What Is Finance?

An Overview of Financial
Management

Finance is the art and science of

managing money
Why science?
because in some situations its fundamental
concepts, principles, theories, and models can be
applied universally to make decisions

Why art?
because in some situations precise models cannot
be created and intuition is used to make decisions

Financial Management (11th edt)

By E.F. Bringham and M.C. Ehrhardt

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What Is Finance?

What Is Financial Management?

Finance is concerned with

---the process, institutions, markets, and

instruments involved in the
---transfer of money among individuals,
businesses, and governments

FM is the managerial activity concerned

with planning and controlling of a firms
financial resources
---to create and maintain the economic
value (wealth) of the firm, and

Financial management or managerial

finance is the branch of Finance

---to use corporate resources efficiently to

achieve the goals of the firm
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What Is Managerial Finance?

Finance VS Economics & Accounting

MF deals with the duties/responsibilities

of the financial manager working in a
business

Focuses on monetary decisions, tools and analysis

used to make these decisions
Shows how to improve financial conditions of a
company

Finance grew out of Economics and

Accounting
Economics provides structure for decision
making and suggests that assets value is based
on its ability to generate cash CFs now and in
the future.
Accounting provides financial data regarding
the likely size of those CFs.

Attempts to maximize shareholder value while

managing risks

Finance links economic theory with the

numbers of accounting
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Finance Vs. Accounting

Areas of Specialization in Finance

Accounting

Finance

Backward looking

Forward looking

Accounting focuses
on collection and
presentation of
financial data

Finance focuses on evaluating

accounting statement,
developing additional data, and
making decisions based on
associated risk and return

Accountant measures
firms performance

Financial manager plans CFs to

maintain firms solvency

Financial Markets
Markets for users and savers of funds.

Financial Services
Design and delivery of financial advice and
products to individuals, businesses,
government.

Managerial Finance
Financial management of business firms.

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Functions of the Financial Manager

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Hypothetical Organization Chart

Board of Directors
Chairman of the Board and
Chief Executive Officer (CEO)
President and Chief
Operating Officer (COO)
Vice President and
Chief Financial Officer (CFO)

Treasurer

Controller

Cash Manager

Credit Manager

Tax Manager

Cost Accounting

Capital Expenditures

Financial Planning

Financial Accounting

Data Processing

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Financial Management Decisions

Capital budgeting
What LT investments should we engage in?
Where, when & how to make LT investments?

Capital structure

Financial Management Decisions

Risk Management
What financial risks should we take on or
hedge out

How should we pay for our assets?

Should we use debt or equity or both?
From which source should we raise capital?

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Capital Analysis
What is something worth?
How can we create value for the firm?

Working capital management

How do we manage the day-to-day CFs?
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The Balance-Sheet Model of the Firm

Total Value
of Assets:

The Balance-Sheet Model of the Firm

The Capital Budgeting Decision

Total Firm Value

to Investors:
Current
Liabilities

Current Assets

Current
Assets

Long-Term
Debt

Fixed Assets

Fixed Assets

1 Tangible

Shareholders
Equity

1 Tangible
2 Intangible

2 Intangible

What LT
investments
should the
firm engage
in?

Shareholders
Equity
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The Balance-Sheet Model of the Firm

The Net Working Capital Investment Decision

The Capital Structure Decision

Current
Liabilities

Current
Assets

1 Tangible

Long-Term
Debt

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The Balance-Sheet Model of the Firm

Fixed Assets

Current
Liabilities

How can the

firm raise the
money for the
required
investments?

2 Intangible

Current
Assets

Long-Term
Debt

Fixed Assets
1 Tangible

Shareholders
Equity

2 Intangible

Current
Liabilities
Net
Working
Capital

How much ST
CF does a firm
need to pay its
bills?

Long-Term
Debt

Shareholders
Equity

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Types of Markets

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Types of Markets

Financial Market--market for financial assets

(securities) such as stocks, bonds, currencies,
and derivatives

Capital Market--financial market for stocks

and intermediate & LT debt

Money Market--financial market for ST debt

securities (B/A, commercial paper, T-bills with
a maturity of less than 1 year

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Primary market--a part of capital market in

which security is directly sold to the public by
the issuer
Secondary market--market in which
securities are traded after they have been
initially offered
Spot market--market for assets which are
bought or sold for on-the-spot delivery
Future market--market for commodity, and
future contracts for delivery at a specified
future date

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Basic Forms of Business

Organization

Basic Forms of Business

Organization

Sole Proprietorship

Owned by one person

Legal entity created by law

Operated for personal profit

Unlimited liability

Corporations
Mandatory registration
Legally functions separate and apart from its
owners.

Partnerships (general and limited)

Owners liability is limited to the amount of their

investment

Owned by two or more people

Operated for joint profit

Owners hold common stock, and ownership can

be transferred

Liable personally and collectively

Run by partnership deed
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Partnership Vs. Corporations

Corporation

Partnership

Liquidity

Shares can easily be

exchanged.

Subject to substantial
restrictions.

Voting Rights

Usually each share

gets one vote

Taxation

Double

General Partner is in
charge; limited
partners may have
some voting
Partners
payrights.
taxes

Reinvestment and
dividend payout

Broad latitude

Liability

Limited liability

Continuity

Perpetual life

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Sole Proprietorships & Partnerships

Advantages
Ease of formation
Subject to few regulations
No corporate income taxes

on distributions.
All NCF is distributed
to partners.

Disadvantages
Difficult to raise capital

General partners may

have unlimited liability.
Limited partners enjoy
limited liability.
Limited life

Unlimited liability
Limited life
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Separation of Ownership and

Control

Corporation

Advantages

Board of Directors

Disadvantages
Difficult to set up and
report filing

Transferability of
ownership

Separation of owners
from management

Better access to
capital markets

Double taxation

Management
Debt

Less control

Assets

Shareholders

Permanency

Debtholders

Limited Liability

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Equity
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Rights of Ownership

Characteristics of Corporation

Ownership
Stock holders are the owners of the corporation

Dividend Rights

Voting Rights
Majority voting--one vote per share per director
Cumulative voting--one can cast all votes for a
single candidate

Control
Ultimate control rests with the stock holders, but
managers control day-to-day operations

Liquidation Rights
The right of a firms residual value in the event of
liquidation

Risk Bearing
Shareholders bear all residual risk

Preemptive Rights
The right to subscribe proportionally to any new
shares issued by the firm

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The Goal of the Corporation

The Goal of the Corporation

What should be the goal of a corporation?

Which Investment is Preferred?

To survive?
To avoid financial distress and bankruptcy?
To beat the competition?
To maximize sales or market share?
To maintain steady earnings growth?
To minimize costs?

Earnings per share (EPS)

Investment

To maximize profit???
Does this mean we should do anything and
everything to maximize profit?

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

Profit maximization
Fails to account for differences in the level of CFs
Does not consider the timing of these CFs
Does not consider the risk of these CFs.

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The Goal of the Corporation

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The Goal of the Corporation

To

maximize shareholder wealth

market price of stock value of firm

Why

This

can be illustrated using the following

simple stock valuation equation:

best goal?

A comprehensive goal for the firm, its managers,

and employees
This goal can be explored through economic
valued added (EVA)
This goal focuses on stakeholders
This goal meets triple bottom line (economic,
social and environmental)
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Is Stock Price Maximization the Same

as Profit Maximization?

The Goal of the Corporation

The process of shareholder wealth
maximization can be described using the
following flow chart:

No,

despite a generally high correlation

amongst stock price, EPS, and CFs
Current stock price depends on current as well as
future earnings and CFs

Financial
Manager

Financial
Decision
Alternative
or Actions

Return?
Risk?

Increase
Share
Price?

Yes

Some actions may cause earnings to increase,

yet cause the stock price to decrease (vice-versa)

Accept

No
Reject

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What about Stakeholders?

The Goal of Non-Business Firm

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To maximize the interests (benefits) of

stakeholders given a set of resources.

Example: The goals of a university:

Stakeholders include groups that have

direct economic links to the firm
Owners, employees, customers, suppliers, and
creditors

Quality education for the students

Good management for the university

Right contribution to the society and to the

country

Maintaining positive relationships with

stakeholders helps maximize LT benefits to
shareholders

Financially healthy condition

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Stock Price Maximization Increases

Social Welfare

Three Basic Questions

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Do firms have any responsibilities to society

at large?

Society receives benefits as owners of stocks

Increased stock price give society benefits

Is stock price maximization good or bad for

the society?

Consumers receive benefits

Increased stock price requires being efficient i.e.
producing high-quality goods at the lowest cost

Should firms behave ethically?

Employees receive benefits

Increased stock price helps company grow fast
because company can easily raise capital
Thus, employment opportunity is created

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Determinants of a Firms Value

Factors That Affect Stock Price

Projected

CFs to
shareholders

Timing

Sales
Rev.

Opera
costs &
taxes

of CF stream

Riskiness

Required
invest in
operations

Interest
rates

Firm
risk

Market
Risk

Financing
decisions

of the CFs
WACC

FCF

Value of the Firm

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Determinants of a Firms Value

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Calculation of WACC
What is WACC, if a firm raises the following funds?

Free Cash Flow (FCF)

Equity $30,000 and required rate of return 12%

Bank loan (Notes payable) $10,000 @ 15% interest
rate and tax rate is 40%
Bonds $10,000 @ 10% interest rate

Cash available for distribution to all investors after

meeting all expenses and making required
investment in operations to support growth

Weighted Average Cost of Capital (WACC)

Funds
(1)

A firm's cost of capital in which each category of

capital is proportionately weighted
The average return required by all investors
Determined by the capital structure, interest
rates, the firms risk, and attitude toward risk

Amount
(2)

Weight
(3)

Rate
(4)

WACC
(5)=(1-t) (3)(4)

Equity

$30,000

0.6

0.12

0.60.12=0.072

Bank Loan

$10,000

0.2

0.15

(1-0.4) 0.2 .15=0.018

Bonds

$10,000

0.2

0.10

(1-0.4) 0.2.10)=0.012

Total

$50,000

1.0

0.102

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The Cost of Money or Fund

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Factors Affecting the Cost of Money

The interest rate paid as price to borrow

debt capital

The cost of equity is the required return an

investor expects in form of dividends and
capital gains

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Production opportunities (returns available

within an economy)
Time preferences for consumption (as
opposed to saving for future consumption)

Risk of return

Expected inflation

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Risks Associated with Investing

Overseas

Determinants of Market Interest Rate

r = r* + IP + DRP + LP + MRP

r = required return on a debt security

r*= real risk-free rate of interest
IP= inflation premium
DRP = default risk premium
LP = liquidity premium
MRP = maturity risk premium (interest rate)

Exchange rate risk--the risk to which

investors are exposed because changes
in exchange rates may have an effect on
investments

Country risk--the risk arises in a

particular country and depends on the
countrys economic, political, and social
environment.

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Economic Factors Influencing

Interest Rate (r)

Four Golden Rules of Finance

Policy of Central Bank

To support growth, increased money supply forces
r to go down, but larger money supply increases
inflation rate which again drives up r

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Budget Deficit or Surplus

If government runs trade deficit, then financed

from borrowing will drive up r and vice-versa

International Trade Deficits or Surplus

If it dont jingle it dont count

Risk is the possibility that bad or good things
may happen
The greater the risk the greater the expected
reward
A $1 today is worth more than a $1 tomorrow

International trade deficit is financed by borrowing

from foreign sources which drives up r
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Agency Relationships

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Agency Problems and Costs

An agency relationship exists whenever

stockholders (principals) hire managers
(agents) to act on their behalf

Within corporations, agency relationships

exist between:

Agency problems arise when managers

place personal goals ahead of the goals of
shareholders
Agency costs arise from agency problems
Borne by shareholders and represent a loss of
shareholder wealth

Stockholders and managers, and

Stockholders and creditors
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Stockholders Vs. Managers

Stockholders Vs. Creditors

Managers are naturally inclined to act in their

own best interests
How to increase personal wealth, job security,
fringe benefits, and lifestyle

Stockholders through managers could

take actions to maximize stock price that
are detrimental to creditors

But the following factors affect managerial

behavior:

In the long run, such actions will raise the cost of

debt and ultimately lower stock price

The threat of firing

The threat of hostile takeover
Structuring managerial incentives
Legal forces--fraud and fiduciary misconduct laws
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Set of Contracts Model of the Firm

Bondholders

Banks
Customers

Employees

Governments

Environment
Common
Stockholders

Communities

Society

Suppliers

Preferred
Stockholders

The Firm

Creditors
Managers

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