An Introduction To The Financial Management

Topic 1

Learning Objectives

1. Explain the definition of financial management.

2. Identify the roles of financial manager.

3. Determine the basic forms of business as well as the advantages and disadvantages of each form of business.

4. Identify and explain the aims of a company.

5. Market and financial institutions.

WRMAS 2

WHAT IS FINANCE?

• A branch of economics concerned with resource allocation as well as resource management, acquisition and investment. Simply finance deals with matters related to money and the markets (Investorword.com).

• Finance can be defined as the art and science of managing money. Finance is concerned with the process, institutions, markets, and instruments involved in the transfer of money among individuals, businesses, and governments (Gitman).

• Is concerned with the maintenance and creation of economic value or wealth (Keown).

WRMAS 3

FOUNDATIONAL PRINCIPLES OF FINANCE

WRMAS 4

Principle 1: Cash flow is what matters Accounting profits are not equal to cash flows. Cash flow drives the value of a business. We must determine incremental cash flows (ICFs) when making

financial decisions. (ICF = Accepted Projected CFs if the project is selected - 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.

Foundational Principles Of Finance

WRMAS 5

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”.

Principle 4: Market Prices are generally Right In an efficient market, the prices of all traded assets (such as stocks

and bonds) is fully reflect all available information. Thus stock prices are a useful indicator of the value of the firm.

Good decisions Increase stock prices Increase expected CFs Note there are inefficiencies in the market that may distort the prices.

Principle 5: Conflicts Of interest cause agency problems Agency problem conflicts of interest between principal (owners)

and agents (managers) due to the separation of management and the ownership.

Managers may make decisions that are not consistent with the goal of the company.

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

Foundational Principles Of Finance

WRMAS 6

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

WRMAS 7

WRMAS 8

BASIC FORMS OF BUSINESS ORGANISATION

WRMAS 9

Business Forms

Sole Proprietorship

Partnership Corporation

Sole Proprietorship

A business owned by a single individual.

Advantages:

Ease of formation

Few regulations

No corporate tax

Complete control and decision-making power

Retention of all profits and assets

Disadvantages:

Financing limitations

Unlimited liability (Incur all losses and debts)

Lacks continuity when proprietor dies

WRMAS 10

Partnerships

Co-owned by 2 or more individuals agreed to form a business in order to get profit based on agreement.

2 types: General partnership All partners have unlimited liability-fully liable for the

indebtedness incurred by the partnership. – Limited partnership Some partners can have limited liability to cash/property

they invested in the firm. There must be at least one general partner with unlimited

liability-actively manage the business, receive a salary, share in profits and losses.

Limited partners (investors) cannot participate in the business management and their names cannot appear in the name of the firm.

WRMAS 11

Partnerships Advantages:

More available brain power and managerial skill

Easy to form

Able to raise capital

Disadvantages:

Unlimited liability

Difficult to transfer ownership

Partnership is dissolved by the death or withdraw of partners

WRMAS 12

Corporation • Legally functions separate and apart from its owners

– Co. can sue, be sued, purchase, sell, and own property

• Owners (shareholders) dictate direction and policies of the company.

• Life of company does not depend on the status of its owners.

• Advantages:

– Limited liability for shareholders

– Ownership can be easily transferred

– Unlimited life (unless the firm goes through corporate restructuring such as mergers and bankruptcies)

– Easy to raise capital

• Disadvantages:

– No secrecy of information

– Maybe delays in decision making

– Greater regulation therefore expensive and complex to form

– Double taxation

WRMAS 13

WRMAS 14

WHAT SHOULD BE THE GOAL OF THE FIRM? • 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!

WRMAS 15

Why is Shareholder Maximization NOT Profit Maximization?

• 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.

WRMAS 16

FINANCIAL MARKETS & INSTITUTION

WRMAS 17

• 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 the CAPITAL MARKET.

Money Market – Market for short-term debt instruments (maturity < 1 year). – Money market is typically a telephone and computer market

(rather than a physical building) 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.

WRMAS 18

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: It refers to 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.

WRMAS 19

FINANCIAL MARKETS & INSTITUTION

• 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.

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

WRMAS 20

WRMAS 21

ROLE OF FINANCIAL MARKET

FIRM

2. Investment

INVESTOR

Secondary

Market

GOVERNMENT

Cash Security

Cash flow

Tax

Reinvest

3. Dividend, etc

1. Primary Market