FM 1 Introduction

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Copyright 2009 Pearson Prentice Hall. All rights reserved.

Chapter 1

The Role andEnvironmentof FinancialManagement


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Course Outline

1-2

Topics Chapter number

Introduction of the Subject Chapter 1

Tax Structure and Business Decisions Chapter 2

Time Value of Money Chapter 3

Financial Statement Analysis Chapter 6

Working Capital Management

Capital Budgeting

Chapter 8

Chapter 13

Cost of Capital Chapter 15


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Learning Goals

1. Define finance, its major areas and opportunitiesavailable in this field, and the legal forms of businessorganization.

2. Describe the managerial finance functions (keyactivities) and its relationship to economics andaccounting.

3. Differentiation between Bonds and Shares

4. Differentiation between Preference Shares andCommon Shares.


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Learning Goals (cont.)

5. Explain the goal of the firm, corporate

governance, the role of ethics, and the agency

issue.

6. Understand financial institutions and markets,

and the role they play in managerial finance


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What is Finance?

Finance can be defined as science and art of managing

money.

It is a process which shows that how people allocatetheir resources over some future period to make it

grow.

Finance is concerned with the process whereinstitutions, markets, and instruments involved in the

transfer of money among individuals, businesses, and

governments.


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Major Areas & Opportunities in Finance:

Financial Services

Financial Servicesis the area of finance

concerned with the design and delivery of

advice and financial products to individuals,businesses, and government.

Career opportunitiesavailable in the fields of

banking, financial consultancy, investments,real estate and insurance.


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Managerial Finance

Managerial financeis concerned with the duties of the

financial manager in the business firm.

The financial manageractively manages the financial

affairs of any type of business, whether private or

public, large or small, profit-seeking or not-for-profit.

They are also more involved in developing corporate

strategy and improving the firms competitive position.


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Managerial Finance (cont.)

Increasing globalization has complicated thefinancial management function by requiringthem to be proficient in managing cash flows indifferent currencies and protecting against therisks inherent in international transactions.

Changing economic and regulatory conditions

also complicate the financial managementfunction.


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Figure 1.1 Corporate Organization


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Table 1.3 Career Opportunities inManagerial Finance


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Table 1.1 Strengths and Weaknesses of theCommon Legal Forms of Business Organization


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The Managerial Finance Function

The importance of the managerial finance function

depends on the size of the firm.

In small companies, the finance function may beperformed by the company president or accounting

department.

As the business expands, finance typically evolves into

a separate department linked to the president as was

previously described in Figure 1.1.


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The Managerial Finance Function:

Relationship to Economics

The field of Finance is actually an outgrowth ofEconomics.

In fact, Finance is sometimes referred to asFinancial Economics.

Financial managers must understand theeconomic framework within which they operate

in order to react or anticipate to changes inconditions.


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Relationship to Economics (cont.)

The primary economic principal used by

financial managers is marginal cost-benefit

analysiswhich says that financial decisionsshould be implemented only when added

benefits exceed added costs.


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Relationship to Accounting

The firms Finance (treasurer) and Accounting

(controller) functions are closely-related and

overlapping.

In smaller firms, the financial manager generally

performs both functions.


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Relationship to Accounting (cont.)

One major difference in perspective and

emphasis between Finance and Accounting is

that accountants generally use the AccrualMethod while in Finance, the focus is on cash

flows i.e. the Cash basis of Accounting.

The significance of this difference can beillustrated using the following simple example.


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Sales $100,000 (1 yacht sold, 100% still uncollected)

Costs $ 80,000 (all paid in full under supplier terms)



The ABC Corporation experienced the following

activity last year:

Now contrast the differences in performance under the

accounting method versus the cash method.


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INCOME STATEMENT SUMMARY

ACCRUAL CASH

Sales $100,000 $ 0

Less: Costs (80,000) (80,000)

Net Profit/(Loss) $ 20,000 $(80,000)




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Finance and accounting also differ with respect todecision-making.

While accounting is primarily concerned with the

presentation of financial data, the financial manager isprimarily concerned with analyzing and interpretingthis information for decision-making purposes.

The financial manager uses this data as a vital tool for

making decisions about the financial aspects of thefirm.


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Functions or Activities ofFinancial Manager

Concerns the acquisition, financing,

and managementof assets with someoverall goal in mind.


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Copyright 2009 Pearson Prentice Hall. All rights reserved. 1-21

Figure 1.2 Financial Activities orFunctions


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Investment Decisions

What is the optimal firm size?

What specific assets should be acquired?

Whether current or fixed assets or both.

What assets (if any) should be reduced or

eliminated?

Most important of the threedecisions.


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Investing Activities

WORKING CAPITAL MANAGEMENT

Involves the managing of current assets and current

liabilities.

CAPITAL BUDGETING Making investment in fixed

assets is called Capital Budgeting. It involves the

decision-making process regarding:

o What to invest?o When to invest?

o Why to invest?

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Financing Decisions

What is the best type of financing? Debt or

Equity.

What is the best financing mix? What is the best dividend policy?

Determine how the assets (LHS ofBalance Sheet) will be financed (RHS of

Balance Sheet).


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Asset ManagementDecisions

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. It consists of

almost 60% of total assets.


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2008 Prentice Hall, Inc. All rights reserved. 926

Bonds and Shares

Bonds

Common Shares

Preference Shares

Points ofdistinction

among:


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BONDS vs. COMMON SHARES

EVENTS BONDS COMMON SHARES

STATUS Debt instrument and shown as

long term liability of the

business

Owner of the business, shown

under the head of

Shareholders Equity

RETURN Interest is paid to Bondholders Dividend is paid to

Shareholders

RATE OF RETURN Fixed interest rate Dividend is fluctuating in

nature

DURATION Bonds are issued for a stipulatedperiod

Shares are perpetual, meansperiod for issue of shares is not

mentioned

RISK FACTORE More risky for company Less risky for company

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BONDS vs. SHARES cont---

EVENTS BONDS COMMON SHARES

PAYMENT AT THE

TIME OFLIQUIDATION

The first payment is made to

Bondholders out of the assetsrealized

The Common Shareholders

are paid at the end

VOTIN RIGHT Bondholders have no voting

right

Shareholders enjoy the voting

right

ROLE IN DECISION

MAKING

No role in decision making

process.

As owner of the business, the

shareholders play important

role in decision making

process of the company.

TAX FACTOR No tax payment involved on the

payment of interest , it is tax

deductible.

Dividend is Taxable

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COMMON SHARES VS PREFERNCE


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COMMON SHARES VS PREFERNCE

SHARES

EVENTS COMMON SHARES PREFERNCE SHARES

STATUS Real owner of the business Hybrid equity

RETURN Fluctuating dividend Fixed dividend is paid to

Preference shareholders

DURATION Perpetual ,issued for unlimited

time period

Perpetual but sometimes call

provision is added.

RISK FACTORE Minimum risk for company Carry medium level risk for

the company

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COMMON SHARES VS PREFERNCE SHARES

EVENTS COMMON SHARES PREFERNCE SHARES

PAYMENT AT THE

TIME OFLIQUIDATION

Paid at the end paid ahead of Common Shares

VOTIN RIGHT Bondholders enjoy the voting

right

Dont enjoy the voting right

ROLE IN DECISION

MAKING

As owner of the business, the

shareholders play important role

in decision making process of

the company.

No role in decision making

process.

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As an investor which one you will

prefer?

It depends upon:

o Your risk profile

o Financial position

o Age

o Health condition

o Level of responsibilities



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As an investor which one you will

prefer?

If your financial position is good, enjoying good health,

low responsibility level and willing to take risk, then go

for Common Shares.

On the contrary, due to more responsibilities, you want

to play safe, need fixed income at the end of specified

period, go for Bonds.

Remember,these are not the Hard and Fast Rules Better to have a mixture of both to adjust the risk

factor.



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Investment Year 1 Year 2 Year 3 Total (years 1-3)Rotor 1.40$ 1.00$ 0.40$ 2.80$

Valve 0.60$ 1.00$ 1.40$ 3.00$

Earnings per share (EPS)

Which Investment is Preferred?

Goal of the Firm: Maximize Profit???

Profit maximization fails to account for differences in the level

of cash flows (as opposed to profits), the timing of these cash

flows, and the risk of these cash flows.


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Share Price = Future Dividends

Required Return

level & timingof cash flows

risk of cashflows

Goal of the Firm:

Maximize Shareholder Wealth!!!

Why?

Because maximizing shareholder wealth properly considers cashflows, the timing of these cash flows, and the risk of these cashflows.

This can be illustrated using the following simple stock valuationequation:


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Goal of the Firm:

Maximize Shareholder Wealth!!! (cont.)

The process of shareholder wealth maximization

can be described using the following flow chart:

Figure 1.3 Share Price Maximization

F t i d i fit bilit


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Factors ignored in profitability

concept

Only dividend is considered, whereas, capital

gain is ignored.

Timings of returns is not considered. Quality of benefits is not given the due

importance

Risk involved must beevaluated properly.

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Total return on shares

Dividend which distribution out of the profit

available.

Capital gain you can get by selling the shares inthe Stock Exchange Market.

Gordons formula

Total Yield = Dividend Yield + Capital Yield



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Timings of return

PROJECT A PROJECT B

Year 1 Rs. 20,000 Rs. 10,000

Year 2 15,000 15,000

Year 3 10,000 20,000

TOTAL 45,000 45,000

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Which one is better, A or B ?


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Risk factor

PROJECT A PROJECT B

Highly Risky Rs. 120,000

Less Risky Rs. 120,000

TOTAL RETURN 120,000 120,000

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Quality of returns

PROJECT A PROJECT B

Boom period Rs. 20,000 Rs. 18,000

Normal period 15,000 15,000

Depression 10,000 12,000

TOTAL 45,000 45,000

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The Modern Corporation

There exists a SEPARATION between

owners and managers.

Modern Corporation

Shareholders Management

G l f th Fi


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Goal of the Firm:

What About Other Stakeholders?

Stakeholders include all groups of individuals whohave a direct economic link to the firm includingemployees, customers, suppliers, creditors, owners, and

others who have a direct economic link to the firm. The "Stakeholder View" prescribes that the firm make a

conscious effort to avoid actions that could bedetrimental to the wealth position of its stakeholders.

Such a view is considered to be "socially responsible."


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Corporate Governance

Corporate Governance is the system used to direct and

control a corporation.

It defines the rights and responsibilities of keycorporate participants such as shareholders, the board

of directors, officers and managers, and other

stakeholders.

The structure of corporate governance was previously

described in Figure 1.1.


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Individual versus Institutional Investors

Individual investors are investors who purchase relatively small

quantities of shares in order to earn a return on idle funds, build a

source of retirement income, or provide financial security.

Institutional investors are investment professionals who are paid

to manage other peoples money.

They hold and trade large quantities of securities for individuals,

businesses, and governments and tend to have a much greaterimpact on corporate governance.


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The Role of Ethics: Ethics Defined

Ethicsis the standards of conduct or moral

judgmenthave become an overriding issue in

both our society and the financial community Ethical violations attract widespread publicity

Negative publicity often leads to negative

impacts on a firm


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The Role of Ethics: Considering Ethics

Robert A. Cooke, a noted ethicist, suggests that thefollowing questions be used to assess the ethicalviability of a proposed action:

Does the action unfairly single out an individualor group?

Does the action affect the morals, or legal rights of anyindividual or group?

Does the action conform to accepted moral standards?

Are there alternative courses of action that are less likely tocause actual or potential harm?

Th R l f Ethi


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The Role of Ethics:

Considering Ethics (cont.)

Cooke suggests that the impact of a proposed decision should be

evaluated from a number of perspectives:

Are the rights of any stakeholder being violated?

Does the firm have any overriding duties to any stakeholder?

Will the decision benefit any stakeholder to the detriment of another

stakeholder?

If there is a detriment to any stakeholder, how should it be remedied, if at

all?

What is the relationship between stockholders and stakeholders?

The Role of Ethics


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The Role of Ethics:

Ethics & Share Price

Ethics programs seek to:

reduce litigation and judgment costs

maintain a positive corporate imagebuild shareholder confidence

gain the loyalty and respect of all stakeholders

The expected result of such programs is topositively affect the firm's share price.

The Agency Issue:


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The Agency Issue:

The Agency Problem

Whenever a manager owns less than 100% of the firms equity, a

potential agency problemexists.

In theory, managers would agree with shareholder wealth

maximization.

However, managers are also concerned with their personal

wealth, job security, fringe benefits, and lifestyle.

This would cause managers to act in ways that do not alwaysbenefit the firm shareholders.

The Agency Issue:


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The Agency Issue:

Resolving the Problem

Market Forcessuch as major shareholders andthe threat of a hostile takeover act to keepmanagers in check.

Agency Costs are the costs borne bystockholders to maintain a corporate governancestructure that minimizes agency problems and

contributes to the maximization of shareholderwealth.

The Agency Issue:


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The Agency Issue:

Resolving the Problem (cont.)

Examples would include bonding or monitoring

management behavior, and structuring

management compensation to make

shareholders interests their own.

A stock optionis an incentive allowing

managers to purchase stock at the market priceset at the time of the grant.

The Agency Issue:


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The Agency Issue:

Resolving the Problem (cont.)

Performance planstie management

compensation to measures such as EPS growth;

performance shares and/or cash bonuses are

used as compensation under these plans.

Recent studies have failed to find a strong

relationship between CEO compensation andshare price.


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Financial Institutions & Markets

Firms that require funds from external sources

can obtain them in three ways:

through a bank or other financial institution

through financial markets

through private placements


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Financial Institutions & Markets:


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Financial Markets

Financial marketsprovide a forum in which suppliers

of funds and demanders of funds can transact business

directly.

The two key financial markets are the money market

and the capital market.

Transactions in short term marketable securities take

place in the money market while transactions in long-

term securities take place in the capital market.



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Financial Markets (cont.)

Whether subsequently traded in the money or capitalmarket, securities are first issued through the primarymarket.

The primary market is the only one in which acorporation or government is directly involved in andreceives the proceeds from the transaction.

Once issued, securities then trade on the secondarymarketssuch as Stock Exchange .


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Figure 1.4 Flow of Funds


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The Money Market

The money marketexists as a result of the interaction

between the suppliers and demanders of short-term

funds (those having a maturity of a year or less).

Most money market transactions are made in

marketable securities which are short-term debt

instruments such as T-bills and commercial paper.

Money market transactions can be executed directly or

through an intermediary.


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The Capital Market

The capital market is a market that enables suppliers and

demanders of long-term funds to make transactions.

The key capital market securities are bonds (long-term debt) and

both common and preferred stock (equity).

Bonds are long-term debt instruments used by businesses and

government to raise large sums of money or capital.

Common stock are units of ownership interest or equity in acorporation.


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Capital Gains

A capital gainresults when a firm sells an asset such

as a stock held as an investment for more than its initial

purchase price. The difference between the sales price and the purchase

price is called a capital gain.


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