Part I: Introduction

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Part I Introduction

• Chapter 1 Overview of Managerial Finance /
  Financial Management

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1.1 Financial Management An Intro.

• The business function relating to the decisions
  involving
• What long-term investments should you take on ?
  What lines of businesses ? What sorts of
  buildings, machineries and equipments?
  (Investment Decisions)
• Where will you get the long-term financing to pay
  for your investment? Will you bring in other
  owners or will you borrow the money? (Capital
  Structure Decisions)
• How will you manage your everyday financial
  activities such as collecting from customers and
  paying suppliers? (Working Capital Management
  Decisions)
• How the profit earned by the business shall be
  allocated to the owners? (Dividend Decisions)

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• Financial Management, broadly speaking is the
  study of ways to answer these three questions.
• The maintenance and creation of economic value or
  wealth.
• The study of investment decisions by corporations
  and ways the investment is financed
• Finance uses accounting information together with
  other information to make decisions that affect
  the market value of the firm.
• Conducting all financial matters of the
  organization in a way that ensures that funds are
  used in a proper and efficient manner

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1.2 Financial Management Decisions

• Capital Budgeting/ Investment Decisions (Part IV)
• Capital Structure Decisions/ Financing Decisions
  (Part V)
• Working Capital Management Decisions (Part VI)
• Dividend Decisions (Part V)
• Dividend Decisions are also sometimes considered
  as a part of Capital Structure Decisions.

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1. Capital Budgeting/ Investment Decisions

• The process of planning and managing a firms
  long-term investments.
• The types of investment opportunities that would
  typically be considered depend in part on the
  nature of the firms business.
• Evaluating the size, timing, and risk of future
  cash flows is the essence of capital budgeting.
• The financial manager tries to identify
  investment opportunities that are worth more to
  the firm than they cost to acquire.

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2. Capital Structure Decisions

• A firms capital structure is the specific
  mixture of long-term debt and equity the firm
  uses to finance its operations and long-term
  investments.
• Two concerns of financial manager
• How much of debt and how much of equity should
  the firm borrow? (the mixture chosen will affect
  both, the value and the risk of the firm)-
  optimum debt-equity ratio
• What are the least expensive sources of funds for
  the firm?
• How the firm as a pie is sliced among creditors
  and shareholders?
• How and where to raise the money ?

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3. Working Capital Management Decisions

• Working Capital refers to a firms short-term
  assets, such as inventory, and its short-term
  liabilities, such as money owed to suppliers (a/c
  receivables)
• Day-to-day activity
• Ensuring that firm has sufficient resources to
  continue its operations.
• To avoid costly interruptions.
• Relevant issues
• How much cash and inventory should we keep on
  hand?
• Should we sell in credit ? What should be credit
  policy?
• How shall we obtain needed short-term financing?

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4. Dividend Decisions

• Related to the decisions regarding allocation of
  profit among the shareholders/owners.
• What should be done with the profits of the firm
  ?
• Whether dividend should be distributed or not ?
• How much profit shall be kept in the form of
  retained earnings?
• How much shall be ploughed back to the business?
• Does the distribution of dividend increase the
  value of the firm ?

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Some Fundamental Principles

• Before we begin to study financial management in
  detail, there are two fundamental concepts that
  must be understood
• The right goal of the firm/financial mgt/manager
• The risk/return tradeoff
• These two concepts underlie every major technique
  that we will study

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All management decisions should help to
accomplish the goal of the firm!

• What should be the goal of the firm and hence the
  goal of FM ?

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1.3 Goal of Financial Management

• Possible Goals
• Survive
• Avoid financial distress
• Beat the competition
• Maximize sales of market share
• Minimize costs
• Maintain steady earnings growth

Controlling Risk
Profitability
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Problems with such goals

• Maximize sales or market share
• By lowering price or relaxing credit terms ?
• Minimize cost
• Doing away with things like R D ?
• Avoid distress and bankruptcy
• By never borrowing any money or never taking risk
  ?
• Survive
• What about growth ?
• Beat the competition
• Placing dependence of your activities on
  competitors actions ?

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Is it ?

• Profit Maximization?
• Probably most commonly cited goal
• But even this is not precise objective

WHY ?
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Issues regarding this goal
What about risk from the perspective of
shareholders

• Do we mean profits this year ( current profit )?
• If yes, then why not maximize profit by
• Deferring maintenance
• Letting inventories run down
• Canceling all casualty and liability insurance
  policies so that the money spent on premiums
  could go to profit instead.
• Taking other short-run cost cutting measures
• Shall we be overly concerned about short-term
  profits results rather than the long-term
  strategic positioning of the company ?
• Ok fine ! Lets us refer to some sort of long
  run or average profits.
• Does it give clear definition of what are we
  trying to maximize ?

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Issues regarding this goal (contd)

• Do we mean something like accounting net income
  (NI) or earnings per share (EPS) ?
• If yes, then these accounting numbers may be
  easily manipulated.
• What do we mean by long run ?
• This goal doesnt tell us what the appropriate
  trade-off is between current and future profits.

In the long run, were all DEAD !
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Incorrectness of this goal.

• This goal is inadequate for at least three
  reasons
• It ignores the time value of money
• It ignores risk
• It can lead to a preoccupation with short-term
  results which, in turn, can lead to sub-optimal
  long-term results

We need goal that encompasses both factors
safety and profit
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Correct Goal of the Firm/ FM
Shareholders Wealth Maximization
this is the same as a) Maximizing Firm Value b)
Maximizing Stock Price
Eureka !!!!!
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The Correct Goal of the Firm

• The correct goal of the firm is to maximize
  shareholder wealth (i.e., shareholders equity)
  or, equivalently, to maximize the firms stock
  price.
• By this we mean to imply that the managers of the
  firm work for the shareholders
• For this reason, they have a duty to make
  investments that are expected to increase
  shareholder wealth
• Further, they have a duty to take all investments
  that are expected to increase shareholder wealth

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The Goal of U.S. West Inc.

• From the U.S. West Annual Report to Shareowners
  1988
• Our mission is to provide quality products and
  services to customers in responsive and
  innovative ways in order to create the highest
  possible value for our investors through
  long-term growth and profitability

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The goal of the firm should be to maximize the
stock price!

• This is equivalent to saying the goal is to
  maximize owners wealth.
• Note that the stock price is affected by
  managements decisions affecting both risk and
  profit.
• Stock price can be maintained or increased only
  when stockholders perceive that they are
  receiving profits that fully compensate them for
  bearing the risk they perceive.

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Shareholders Wealth Maximization

• Good decisions increase the value of the stock,
  and poor decisions decrease the value of the
  stock.
• Financial manager should act in the shareholders
  best interest by making decisions that increase
  the value of the stock.
• The goal of FM is thus, to maximize the current
  value per share of the existing stock.
• There is no ambiguity in the criterion, and there
  is no short-run vs long-run issue.
• We explicitly mean that our goal is to maximize
  the current stock value (firms present value)

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Does it seem little strong and one-dimensional ?

• But, remember, shareholders are residual owners.
• They get whats left after employees, suppliers
  and creditors are paid their due.
• If the stockholders are winning in the sense that
  the leftover, residual portion is growing, it
  must be true that everyone else is winning also.
• How to identify those investments and financing
  arrangements that favorably impact the value of
  the stock ?

Thats precisely what we will be studying in FM
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Is stock price maximization the same as profit
maximization?

• No, despite a generally high correlation amongst
  stock price, EPS, and cash flow.
• Current stock price relies upon current earnings,
  as well as future earnings and cash flow.
• Some actions may cause an increase in earnings,
  yet cause the stock price to decrease (and vice
  versa).

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The Goal of Financial Management

• The primary financial goal is shareholder wealth
  maximization, which translates to maximizing
  stock price.
• Do firms have any responsibilities to society at
  large?
• Is stock price maximization good or bad for
  society?
• Should firms behave ethically?

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A more General Goal

• What is the appropriate goal with firm without
  traded stock ?
• It is difficult to say what the value per share
  is at any given time.
• More generally it can be said that the goal is to
  maximize the market value of the existing owners
  equity.

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Goal Objective Advantages Disadvantages
Profit maximization Large amount of profits Easy to calculate profits Easy to determine the link between financial decisions and profits. Emphasizes the short term Ignores risk or uncertainty Ignores the timing of returns Requires immediate resources.
Shareholders Wealth Maximization Highest market value of shares Emphasizes the long term Recognises risk of uncertainty Recognises the timing of returns Consider shareholders return. Offer no clear relationship between financial decisions and share price. Can lead management anxiety and frustration.
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1.4 The Risk/Return Tradeoff

• Throughout financial theory, we assume that
  individuals are risk averse
• This means that individuals prefer less risk to
  more risk
• However, a risk averse individual will accept
  almost any level of risk as long as they are
  properly compensated
• We assume that the risk-return tradeoff is a
  linear function (there is no good evidence that
  it isnt)

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The Risk/Return Tradeoff Graphically

• Assume that there are two projects A and B
• Project B is riskier than project A
• Therefore, we expect that B will, on average over
  time, earn a higher return than A
• Otherwise, nobody would ever invest in B

Return
B
A
B
A
Risk
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Risk-Return Tradeoff in Financial Decisions

• Financial decisions often involve alternative
  courses of action.
• Should the firm set up a plant which has a
  capacity of 1 Mln tons or 2 Mln tons ?
• Should the debt-equity ratio of the firm be 21
  or 11 ?
• Should the firm pursue a generous credit policy
  or niggardly credit policy ?
• Should the firm carry a large inventory or a
  small inventory ?
• Each of alternative actions has different
  risk-return implications.

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Risk-Return Tradeoff (contd.)

• In general, making financial decisions involves
  answering following questions
• What is the expected return ?
• What is the risk exposure ?
• Given the risk-return characteristics of the
  decision, how would it influence value ?

Capital Budgeting Decisions
RETURN
Capital Structure Decisions
Market Value of the Firm
Dividend Decisions
RISK
Working Capital Decisions
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1.5 Organization for the finance function

• The responsibilities for financial management are
  dispersed throughout the organization.
• The engineer, proposing a new plant, shapes the
  investment policy of the firm.
• Marketing analyst provides inputs in the process
  for forecasting and planning.
• Departmental managers, in general, are important
  links in the financial control system of the
  firm.
• However, many of the specialized jobs of the FM
  are attended by specialist.
• These tasks can be distributed between two key
  financial functions viz Treasurership and
  Controllership

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Finance function in a Typical Business
Organization
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Functions of the Treasurer and Controller
Treasurer Controller
Obtaining Finance Financial Accounting
Banking Relationship Internal Auditing
Cash Management Taxation
Credit Administration Management Accounting
Capital Budgeting
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Role of The Financial Manager
Financial
Firm's
Financial
manager
operations
markets
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Other functions of financial officers

• Involvement in injecting financial discipline in
  corporate management processes.
• Monitoring the operations of the firm to achieve
  desired financial results.
• Guide and participate in tasks of planning, funds
  allocation, and control so that the financial
  point of view is sufficiently emphasized in the
  process of corporate management.

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1.6 Agency Problem and the Control of the
Corporation

• Because managers work for the shareholders, they
  are considered to be agents for the shareholders.
• Occasionally, managers may act in their own best
  interest, rather than in the interest of their
  shareholders
• This is known as an agency problem

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Agency Problem

• Shareholders desire wealth maximization (at all
  cost?)
• Do managers maximize shareholder wealth?
• Mangers have many constituencies stakeholders
• Agency Problems represent the conflict of
  interest between management and owners (within
  the agency relationship)

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Agency relationships

• An agency relationship exists whenever a
  principal hires an agent to act on their behalf
  and represent his/her interest.
• Within a corporation, agency relationships exist
  between
• Shareholders and managers
• Shareholders and creditors

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Ownership vs. Management

• Difference in Information
• Stock prices and returns
• Issues of shares and other securities
• Dividends
• Financing

• Different Objectives
• Managers vs. stockholders
• Top mgmt vs. operating mgmt
• Stockholders vs. banks and lenders

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Shareholders versus Managers

• Managers are naturally inclined to act in their
  own best interests.
• But the following factors affect managerial
  behavior
• Managerial compensation plans
• Direct intervention by shareholders
• The threat of firing
• The threat of takeover

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Shareholders versus Creditors

• Shareholders (through managers) could take
  actions to maximize stock price that are
  detrimental to creditors.
• In the long run, such actions will raise the cost
  of debt and ultimately lower stock price.

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Managers and Shareholder Interests

• Tools to Ensure Management Pays Attention to the
  Value of the Firm

• Mangers actions are subject to the scrutiny of
  the board of directors.
• Shirkers are likely to find they are ousted by
  more energetic managers.
• Financial incentives such as stock options

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Solutions

• Agency Problem Solutions
• 1 - Compensation plans tied to financial
  performance in general and oftentimes to share
  value in particular.
• 2 - Board of Directors- elected by shareholders,
  who, in trun hire and fire management.
• 3 - Takeovers
• 4 - Specialist Monitoring
• 5 - Auditors

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Conflict between shareholders and Managers
Owners delegate operational control to agents.
Agents, the managers, have their own goals which
may not be consistent with those of shareholders.
Managers are monitored and selected by directors,
who are elected by shareholders
Shareholders attempt to control managers by

• Using incentives in employment contracts or pay
  with shares, stock options or profit sharing
  Agency cost
• Agency costs are sum of
• monitoring costs of the shareholders
• costs of implementing the control devices
• Exploiting a competitive labor market
• Mounting a takeover offer and casting out the
  current managers

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Agency Costs

• There are two types of costs associated with the
  agency problem
• Direct agency costs are the loss in shareholder
  wealth due to managerial misconduct
• Direct agency cost come in two forms
• Corporate expenditure that benefits management
  but costs the stockholders. Eg. Purchase of a
  luxurious and unneeded corporate jet.
• An expense that arises from the need to monitor
  management actions. Eg. Paying external auditors.
• Indirect agency costs are the costs of avoiding
  the agency problem

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Whose Company Is It?
Survey of 378 managers from 5 countries
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Dividends vs. Jobs
Survey of 399 managers from 5 countries. Which
is more important...jobs or paying dividends?
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Control of Corporation
elections
Board of Directors
selections
Management
Shareholders
operations
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1.7 Relationship of Finance to Economics

• Two important linkages
• Macro-economic environment defines the settings
  within which a firm operates
• Micro-economic theory provides the conceptual
  underpinning for the tolls of financial decision
  making
• Understanding of the macro-economic developments
  sensitizes the financial manager to the
  opportunities and threats in the environment.
• Firm grounding in micro-economic principles
  sharpens his analysis of decision alternatives.
• In fact, finance is applied micro-economics.

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Relationship of Finance to Accounting

• In popular perception finance and accounting are
  often considered indistinguishable or at least
  substantially overlapping.
• Differences and Relationship between the two
• Score Keeping Vs Value Maximizing
• Accrual Method Vs Cash Flow Method
• Certainty Vs Uncertainty
• The accountants role is to provide
  consistently developed and easily interpreted
  data about the firms past, present and future
  operations. The financial manager uses these data
  either in raw form or after certain adjustments
  and analyzes, as an important input to the
  decision-making process

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Something You Should Know Before You Enter Into
the subject of FINANCIAL MANAGEMENT
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The Fundamental Principal of Finance

• A business proposal regardless of whether it
  is a new investment or acquisition of another
  company or a restructuring initiative- raises the
  value of the firm only if the present value of
  the future stream of net cash benefits expected
  from the proposal is greater than the initial
  cash outlay required to implement the proposal

• Investors
• Shareholders
• Lenders

The Business Proposal
Investors provide the initial cash required to
finance the business proposal
The proposal generates cash returns to investors
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Functional Areas Needed to Accomplish the
Strategic Plan
Examples
Team Support
Marketing and Sales
Communication
Recruiting
People
What results must we accomplish in these areas?
GOALS
By what means () are we going to
accomplish these results OBJECTIVES/STRATEGY
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Important focal points in the study of finance

• Accounting and Finance often focus on different
  things
• Finance is more focused on market values rather
  than book values.
• Finance is more focused on cash flows rather than
  accounting income.

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Why is market value more important than book
value?

• Book values are often based on dated values
  (historical costs)
• For current assets, MV and BV might be somewhat
  similar.
• For fixed assets, theyre different by far.
• The MV of financial assets depends on things like
  its riskiness and cash flows, neither of which
  have anything to do with accounting.
• They consist of the original cost of the asset
  from some past time, minus accumulated
  depreciation (which may not represent the actual
  decline in the assets value).
• Maximization of market value of the stockholders
  shares is the goal of the firm.
• Financial manager must be more interested on MV
  than BV.

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Why is cash flow more important than accounting
income?

• Cash flow to stockholders (in the form of
  dividends) is the only basis for valuation of the
  common stock shares. Since the goal is to
  maximize stock price, cash flow is more directly
  related than accounting income.
• Accounting methods recognize income at times
  other than when cash is actually received or
  spent. (Accrual and Matching Principle)

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One more reason that cash flow is important

• When cash is actually received is important,
  because it determines when cash can be invested
  to earn a return.
• Also When cash must be paid determines when
  we need to start paying interest on money
  borrowed.

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Examples of when accounting income is different
from cash flow

• Credit sales are recognized as accounting income,
  yet cash has not been received.
• Depreciation expense is a legitimate accounting
  expense when calculating income, yet depreciation
  expense is not a cash outlay.
• A loan brings cash into a business, but is not
  income.

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More examples

• When new capital equipment is purchased, the
  entire cost is a cash outflow, but only the
  depreciation expense (a portion of the total
  cost) is an expense when computing accounting
  income.
• When dividends are paid, cash is paid out, though
  dividends are not included in the calculation of
  accounting income.

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Definitions Operating income vs. operating cash
flow

• Operating income earnings before interest and
  taxes (EBIT).
• This is the total income that the company earned
  by operating during the period. It is income
  available to pay interest to creditors, taxes to
  the government, and dividends to stockholders.

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Operating cash flow

• Operating cash flow
  EBIT Depreciation - Taxes.
  
• This definition recognizes that depreciation
  expense is subtracted in computing EBIT, though
  it is not a cash outlay.
• It also recognizes that taxes paid is a cash
  outlay.

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Fund Flows via Market
Markets
Surplus Units
Deficit Units
Intermediaries
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Fund Flows via Intermediary
Markets
Surplus Units
Deficit Units
Intermediaries
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Fund Flows via Intermediary and Market
Markets
Surplus Units
Deficit Units
Intermediaries
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Funds Flow via Markets and Intermediaries
Markets
Surplus Units
Deficit Units
Intermediaries
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Funds Flow Disintermediation
Markets
Markets
Surplus Units
Deficit Units
Surplus Units
Deficit Units
Intermediaries
Intermediaries
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The end

• Thank you