Financial managemet mba lect 1

LECTURE NO 1

THE ROLE OF FINANCIAL MANAGEMENT

WHAT IS FINANCE ??? Finance is the science of funds management.

Finance includes saving money and often includes lending money. The field of finance deals with the concepts of time, money, and risk and how they are interrelated. It also deals with how money is spent and budgeted.

WHAT IS BUSINESS FINANCE?

Raising and managing of funds by business organizations.

THE ROLE OF FINANCIAL MANAGEMENT

What is Financial Management? The Goal of the Firm Corporate Governance Organization of the Financial

Management Function

WHAT IS FINANCIAL MANAGEMENT?

Concerns the acquisition, financing,

and management of assets with some overall goal in mind.

INVESTMENT DECISIONSMost important of the three

decisions. What is the optimal firm size? What specific assets should be

acquired? What assets (if any) should be

reduced or eliminated? eg. How much of total cash is

devoted to cash or inventory?

FINANCING DECISIONSDetermine how the assets (LHS of

balance sheet) will be financed (RHS of balance sheet).

What is the best type of financing? What is the best financing mix?What is the best dividend policy (e.g.,

dividend-payout ratio)?How will the funds be physically

acquired? eg. Shortterm loan, long term lease

arrangement, stocks or bonds.

ASSET MANAGEMENT DECISIONS

How do we manage existing assets efficiently?

Financial Manager has varying degrees of operating responsibility over assets.

Greater emphasis on current asset management than fixed asset management.

WHAT IS THE GOAL OF THE FIRM?

Maximization of Shareholder Wealth!

Value creation occurs when we maximize the share price for

current shareholders.

SHORTCOMINGS OF ALTERNATIVE PERSPECTIVES

Profit Maximization Maximizing a firm’s earnings

after taxes.Problems Could increase current profits while harming

firm (e.g., defer maintenance, issue common stock to buy T-bills, etc.).

Ignores changes in the risk level of the firm. Decrease in each owners share of profits i.e

earnings per share.

SHORTCOMINGS OF ALTERNATIVE PERSPECTIVES

Earnings per Share Maximization Maximizing earnings after taxes

divided by shares outstanding. Problems Does not specify timing or duration of

expected returns. Ignores changes in the risk level of the firm. Calls for a zero payout dividend policy.

STRENGTHS OF SHAREHOLDER WEALTH MAXIMIZATION

Takes account of: current and future profits and EPS; the timing, duration, and risk of profits and EPS; dividend policy; and all other relevant factors.

Thus, share price serves as a barometer for business performance

THE MODERN CORPORATION

There exists a SEPARATION between owners and managers.

Modern Corporation

Shareholders Management

ROLE OF MANAGEMENT

An agent is an individual authorized by another person, called the principal, to act in the latter’s behalf.

Management acts as an agent for the owners (shareholders) of the

firm.

AGENCY THEORYJensen and Meckling developed a

theory of the firm based on agency theory.

Agency Theory is a branch of economics relating to the behavior of principals and their agents.

AGENCY THEORYPrincipals must provide incentives

so that management acts in the principals’ best interests and then monitor results.

Incentives include, stock options, perquisites, and bonuses.

SOCIAL RESPONSIBILITY Wealth maximization does not

preclude the firm from being socially responsible.

Assume we view the firm as producing both private and social goods.

Then shareholder wealth maximization remains the appropriate goal in governing the firm.

CORPORATE GOVERNANCECorporate governance: represents

the system by which corporations are managed and controlled.Includes shareholders, board of

directors, and senior management.

Then shareholder wealth maximization remains the appropriate goal in governing the firm.

BOARD OF DIRECTORSTypical responsibilities:

Set company-wide policy;Advise the CEO and other senior

executives;Hire, fire, and set the compensation of

the CEO;Review and approve strategy, significant

investments, and acquisitions; andOversee operating plans, capital

budgets, and financial reports to common shareholders.

ORGANIZATION OF THE FINANCIAL MANAGEMENT FUNCTION

Board of Directors

President(Chief Executive Officer)

Vice PresidentOperations

Vice PresidentMarketing

VP ofFinance

THE BUSINESS AND FINANCIAL ENVIRONMENTS

The Business Environment The Financial Environment

THE BUSINESS ENVIRONMENT Sole Proprietorships Partnerships (general and limited) Corporations Limited liability companies

THE BUSINESS ENVIRONMENT Sole Proprietorship -- A business form

for which there is one owner. This single owner has unlimited liability for all debts of the firm.

Oldest form of business organization. Business income is accounted for on the

owner’s personal income tax form.

SUMMARY FOR SOLE PROPRIETORSHIP

Advantages Simplicity Low setup cost Quick setup Single tax filing on

individual form

Disadvantages Unlimited liability Hard to raise additional

capital Transfer of ownership

difficulties

THE BUSINESS ENVIRONMENT

Business income is accounted for on each partner’s personal income tax form.

Partnership -- A business form in which two or more individuals act as owners.

SUMMARY FOR PARTNERSHIP

Advantages Can be simple Low setup cost, higher

than sole proprietorship Relatively quick setup Limited liability for limited

partners

Disadvantages Unlimited liability for the

general partner Difficult to raise

additional capital, but easier than sole proprietorship

Transfer of ownership difficulties

THE BUSINESS ENVIRONMENT

An artificial entity that can own assets and incur liabilities.

Business income is accounted for on the income tax form of the corporation.

Corporation -- A business form legally separate from its owners.

SUMMARY FOR CORPORATION

Advantages Limited liability Easy transfer of

ownership Unlimited life Easier to raise large

quantities of capital

Disadvantages Double taxation More difficult to

establish More expensive to

set up and maintain

THE BUSINESS ENVIRONMENT

Business income is accounted for on each “member’s” individual income tax form.

Limited Liability Companies -- A business form that provides its owners (called “members”) with corporate-style limited personal liability and the federal-tax treatment of a partnership.

LIMITED LIABILITY COMPANY (LLC)

Limited liability Centralized management Unlimited life Transfer of ownership without other owners’

prior consent

Generally, an LLC will possess only the first two of the following

four standard corporation characteristics

SUMMARY FOR LLC

Advantages Limited liability Eliminates double

taxation No restriction on

number or type of owners

Easier to raise additional capital

Disadvantages Limited life

(generally) Transfer of

ownership difficulties (generally)

FINANCIAL ENVIRONMENT

Businesses interact continually with the financial markets.

Financial Markets are composed of all institutions and procedures for bringing buyers and sellers of financial instruments together.

The purpose of financial markets is to efficiently allocate savings to ultimate users.

TYPES OF FINANCIAL MARKETS

Primary market: in which newly issued securities are traded.

Secondary Market: in which previously issued securities are traded

TYPES OF FINANCIAL MARKETS

Money Market: In which securities having maturity less than one year are traded

Capital Market: In which securities having maturity more than a year are traded