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Financial ManagementFinancial Management

An IntroductionAn Introduction

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What is Finance Anyway?What is Finance Anyway?

What is this course all about?What is this course all about? Accounting is the language of business.Accounting is the language of business.

Finance uses accounting informationFinance uses accounting informationtogether with other information to maketogether with other information to makedecisions that affect the market value of thedecisions that affect the market value of thefirm.firm.

There areThere are threethree rimary decision areas that rimary decision areas thatare of concern.are of concern.

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Three decision areas in finance!Three decision areas in finance!

Investment decisions " What assets shouldInvestment decisions " What assets shouldthe com any hold? This determines thethe com any hold? This determines theleft"hand side of the balance sheet.left"hand side of the balance sheet.

Financing decisions " #ow should theFinancing decisions " #ow should thecom any ay for the investments it makes?com any ay for the investments it makes?This determines the right"hand side of theThis determines the right"hand side of the

balance sheet. balance sheet. $ividend decisions " What should be done$ividend decisions " What should be done

with the rofits of the business?with the rofits of the business?

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All management decisionsAll management decisionsshould hel to accom lish theshould hel to accom lish the

goal of the firm%goal of the firm%

What should be the goal of the firm?What should be the goal of the firm?

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Many eo le think the goal is toMany eo le think the goal is to

ma&imi'e rofits.ma&imi'e rofits. Would this mean short"term rofit( or long"Would this mean short"term rofit( or long"

term rofit? )usinesses are sometimesterm rofit? )usinesses are sometimescritici'ed for being overly concerned aboutcritici'ed for being overly concerned aboutshort"term rofits results rather than theshort"term rofits results rather than thelong"term strategic ositioning of thelong"term strategic ositioning of thecom any.com any.

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What about risk? Isn*t riskWhat about risk? Isn*t riskim ortant as well as rofits?im ortant as well as rofits?

#ow would the stockholders of a small#ow would the stockholders of a small business react if they were told that their business react if they were told that their

manager canceled all casualty and liabilitymanager canceled all casualty and liabilityinsurance olicies so that the money s entinsurance olicies so that the money s enton remiums could go to rofit instead.on remiums could go to rofit instead.

+ven though the+ven though the expectedexpected rofits increased rofits increased by this action( it is likely that stockholders by this action( it is likely that stockholderswould be dissatisfied because of thewould be dissatisfied because of theincreased risk they would bear.increased risk they would bear.

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The common stockholders areThe common stockholders arethe owners of the cor oration%the owners of the cor oration%

,tockholders elect a board of directors who,tockholders elect a board of directors whoin turn hire managers to ma&imi'e thein turn hire managers to ma&imi'e the

stockholders stockholders well being.well being. When stockholders erceive thatWhen stockholders erceive that

management is not doing this( they mightmanagement is not doing this( they might

attem t to remove and re lace theattem t to remove and re lace themanagement( but this can be very difficultmanagement( but this can be very difficultin a large cor oration with manyin a large cor oration with manystockholders.stockholders.

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More likely( when stockholdersMore likely( when stockholdersare dissatisfied they will sim lyare dissatisfied they will sim ly

sell their stock shares.sell their stock shares.

This action by stockholders willThis action by stockholders willcause the market rice of thecause the market rice of the

com any*s stock to fall.com any*s stock to fall.

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When stock rice falls relativeWhen stock rice falls relative

to the rest of the market -orto the rest of the market -orrelative to the rest of therelative to the rest of theindustry ...industry ...

Management is failing in their /ob toManagement is failing in their /ob toincrease the welfare -or wealth of theincrease the welfare -or wealth of the

stockholders -the owners .stockholders -the owners .

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0onversely( when stock rice is0onversely( when stock rice isrising relative to the rest of therising relative to the rest of the

market -or industry ( ...market -or industry ( ...

Management is accom lishing theirManagement is accom lishing theirgoal of increasing the welfare -orgoal of increasing the welfare -or

wealth of the stockholders -thewealth of the stockholders -theowners .owners .

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Im ortant focal oints in theIm ortant focal oints in thestudy of finance!study of finance!

Accounting and Finance often focus onAccounting and Finance often focus ondifferent thingsdifferent things

Finance is more focused onFinance is more focused on market valuesmarket values rather than book values.rather than book values.

Finance is more focused onFinance is more focused on cash flowscash flows rather than accounting income.rather than accounting income.

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Why is market value moreWhy is market value moreim ortant than book value?im ortant than book value?

)ook values are often based on dated)ook values are often based on datedvalues. They consist of the original cost ofvalues. They consist of the original cost ofthe asset from some ast time( minusthe asset from some ast time( minusaccumulated de reciation -which may notaccumulated de reciation -which may notre resent the actual decline in the assets*re resent the actual decline in the assets*

value .value . Ma&imi'ation of market value of theMa&imi'ation of market value of the

stockholders* shares is the goal of the firm.stockholders* shares is the goal of the firm.

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Why is cash flow more im ortantWhy is cash flow more im ortantthan accounting income?than accounting income?

0ash flow to stockholders -in the form of0ash flow to stockholders -in the form of

dividends is the only basis for valuation ofdividends is the only basis for valuation ofthe common stock shares. ,ince the goal isthe common stock shares. ,ince the goal isto ma&imi'e stock rice( cash flow is moreto ma&imi'e stock rice( cash flow is more

directly related than accounting income.directly related than accounting income.

Accounting methods recogni'e income atAccounting methods recogni'e income attimes other than when cash is actuallytimes other than when cash is actuallyreceived or s ent.received or s ent.

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3ne more reason that cash flow3ne more reason that cash flow

is im ortant!is im ortant!

WhenWhen cash is actually received is im ortant(cash is actually received is im ortant( because it determines when cash can be because it determines when cash can beinvested to earn a return.invested to earn a return.

4Also!4Also! WhenWhen cash must be aid determinescash must be aid determineswhen we need to start aying interest onwhen we need to start aying interest onmoney borrowed.5money borrowed.5

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+&am les of when accounting+&am les of when accountingincome is different from cashincome is different from cash

flow!flow! 0redit sales are recogni'ed as accounting0redit sales are recogni'ed as accounting

income( yet cash has not been received.income( yet cash has not been received. $e reciation e& ense is a legitimate$e reciation e& ense is a legitimate

accounting e& ense when calculatingaccounting e& ense when calculating

income( yet de reciation e& ense is not aincome( yet de reciation e& ense is not acash outlay.cash outlay. A loan brings cash into a business( but isA loan brings cash into a business( but is

not income.not income.

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More e&am les!More e&am les!

When new ca ital e1ui ment is urchased(When new ca ital e1ui ment is urchased(the entire cost is a cash outflow( but onlythe entire cost is a cash outflow( but onlythe de reciation e& ense -a ortion of thethe de reciation e& ense -a ortion of thetotal cost is an e& ense when com utingtotal cost is an e& ense when com utingaccounting income.accounting income.

When dividends are aid( cash is aid out(When dividends are aid( cash is aid out(though dividends are not included in thethough dividends are not included in thecalculation of accounting income.calculation of accounting income.

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$efinitions! 3 erating income vs.$efinitions! 3 erating income vs.

o erating cash flowo erating cash flow 3 erating income 6 earnings before interest3 erating income 6 earnings before interest

and ta&es -+)IT . This is the total incomeand ta&es -+)IT . This is the total incomethat the com any earned by o eratingthat the com any earned by o eratingduring the eriod. It is income available toduring the eriod. It is income available to

ay interest to creditors( ta&es to the ay interest to creditors( ta&es to thegovernment( and dividends to stockholders.government( and dividends to stockholders.

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3 erating cash flow!3 erating cash flow!

3 erating cash flow3 erating cash flow6 +)IT 7 $e reciation " Ta&es.6 +)IT 7 $e reciation " Ta&es.

This definition recogni'es that de reciationThis definition recogni'es that de reciatione& ense is subtracted in com uting +)IT(e& ense is subtracted in com uting +)IT(though it is not a cash outlay.though it is not a cash outlay.

It also recogni'es that ta&es aid is a cashIt also recogni'es that ta&es aid is a cashoutlay.outlay.