownership of shares

• Documents changes in operation

– Acquisitions and divestitures

• Documents off-balance-sheet items

– Derivatives, employee stock options

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Market vs. Book Values

• The book values (the official accounting values of assets

and shareholders’ equity) do not equal the market values.

Why?

– The book value does not include all of a firm’s assets and

liabilities.

• Intangible assets such as patents and goodwill are included,

but brand loyalty, technological know-how, or a highly trained

loyal workforce are not valued.

• Some contingent liabilities such as law-suits are not routinely

disclosed, or only disclosed in the notes.

– The assets and liabilities on the balance sheet are valued at

original acquisition cost less depreciation.

• Assets of pension funds are now mark-to-marketed.

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Accounting vs. Economic Measures of

Income

• Economist’s Measure of Net Income

– Net cash flow to shareholders plus change in market value of

existing shareholders equity.

• Accountant's Measure of Net Income

– Revenue less Expenses less Taxes

• Example: GPC

• Accounting net income was plus $23,400,000 in 2xx1

• But the total market value of the stock fell from

$200,000,000 to $187,200,000 from year 2xx0 to 2xx1.

The cash dividend to shareholders was $10,000,000. The

economic income in year 2xx1 was minus $2,800,000.

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Returns to Shareholders vs. ROE

• The total shareholder return:

• Traditionally, corporate performance has been

measured by Return on Equity (ROE):

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4.1200$

8.2$

Re

Million

Million

StartPrice

comeEconomicIn

StartPrice

ndsCashDivideStartPriceEndPriceturn

Analysis using Financial Ratios

• Despite the differences in accounting and financial

principles, the published accounts of a firm yield clues

about its financial condition.

• Five aspects of a firm’s performance:

– Profitability – measured w.r.t. sales (ROS), assets (ROA) or equity

base (ROE).

– Asset turnover – the firm’s ability to use its assets productively in

generating revenue (e.g. Sale / Assets = X times).

– Financial leverage – extent of debt and interest payment burdens.

– Liquidity – the firm’s ability to meet its short-term obligations.

– Market value – measures the relation between accounting

representation and the market value, e.g. price to earning (P/E).

• See p.85 Table 3.5 in BMC.

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Financial Planning : Percent-of-Sales Method

• Financial planning is a dynamic process that follows a

cycle of making plans, implementing them, and revising

them in the light of actual results.

– Management forecasts the key external factors, including level of

economic activity, inflation, interest rates, and the competition’s

output and prices.

– Based on above, they forecast revenues, expenses, cash flows,

and implied need for external financing.

• Demonstrate using historical performance of GPC.

• Percent-of-sales method

– First examine which items in the income statement have

maintained a fixed ratio to sales.

• This enables us to decide which items should be forecast on projected

sales, and which need to be forecast on another basis.

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36

GPC Financial Statements, Years xxx1 - xxx3(Nearest $ Million) (Percent of Year's Sales)

Year xxx0 xxx1 xxx2 xxx3 xxx1 xxx2 xxx3

Income Statement

Sales 200 240 288 100.0% 100.0% 100.0%

Cost of goods sold 110 132 158 55.0% 55.0% 55.0%

Gross margin 90 108 130 45.0% 45.0% 45.0%

Selling, general & admin. expenses 30 36 43 15.0% 15.0% 15.0%

EBIT 60 72 86 30.0% 30.0% 30.0%

Interest expenses 30 45 64 15.0% 18.8% 22.2%

Taxes 12 11 9 6.0% 4.5% 3.1%

Net income 18 16 13 9.0% 6.7% 4.7%

Dividends 5 5 4 2.7% 2.0% 1.4%

Change in shareholder's equity 13 11 9 6.3% 4.7% 3.3%

Balance SheetAssets:

Cash & equivalents 10 12 14 17 6.0% 6.0% 6.0%

Receivables 40 48 58 69 24.0% 24.0% 24.0%

Inventories 50 60 72 86 30.0% 30.0% 30.0%

Property, Plant & equipment 500 600 720 864 300.0% 300.0% 300.0%

Total Assets 600 720 864 1037 360.0% 360.0% 360.0%

Liabilities:

Payables 30 36 43 52 18.0% 18.0% 18.0%

Short-term debt 120 221 347 502 110.7% 144.6% 174.2%

Long-term debt 150 150 150 150 75.0% 62.5% 52.1%

Total Liabilities 300 407 540 704 203.7% 225.1% 244.3%

Shareholder's equity 300 313 324 333 156.3% 134.9% 115.7%

Percent-of-Sales Method: Cont’d

• The income statement may now be constructed

given the tax rate and the dividend pay-out ratio

(40% and 30%).

• The change in equity is added to the equity for

year xxx3, to give the new balance for year xxx4.

• “Total assets” is available, so the “Total liabilities”

may now be computed.

37

38

Percent-of-Sales Method: Cont’d

• Complete the balance sheet by recognising that

there are only two accounts that need to be

estimated: Short-term debt, and Long-term debt.

• The sum is then 904 (liabilities) – 62 (payables) =

$842 Million.

• Assuming no change in long-term debt then,

Short-term debt = 842 –150 = $692 million.

• Then in order to grow by 20%, the firm will need

an additional 692 -502 = $190 million in external

funding.

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