The Roles of the Financial Manager

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The Roles of the Financial Manager

• Assessing the financial health of the firm
• Financial analysis
• Ratio Analysis
• Trends
• Industry peers
• (the DuPont model)
• Planning Future Operations
• Forecasting and sustainable growth
• Restructuring
• Operational and Financial

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• Financing the operations of the firm
• Financing growth
• Do we use debt or equity? Why?
• Evaluating Investment Opportunities
• NPV rules
• Business valuation
• EVA
• Working Capital Management
• Current asset management
• Cash management

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The Importance of Financial Statements in Finance

• Why are Financial Statement important to finance?
• Financial Statements are an important window on
  reality.
• Operating policies are reflected in a companys
  financial profile.
• Financial statements provide an objective
  interpretation of the firms condition.

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Balance Sheet

• Snap shot of a firm at one point in time.
• Reports book values
• BV Assets BV liabilities BV Equity
• Influenced by
• Inventory choice
• FIFO, LIFO
• Depreciation choice
• Straight line, MACRS
• Window dressing
• Ultimately of little importance to investors
• You are expected to be familiar with basic
  financial statement form and function.

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Trout Slayer Products

• Fictitious Producer of High-End Fly Fishing Gear
  (not the beer)
• Poor weather and a downturn in the economy
  resulted in lower than expected sales in 2000.
• The following financial data is available

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• Balance Sheet

• What can you tell from this balance sheet?

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• What can you tell from this balance sheet?

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Income Statement

• Dynamic report of performance over some specified
  time period.
• Influenced by
• Operating success
• Financing choices
• Tax management
• But also
• depreciation and inventory choices

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• Example

• What can you tell from this income statement?

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Statement of Cash Flow

• Note that profits do not represent cash flow 
• Credit sales must be collected  
• Accounts payable must be paid etc.
• Cash flow is the lifeblood of a company.
• The statement of cash flow is just one method of
  evaluating cash flow.
• Illustrates that cash flow is impacted in three
  distinct areas.
• Operating activities
• Investment decisions
• Financing decisions

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• Sources and Uses
• Any increase/decrease in asset accounts
  uses/provides cash
• Acquiring new equipment increase PPE (asset) and
  uses cash
• Any increase/decrease in liability accounts
  provides/uses cash
• A new short term bank loan increases notes
  payable (liability) and is a source of immediate
  cash

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Cash Flow Cycle
Changes in Equity
Changes in Liabilities
Taxes
Interest
Dividends
Cash
Collection of Receivables
Cash Sales
A/R
Credit Sales
Production
Inv
Investment
Depreciation
Fixed Assets
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• Example

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• What can you tell about TSP Inc. From its
  Statement of Cash Flow?

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Fin. Statements and the Value Problem

• Market Value vs. Book Value
• Shareholder Equity
• Financial statements report book values
• Value only tangible assets
• What about important intangible assets
• Trademarks
• Patents
• Brand Equity
• Investors buy and sell shares at market value
• Do investors care about the book value of their
  equity?
• Equity investors buy shares for future income

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• Economic vs. Accounting income
• Accountants measure revenues only when realized
• What about unrealized gains
• Discovery of a new drug
• Patented technology
• Do investors really wait for revenues to adjust
  the value of an investment?

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The Value Problem Cont.

• Imputed Costs
• The income sheet includes interest expense but no
  return for shareholders.

Guess
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Question 7

• You are responsible for labor relations in your
  company. During heated labor negotiations, the
  general secretary of your largest union claims,
  Look this company has 10 billion in assets, 5
  billion in equity, and profits of 400 million
  last year due largely to the effort of union
  employees. So dont tell me you cant afford our
  wage demands. How would you reply?

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The Goal of Financial Management

• Maximize Shareholder Wealth
• Shareholders...
• Only real residual claimant
• Cannot afford to be myopic
• The owners of the firm
• Fiduciary responsibility
• Not such valuable goals
• Maximizing EPS
• Maximizing Sales Growth

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Financial Markets and Market Efficiency and Asset
Valuation

• The Value of Financial Instruments
• If we had to define finance in one word it would
  be value.
• Asset valuation, business valuation, strategy
  valuation
• The value of assets is determined by the present
  value of the expected cash flows
• Or the most someone will pay

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• Real Assets vs. Financial Assets
• Real assets are used to produce revenues and cash
  flows.
• When claims to these cash flows are packaged and
  sold they are called financial securities or
  assets.
• Three variables effect the value of financial
  assets
• The claim on future cash flows (expected cash
  flows)
• The right to participate in decision making
• Risk

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Valuation Models (A Review)

• The PV and FV of single payments

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• The PV/FV of an annuity

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• The FV of an annuity

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• For perpetuities
• No growth

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• With constant growth

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• Bonds
• PV (Interest Payments) PV (Principle)
• Inversely related to the required rate of return
• Bond Ratings (Moodys and SP)

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• Stocks
• PV of Dividend Payments

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• Remember the constant growth dividend discount
  model
• Gordon growth model
• D1 is the next period dividend
• g is the expected growth in dividends
• k is investors required return

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• According to this model
• stock price is positively related to Dividends
  and dividend growth
• Negatively related to the required return
• Does this mean that More dividends are always
  better?
• For a firm to increase dividends it must be
  retaining less earnings
• This should result in a lower growth rate
• Div ? then g ?
• g ? then Div ?
• This should have a negative effect on stock price

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• Example
• Assume the following for a hypothetical company
• Expected dividend of 5
• Required return of 12 and a dividend growth rate
  of 9
• The original stock price would be

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• Suppose increasing dividends to 6 per share
  would result in a dividend growth rate of only
  8
• Dividends are up but stock price has fallen

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• This doesnt mean that dividends are always bad
• What if reducing dividends to 4 only increased
  growth to 9.5
• In short
• Increasing dividends benefits shareholders when
  the company can earn more on the retained
  earnings than investors require
• Decreasing dividends benefits shareholders when a
  company is earning less on retained earnings than
  investors require
• This is the basic NPV rule

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• Calculating returns
• Berkshire Hathaways stock originally sold in
  1965 for 15.578 it sold in the fall of 2000 (35
  years later) for 58,100. What is the average
  annual return?

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• i 26
• This is your average annual compound rate of
  return
• Could be called the Internal Rate of Return (IRR)

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The Efficient Market Hypothesis

• States that markets are informationally
  efficient.
• Hypothesizes that current security prices are the
  best estimate of a securities value
• There is no systematic mispricing
• Stock prices react immediately to new information
• Investors can expect to earn a fair return on
  investments
• Price value

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The 3 levels of Market Efficiency

• Weak form efficiency
• If the market is weak form efficient prices fully
  reflect all information about past prices.
• You cannot systematically exploit past pricing
  trends and earn abnormal profits.
• Semi-strong form efficiency
• If the market is semi-strong form efficient,
  prices fully reflect all public information.
• Evidence Most of the pricing impact of
  important announcements is fully realized in
  30-45 minutes.

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• Strong Form Efficiency
• The market is strong form efficient if it
  reflects all information including private
  insider information.
• Obviously it is unreasonable to assume that the
  market is strong form efficient
• However trading on material non public
  information is illegal (in many circumstances)

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Other Evidence

• Malkiel Mutual Fund Research
• The Coin Flipping Exercise
• The success and failure rates of mutual funds
  follow a pattern similar to a coin toss
• Strange challenges to market efficiency
• The January Effect
• The weekend effect
• Holiday Effects
• Statistical significance doesnt always imply
  economic significance

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• Could market crashes really exist in an efficient
  market
• Lets examine a stock with the following
  characteristics
• Expected dividend of 10
• Required return of 15
• Growth of 5
• Thus,

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• What would happen if adverse economic data became
  available and.
• Reduced expected dividends to 9.50
• Increased investors required rate of return to
  16
• Decreased expected growth to 4

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• A 21 drop in price
• Compare this to the crash of 1987
• The market fell 23 in one day Oct. 19th,1987
• In an efficient market prices adjust quickly to
  new information
• Crashes could easily be a result of efficiency
  not evidence of inefficiency
• What does this imply about the markets reaction
  to earnings announcements

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Why Bother?

• If markets are efficient, why bother?
• Perfect Market Timing
• If you invested 1000 in 30-day T-bills in Jan
  1926 your investment would have been worth
  12,186 in 1994
• If you invested 1000 in a portfolio of small
  stocks in Jan 1926 your investment would have
  been worth 2,842,773 in 1994

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• Suppose you could perfectly time the market so
  that each year you rebalanced your portfolio by
  investing in either T-bills or Stocks depending
  on which would perform better for the year. What
  would your perfectly timed portfolio be worth
  in 1994?
• 972,692,500
• What if you timed the market monthly?
• 2,788,068,097,372,240

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Concluding Thoughts

• There are huge incentives for attempting to
  beat the market.
• Perhaps the level of efficiency that exists today
  is a result of all of the efforts to beat the
  market.
• Very little information escapes the eye of
  investors

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• Beating the market may be an attempt to gain
  inside information and exploit strong form
  inefficiencies.
• There exists asymmetric information
• What signal is public information sending
• What signal are we getting when managers choose
  to issue more equity?
• More debt?
• In short the demise of efficient capital markets
  has been greatly exaggerated