An Introduction to Financial Management

Goal of the Firm

1) Profit Maximization?

this goal ignores:

a) TIMING of Returns(Time Value of Money )

b) UNCERTAINTY of Returns(Risk )

Goal of the Firm

2) Shareholder Wealth Maximization?

this is the same as:

a) Maximizing Firm Valueb) Maximizing Stock Price

Legal Forms of Business

1) Sole Proprietorship • A business owned by a single individual.• Owner maintains title to the firm’s assets.• Owner has unlimited liability.

2) Partnership• Similar to a sole proprietorship, except

that there are two or more owners.

2a) General Partnership • All partners have unlimited liability.

2b) Limited Partnership• Consists of one or more general partners,

who have unlimited liability, and• One or more limited partners (investors)

whose liability is limited to the amount of their investment in the business.

Legal Forms of Business

3) Corporation • A business entity that legally functions

separate and apart from its owners.• Owners’ liability is limited to the amount

of their investment in the firm.• Owners hold common stock certificates,

and ownership can be transferred by selling the certificates.

Legal Forms of Business

The Corporation and Financial Markets

cash Investors

Secondarymarkets

Government

securities

Cash flow

reinvest

tax

Corporation

dividends,etc.

CONCEPT OF INVESTMENT

• Concept of Investment

• Today’s sacrifice

• Time value

• Prospective Gain

• Financial Investment

• Extent of liability

• Uncertainty

• Impact of time and risk

Varieties of Securities

• The financial stakes represented by securities are stakes in some

– Business– Government– other legal entity

Constituents of a financial system

Financial System

Financial Financial Financial

assets markets intermediaries

Forex Capital Money Creditmarket market market market

Primarymarket

Secondarymarket

Investment alternatives

Financial assets

Direct investing indirect investing

Mutual Closed end Unit investment funds funds assets

Non marketable Money market Capital market Derivativesecurities

Treasury bills Fixed income common Stock Corporate Futures

Negotiable CDs stock option created Commercial paper Treasuries Repurchase Federal agencies

convertibles agreement Municipals warrantsBankers acceptance Corporates CallsForeign securities Foreign Puts

Mortgage pass throughs Preferred Stock

Characteristics of the financial markets

Market Purpose

Players Regulator

Money Market Short-termfinance

Banks, Govt.,FIs,MFs,

CentralBank

Capital Market Long-termfinance

Companies,Banks,FIs,MFs,individuals

Eg.,SEC,SEBI

Forex Market ForeignCurrencyfinance

Banks, companies, Forex dealers

CentralBank

Credit Market Short/longTerm finance

Banks, FIs CentralBank

Intermediaries operating in financial marketsIntermediary Market Role

Stock exchange Capital market Secondary market for securities

Investment bankers Capital market, credit market

Corporate advisory services/Issue of securities

Underwriters Capital market, money market

Subscribe to unsubscribed portion of securities

Registrars, depositories Capital market Issue securities to the investors on behalf of the issuer and handle share transfer activity

Primary and secondary dealers Money market Market making in government securities

Forex dealers Forex market Facilitate exchange in currencies

Primary and secondary markets

Primary marketMarket in which investors buy newly issued securities and issuers of securities receive the proceeds from the sale.

Secondary marketMarket where previously issued securities are traded among the investors.

Money Market

• Market Characteristics– Wholesale debt market– Market for low risk, highly liquid, short term

instruments– Funds can be raised in this market for periods ranging

from one day to one year• Players in the market– Government – the biggest borrower– Banks– Financial Institutions– Corporations– Mutual funds– Market makers

Money Markets

• Government & Quasi-Government securities– Treasury bills, notes and bonds– Municipal Notes

• Banking sector securities– Call money – interbank funds– Negotiable Certificates of Deposit– Bankers Acceptance

• Corporate sector securities– Commercial paper

The Capital Market

• Market for financing long term investments• Basic instruments for raising finance are shares of

stock (equity) and bonds• Issues are sold to the investing public in the

primary market, through investment bankers- firms that originate, bear the risk of and distribute non-government security issues.

• Stocks and bonds issued in the primary market are traded in the secondary market.

The issuance process for new securities in the primary market

Issuer

Originating invt. banks

Underwriting syndicate of investment banks

Selling groupcomposed of

Underwriting syndicate plus any selected retail brokerage houses

Investors

SECONDARY MARKET TRANSACTION

HOW A TRADE IS MADE

Buyer

Broking Firm

Order

Seller

Broking Firm

Order

Clearing House/Depository

Bid/AskTrade

Execution

Floor Broker

Floor Broker

Broking firm

Broker endorses order & returns to firm

Broker endorses order & returns to firm

Trade confirmation/Settlement

Trade confirmation/Settlement

Secondary Markets

Types of securities Where traded

Equity markets (common stock, Organized exchanges - NSE, BSE,preferred stock, rights & warrants) Regional exchanges

Over the Counter Third market, fourth market

Bond Markets Over-the-counter(Treasuries, agencies, NYSE & ASE (a relatively small amount) municipals, corporates)

Organized exchanges Chicago Board Options Exchange

Derivatives American Stock Exchange(Options & Futures) Pacific Stock Exchange

Philadelphia Stock Exchange,NYSE

Financial Management Axioms• 1) Risk - return trade-off• 2) Time value of money• 3) Cash - not profits - is king• 4) Incremental cash flows count• 5) The curse of competitive markets• 6) Efficient capital markets• 7) The agency problem• 8) Taxes bias business decisions• 9) All risk is not equal• 10) Ethical dilemmas are everywhere in finance