Lec 03 Introduction to Fm

8/9/2019 Lec 03 Introduction to Fm

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Financial Decisions


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These factors are divided into two parts

1. Micro economic factors Nature and Size of the Firm

Level of Stability in is! and "arnin#s

Li$uidity %osition

&sset Structure and %attern of 'wnership

&ttitude of Mana#ement

(. Macro economic factors The state of the "conomy

)overnment %olicies

ac ors n uenc n# nanc aDecision


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1. %ro,tability

*s the ability to earn a pro,t.

Many start-ups are not pro,table durin# their ,rst oneto three years however a ,rm must become

pro,table to remain viable and provide a return to its

owners.

(. Li$uidity*s a company/s ability to meet its short-term ,nancial

obli#ations. "ven if a ,rm is pro,table it is often a challen#e to

!eep enou#h money in the ban! to meet its routine

obli#ations.

0. "ciency

2ow productively a ,rm utilizes its assets relative to its

revenue 3 its pro,ts.

4. Stability/

Financial 'b5ectives of a Firm


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1. Funds aisin#(. Funds &llocation

0. %ro,t %lannin#4. 6nderstandin# 7apital Mar!ets

&ll the mana#ement decisions should help toaccomplish the #oal of the ,rm

8hat should be the #oal of a ,rm9

Ma:imize pro,t9

Minimize costs9

Ma:imize "arnin# per share9

Ma:imize the current value of the company/s stoc!9

Financial Mana#er ole

Fundamental 'b5ective


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%ro,t is a test of economic eciency.*t/s limitations are1.%ro,t is a va#ue and ambi#uous concept.(.Timin# of ;ene,ts< *t i#nores the di=erences in thetime pattern of the bene,ts received over the wor!in#life of the asset irrespective of when they were received.

0.*t i#nores ris!.

%ro,t Ma:imization

Time

Alternative A (Rs inLakh)

Alternative B (Rs inLakh)

%eriod * >? -

%eriod ** 1?? 1??

%eriod *** >? 1??

Total 200 200

Time Alternative A (Rs inLakh)

Alternative B (Rs inLakh)

ecession @%eriod *A B ?

Normal @%eriod **A 1? 1?

;oom @%eriod ***A 11 (?

i i i i h


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"%S is the total earnin# divided by total number of

shares.

*#nores timin# and ris! of the e:pected bene,t.

Mar!et value is not a function of "%S. 2ence

ma:imizin# "%S will not result in hi#hest price for

companyCs shares.

Ma:imizin# "%S implies that the ,rm should ma!e no

dividend payment so lon# as funds can be invested

at positive rate of returnsuch a policy may not

always wor!.

Ma:imizin# "arnin# %er Share


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8ealth Ma:imization criterion is based on the conceptof cash +ows #enerated by the decision rather than

accountin# pro,t. *t incorporates the time value of money and ris!.

Two important issues related to valueEpricema:imization

"conomic value added is after ta: pro,ts - cost of funds used to ,nance

investments.

Sta!eholders include #roup such as employees

customers suppliers creditors owners and otherswho have a direct lin! to the ,rm.

%rincipal hires an a#ent to represent their interest.

Ma:imization

ency elationship


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2ow would the stoc!holder of a small business react if

they were told that their mana#er canceled all

casualty and liability insurance policies so the moneyspent of premium could #o to pro,t instead.

"ven thou#h the e:pected pro,ts increased by this

action it is li!ely that stoc!holders would be

dissatis,ed because of the increase ris! they would

bear.

8hen the stoc!holders are dissatis,ed they will simply

sell the stoc! of the company.

8hy is Mar!et Galue more important than ;oo! Galue9

;oo! value are often based on dated values. They

consist of the ori#inal cost of the asset from the

past time minus the accumulated depreciation

8hat &bout is!


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ency %roblem is the li!elihood that mana#ers may

place personal #oals ahead of corporate #oals. ency %roblem can be minimized in followin# ways


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Wealth maximization does not preclude therm !rom "ein# sociall$ responsi"lesociall$ responsi"le%

Social esponsibility

7orporate )overnance

&orporate #overnance' represents the

s$stem "$ hich corporations are mana#edand controlled%

*ncludes shareholders+ "oard o! directors+and senior mana#ement%

Then shareholder ealth maximizationremains the appropriate #oal in #overnin#the rm%


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Ten %rinciples That Form

The Foundations ofFinancial Mana#ement

HIalthou#h it is not necessary to understand ,nance in order tounderstand these principles it is necessary to understand theseprinciples in order to understand ,nance.J


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%rinciple 1< The is!-

eturn Trade-o= 8e wont ta!e on additional ris! unless

we e:pect to be compensated withadditional return.

*nvestment alternatives have di=erentamounts of ris! and e:pected returns.

The more ris! an investment has thehi#her its e:pected return will be.


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%rinciple (< The Time

Galue of Money & dollar received today is worth more

than a dollar received in the future.

;ecause we can earn interest on moneyreceived today it is better to receive

money earlier rather than later.


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%rinciple 0< 7ashNot

%ro,ts

*s Kin# 7ash Flow not accountin# pro,t is

used as our measurement tool.

7ash +ows not pro,ts are actually

received by the ,rm and can bereinvested.


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%rinciple 4< *ncremental

7ash Flows

*t is only what chan#es that counts

The incremental cash +ow is thedi=erence between the pro5ected cash+ows if the pro5ect is selected versus

what they will be if the pro5ect is notselected.


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%rinciple >< The 7urse of

7ompetitive Mar!ets *t is hard to ,nd e:ceptionally pro,table

pro5ects

*f an industry is #eneratin# lar#e pro,ts newentrants are usually attracted. The additionalcompetition and added capacity can result inpro,ts bein# driven down to the re$uired rate

of return. %roduct Di=erentiation Service and uality

can insulate products from competition


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%rinciple < "cient

7apital Mar!ets The mar!ets are $uic! and the

prices are ri#ht.

The values of all assets and

securities at any instant in timefully re+ect all availableinformation.


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%rinciple < The ency

%roblem Mana#ers wont wor! for the owners

unless it is in their best interest

The separation of mana#ement and theownership of the ,rm creates an a#encyproblem.

Mana#ers may ma!e decisions that are notin line with the #oal of ma:imization ofshareholder wealth.


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%rinciple O< Ta:es ;ias

;usiness Decisions

The cash +ows we consider are

the after-ta: incremental cash+ows to the ,rm as a whole.


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%rinciple B< &ll is! is Not

"$ual Some ris! can be diversi,ed away

and some cannot

The process of diversi,cation canreduce ris! and as a resultmeasurin# a pro5ects or an assets

ris! is very dicult.


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%rinciple 1?< "thical ;ehavior *s Doin# thei#ht Thin# and "thical Dilemmas &re

"verywhere in Finance

"ach person has his or her own set

of values which forms the basis forpersonal 5ud#ments about what isthe ri#ht thin#

Documents

Lec 03 Introduction to Fm