University of Technology, Jamaica

Unit 1: Financial Management & Environment

What is Financial Management?
At the macro level, finance is the study of financial institutions and financial markets and how
they operate within the financial system. At the micro level, Financial Management involves the
management of money and/or funds of an organization. It involves (i) Financing decisions ie
making decisions regarding financial planning, fund raising,(ii) Investment decisions eg.
Acquisition of assets (iii)Management of assets for businesses and financial institutions with
some overall goal in mind. This goal is usually that of maximizing shareholders wealth.
The Financial Manager is primarily concerned with analyzing and interpreting financial
information including that captured in the firms accounts for decision-making purposes.
Some functions and responsibilities of the financial manager include:
Acquisition of funds short term financing bank loans, etc. and long term financing stocks
(equity) and bonds (debt) for investment in assets.
Allocation (uses) of funds: Short term working capital management, and long term capital
management (stocks and bonds)
Forecasting and planning this includes providing advice and recommendations to executive
management.
Investing and financing decisions
Coordination and control as a member of the management team financial managers need to
work closely with other managers in the organization in order to determine the best financial
decisions to make and also to communicate those decisions to the rest of the organization.
Interaction with financial markets link between financial markets and the organization.
Managing risk ensuring that financing, allocation and management of assets is done with
minimal risk.
The goal of the firm remains, primarily, the maximizing of the wealth of the stockholders, its owners.
Wealth maximization is not the same thing as profit maximization. Profit maximization is more short
term and (i) ignores the relative riskiness of different projects (ii) ignores the time value of money (iii)
ignores the profit to the stockholder in favor of profit to the firm. Wealth maximization comes about from
actions that increase or maximize the stock price. The stock price is determined as the present value of
all the firms future expected cash flows, a long-term goal.
To illustrate: One way to raise the profit level of a firm would be to sell off assets such as plant and
equipment. Such sales would increase income in the short run, they would likely be detrimental to the
firms ability to generate income in the future since the firm no longer had the needed assets.
The usual method of maximizing the wealth of the stockholders is to maximize the price of the
corporations common stock.
Factors affecting the goal of the firm (Stock Price)
Neither managers nor stockholders can set the price of the common stock; the market determines the
price. The market price of the common stock reflects the markets estimation of the expected performance
of the economy and the corporation. Important factors in determining that estimation are: (i) Expected
Cash Flows (ii) Timing of Cash Flows (iii) Perceived Riskiness of Cash Flows
Cash Flows The ability of a company to generate cash inflows and reduce outflows will eventually lead
to an increase in its value.
Timing will be examined in more detail later in the course when we look at the time value of money.
Essentially, a dollar received today is worth more than a dollar received in the future because a dollar
received today can earn a days interest by tomorrow.
Uncertainty (Risk) The less certain owners and investors are about a firm's future cash flows, then the
lower they'll value the company. The more certain they are them, the higher they'll value the company.
This concept of risk and return will also be examined later in the course.
Stock price influenced by The price of a companys stock through (i) Dividend policy: the amount of net
income paid out to shareholders versus the amount retained for ongoing investment. (ii) Financing
decisions such as how much debt versus equity it uses to finance its operations. (iii) Investment
decisions including Research and Development efforts and plant expansion (iv)Strategic decisions as to
types of products and services produced and production methods used

Stock price also influenced by external factors outside managements control: (i) Legal constraints e.g.
workplace and product safety regulations, employment practice rules (ii) Environmental regulations (iii)
International rules e.g. trade regulations (WTO, NAFTA, etc.) (iv) Economic activity levels central
bank regulations, interest rates, foreign exchange availability and rates, unemployment levels, inflation
rates (v) Tax laws (vi) Stock Market conditions bull or bear market.

Agency Relationship: Managers vs. Stockholders: Firms are usually owned by a large number of
investors (shareholders) who employ directors and managers to operate the business on their behalf. The
managers are therefore agents of the owners. Sometimes conflicts arise between agent and principal eg
1. Managers may not work as hard for the shareholders as the owners themselves would have worked.
2. Managers may look out for their own interests, rather than the shareholders.
3. The choice between paying out dividends from profits earned or retaining the profits in the business.
4. The desire of managers to pursue decisions that could result in higher profits even though the element
of risk is high. This is common in cases where managements remuneration is tied to the profit
performance of the company. As a result of bonus packages, managers may do everything to
inflate/maximize profits.
Although managers are naturally inclined to act in their own best interests, some factors may be used to
deter adverse managerial behaviour:
Direct intervention by shareholders. Shareholders can vote out board of directors at meetings.
Threat of firing managers. But shareholders usually just sell their stock rather than try to change
management. Institutions collectively holding large blocks of shares have been known to oust managers
Threat of hostile takeover. If a company is subject to hostile takeover, the managers often lose their
jobs. Hostile takeovers are probable only if the common stock price is undervalued. Therefore, managers
can discourage hostile takeovers by maximizing the common stock price.
Positive incentives such as properly constructed managerial compensation plans. Compensation of
the managers can be tied to the performance of the corporation and its common stock
Agency Relationship: Stockholders (through managers) vs. Creditors:
Creditors have a claim on part of a company's earnings for payment of interest and principal on
the debt. They also have a claim on the company's assets in the event of bankruptcy.
Shareholders (through managers) have control of the decisions that affect the profitability and
risk of the company. When creditors lend money to companies, they charge a particular rate
based on a number of factors including the risk involved. If the shareholders (through
management) cause the company to take on a large new project that is far riskier than was
anticipated, the increased risk will cause the required rate of return on the company's debt to
increase, but since the rate on outstanding debt is fixed, its value decreases. If the risky project is
successful, all the benefits go to the shareholders, because the creditors returns are fixed at the
old, low-risk rate. However, if the project is unsuccessful, the creditors may have to share in the
losses (by receiving the liquidated value of assets only).
The interests of other stakeholders ie other people with an interest in a company. They include: (i)
Other non-executive employees (ii) Suppliers (iii) Customers and clients (iv) Government, and (v)General
Society. Management should ensure that these stakeholders' welfare has been properly attended to.

Social Responsibility The most common challenge is how to deal with the adverse side effects of the
goods and services a company provides. A typical example is the pollution caused by the emissions from
the bauxite plants in Jamaica. Excessive pollution control costs, eg new technology, lawsuits, medical
bills, etc may result in high outflows of cash, which in turn can reduce the value of the companies in
question. On the other hand, firms often embark upon projects aimed at being socially responsible
including donations to charities, community programs, etc. The long term aim is to provide "Goodwill"
which in turn generates increased sales, cash inflows and ultimately, additional wealth for the owners.
However, these 'social' actions have costs and not all businesses (shareholders) would voluntarily incur
such costs.
Forms of Organization (i) sole proprietorship;- an unincorporated business owned by an individual.
Pros: easily formed, subject to few government regulations, not subject to corporate taxes. Cons: difficult
to access large sums of capital, owner has unlimited personal responsibility for business debts, business
life limited to owners life. These characteristics make this form of organization best suited for small
business.
(ii) partnerships:- similar to a sole proprietorship, but have more than one owner. It might be a general
partnership where each partner bears full responsibility for all the partnerships liabilities or a limited

partnership where (i) at least one partner will not have limited liability, (ii)limited partners names should
not be included in the firms name, and (iii) limited partners cannot be part of the firms management.
(iii) Corporation:-has a legal existence and function separate from its owners. It can buy, sell, and own
property, as well as sue and be sued. It has owners who elect its Board of Directors, who in turn select its
senior corporate officers like president, secretary etc. Ownership expressed as common stock units or
shares (equity). These are transferable, and the corporations ownership can be changed by transferring
shares. Investors liability limited to investment in the firm, thus exempting personal assets from seizure
in settlement of company claims. Because of this limited liability, ease of ownership transfer through
share sales etc corporations have a major advantage over other forms of organization in the ease of raising
capital.

The financial environment is shaped by (i) institutions (ii) markets (iii) interest rates.
Financial Market: is, like any other market, a place where buyers and sellers transact business.
Because there are so many types of financial instrument, there are several types of Financial
Market eg
Primary where firms raise new capital. They sell new stock and proceeds go to the firm. The
Initial Public Offering (IPO) where firms sell new stock for the first time is a subset.
Secondary. Where existing stocks are traded among investors. Proceeds go to the seller/investor.
Spot: Assets are bought and sold for immediate or on the spot delivery
Futures: Assets are bought and sold for delivery at an agreed time in the future
Money: where short term (1 year or less), highly liquid debt securities are traded
Capital: where longer term (more than 1year) debt instruments & corporate stocks are traded
Markets may be private or public. On private markets, transactions are directly between two
parties and can take any form the parties agree to. Transactions in public markets are conducted
on organized exchanges eg the Jamaica Stock Exchange (JSE). Securities traded on public
markets use standardized contracts because they involve so many parties.
Stock Markets are important markets. Two basic types (i) physical location exchanges eg JSE,
are tangible entities operating from a physical location and have a limited number of members.
(ii) electronic dealer based markets eg Nasdaq are more diffuse. They consist of dealers with
inventories of securities, brokers who bring investors and brokers together, and the computers
and electronic networks that link them together.
Capital transfer might be direct where the saver buys securities from a firm eg (bank, credit
union, etc) receiving his securities eg certificate of deposit in return.
(ii) Indirect include (a) through an Investment Bank eg JMMB, DB&G etc. which act as a
middleman, collecting money from investors, buying the securities from the issuer, then
reissuing them to the investors. (b) Financial Intermediaries (eg Brokers & Investment
Bankers, Commercial Banks, Building Societies, Credit Unions, Life Insurance Companies etc)
facilitate transfers of capital by (a) advising firms (b) underwriting securities issues (c) managing
distribution (d) enhancing credibility. They also create new securities.
Major Financial Instruments: Treasury Bills, Repurchase Agreements (repo), Commercial Paper,
Bankers Acceptances, Money Market Funds, Mortgages, Common Stock, Eurodollars,
Negotiable CDs, Treasury Notes/Bonds, Corporate Bonds, Local Registered Stock (LRS).
Bonds: May be Government or Corporate Bonds. They are usually medium to long term loans
that pay interest during the life of the bond, and repay the principal at maturity. The cost of Debt
Capital, usually bank loans or bonds, is interest.
Stocks/Shares: may be either Common Stock/Shares or Preferred Stocks/Shares. They represent
ownership in a corporation. The cost of Equity Capital has two components; (i) dividends (ii)
capital gains (or losses).
Factors affecting the Cost of Money: Four principal ones (i) Production opportunities, by the
returns they offer an investor influence the cost that he would be willing to pay for borrowed
funds. It would be folly to borrow at a cost higher than expected returns on the investment (ii)
Time preferences for consumption refers to the existence or otherwise of surpluses beyond
immediate consumption needs. Consumption of most or all resources leaves little or no surplus
for investment, leading to shortages of capital and higher prices. (iii) Risk refers to the likelihood
of events occurring which could prevent loan repayment. The higher the risk, the higher will be
the rate of return investors require and the higher the interest rate charged (iv) Expected

inflation refers to future changes in prices. Higher inflation leads to investors requiring higher
rates of return, meaning higher interest rates.
Determinants of Interest Rates Interest rates have a basic underlying structure which reflects
various factors or Risk Premiums eg. Inflation Premium (IP), the average inflation expected
over the securitys life, Default Risk Premium (DRP), reflects the risk that the loan might not be
repaid, Liquidity Premium (LP), reflects the fact that some securities cannot be converted to
cash at a reasonable price at short notice, Maturity Risk Premium (MRP).reflects the risk of
price declines faced by long term securities. So a quoted interest rate k might arise from;
k = k* + IP + DRP + LP + MRP where k* is regarded as the real risk free rate applicable to a
security that has no risks and assuming inflation is zero. Some government securities eg Jamaica
and the U.S. are deemed to be free of default risk and liquidity risk.
Term Structure of Interest Rates describes the relationship between long and short term rates.
Usually, long term rates are higher than short term, because MRP increases as maturity
lengthens. Longer term corporate bonds also tend to be less liquid than shorter term ones, so LP
rises as maturity lengthens. These contribute to a normal yield curve with an upward slope as
interest rates gradually increase as maturity increases. The yield curve is obtained from plotting
interest rates against differing maturities.

Tutorial Questions
1. What is the primary goal of the organization?
2. Would the role of a financial manager be likely to increase or decrease in importance if the rate of
inflation increased? Explain.
3. What is the difference between stock price maximization and profit maximization?
4. What are the three principal forms of business organization? What are the advantages and
disadvantages of each?
5. Is maximizing stock price the same thing as maximizing profit?

6. What mechanisms exist to influence managers to act in shareholders best interests?

7. What is an agency relationship?
8. What agency relationships exist within a corporation?
9. What are financial intermediaries, and what economic functions do they perform?
10. How does an efficient capital market help to reduce the prices of goods and services?
11. What is the term structure of interest rates? What is a yield curve? How should users and
savers of funds behave if they are faced with a downward sloping yield curve?
12. Suppose most investors expect the inflation rate to be 5% next year, 6% the following year,
and 8% thereafter. The real risk-free rate is 3%. The maturity risk premium is zero for
bonds that mature in 1 year or less, 0.1 percent for 2-year bonds, and then the MRP increases
by 0.1% per year thereafter for 20 years, after which it is stable. What is the interest rate on
1-year, 10-year, and 20-year Treasury bonds?
13. The real risk free rate of interest is 3%. Inflation is expected to be 2% this year and 4% for
each of the next 2 years. Assume that the maturity risk premium (MRP) is zero. What is the
yield on a 2 year Treasury security? What is the yield on 3 year Treasury securities?
14. The real risk free rate is 3%, and inflation is expected to be 3% for the next 2 years. A 2 year
Treasury security yields 6.2%. What is the maturity risk premium for the 2 year security?
15. A government bond that matures in 10 years has a yield of 6%.A 10 year corporate bond has
a yield of 8%. Assume that the liquidity premium on a corporate bond is 0.5%. What is the
default risk premium on the corporate bond?
are these two rates measured?