concepts of financial management 2014

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Financial Management (11th edt) By E.F. Bringham and M.C. Ehrhardt

An Overview of Financial Management

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What Is Finance?

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

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What Is Finance?

Finance is concerned with

---the process, institutions, markets, and instruments involved in the

---transfer of money among individuals, businesses, and governments

Financial management or managerial finance is the branch of Finance

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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

---to use corporate resources efficiently to achieve the goals of the firm

What Is Financial Management?

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What Is Managerial Finance?

MF deals with the duties/responsibilitiesof 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

Attempts to maximize shareholder value while managing risks

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Finance VS Economics & Accounting

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.

Finance links economic theory with the numbers of accounting

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Finance Vs. Accounting

Accounting Finance

Backward looking

Accounting focuses on collection and presentation of financial data

Accountant measures firms performance

Forward looking

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

Financial manager plans CFs to maintain firms solvency

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Areas of Specialization in Finance

Financial MarketsMarkets for users and savers of funds.

Financial ServicesDesign and delivery of financial advice and

products to individuals, businesses, government.

Managerial FinanceFinancial management of business firms.

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Functions of the Financial Manager

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Hypothetical Organization Chart

Chairman of the Board and Chief Executive Officer (CEO)

Board of Directors

President and Chief Operating Officer (COO)

Vice President and Chief Financial Officer (CFO)

Treasurer Controller

Cash Manager

Capital Expenditures

Credit Manager

Financial Planning

Tax Manager

Financial Accounting

Cost 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 How should we pay for our assets?

Should we use debt or equity or both?

From which source should we raise capital?

Working capital management How do we manage the day-to-day CFs?

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Financial Management Decisions

Risk Management What financial risks should we take on or

hedge out

Capital Analysis What is something worth?

How can we create value for the firm?

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The Balance-Sheet Model of the Firm

Current Assets

Fixed Assets

1 Tangible

2 Intangible

Total Value of Assets:

Shareholders

Equity

Current

Liabilities

Long-Term Debt

Total Firm Value to Investors:

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Current

Assets

Fixed Assets

1 Tangible

2 Intangible

Shareholders

Equity

Current

Liabilities

Long-Term

Debt

What LT investments should the firm engage in?

The Capital Budgeting Decision


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How can the

firm raise the money for the

required investments?

The Capital Structure Decision

Current

Assets

Fixed Assets

1 Tangible

2 Intangible

Shareholders

Equity

Current

Liabilities

Long-Term

Debt


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How much ST CF does a firm need to pay its

bills?

The Net Working Capital Investment Decision

Net

Working

Capital

Shareholders

Equity

Current

LiabilitiesCurrent

Assets

Fixed Assets

1 Tangible

2 Intangible

Long-Term

Debt


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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

Types of Markets

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Basic Forms of Business Organization

Sole Proprietorship Owned by one person

Operated for personal profit

Unlimited liability

Partnerships (general and limited) Owned by two or more people

Operated for joint profit

Liable personally and collectively

Run by partnership deed

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Basic Forms of Business Organization

Corporations

Legal entity created by law

Mandatory registration

Legally functions separate and apart from its owners.

Owners liability is limited to the amount of their investment

Owners hold common stock, and ownership can be transferred

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Partnership Vs. Corporations

Corporation PartnershipLiquidity Shares can easily be

exchanged.

Subject to substantial

restrictions.

Voting Rights Usually each share

gets one vote

General Partner is in

charge; limited partners may have

some voting rights.Taxation Double Partners pay taxes

on distributions.

Reinvestment and

dividend payout

Broad latitude All NCF is distributed

to partners.

Liability Limited liability General partners may have unlimited liability. Limited partners enjoy limited liability.

Continuity Perpetual life Limited life

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Sole Proprietorships & Partnerships

Advantages Ease of formation

Subject to few regulations

No corporate income taxes

Disadvantages Difficult to raise capital

Unlimited liability

Limited life

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Corporation

Advantages

Limited Liability

Permanency

Transferability of ownership

Better access to capital markets

Disadvantages

Difficult to set up and report filing

Separation of owners from management

Less control

Double taxation

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Separation of Ownership and Control

Board of Directors

Management

Assets

Debt

Equity

Sh

are

ho

lde

rs

De

bth

old

ers

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Characteristics of Corporation

Ownership Stock holders are the owners of the corporation

Control Ultimate control rests with the stock holders, but

managers control day-to-day operations

Risk Bearing Shareholders bear all residual risk

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Rights of Ownership

Dividend Rights

Voting Rights Majority voting--one vote per share per director

Cumulative voting--one can cast all votes for a single candidate

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

liquidation

Preemptive Rights The right to subscribe proportionally to any new

shares issued by the firm

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The Goal of the Corporation

What should be the goal of a corporation?

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?

To maximize profit???

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

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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?

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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To maximize shareholder wealth market price of stock value of firm

Why 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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This can be illustrated using the following simple stock valuation equation:

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The process of shareholder wealth

maximization can be described using the

following flow chart:


Financial Manager

Financial Decision

Alternative or Actions

Return?

Risk?

Increase Share Price?

Yes Accept

No

Reject

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Is Stock Price Maximization the Same as Profit Maximization?

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

Some actions may cause earnings to increase,

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

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The Goal of Non-Business Firm

To maximize the interests (benefits) of

stakeholders given a set of resources.

Example: The goals of a university:

Quality education for the students

Good management for the university

Right contribution to the society and to the

country

Financially healthy condition

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What about Stakeholders?

Stakeholders include groups that have direct economic links to the firm

Owners, employees, customers, suppliers, and

creditors

Maintaining positive relationships with stakeholders helps maximize LT benefits to

shareholders

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Three Basic Questions

Do firms have any responsibilities to society at large?

Is stock price maximization good or bad for

the society?

Should firms behave ethically?

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Stock Price Maximization Increases Social Welfare

Society receives benefits as owners of stocks

Increased stock price give society benefits

Consumers receive benefits

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

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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Factors That Affect Stock Price

Projected CFs to shareholders

Timing of CF stream

Riskiness of the CFs

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Determinants of a Firms Value

Sales

Rev.

Interest

rates

Financing

decisions

Required

invest in

operations

Opera

costs &

taxes

Firm

risk

Market

Risk

FCF WACC

Value of the Firm

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Free Cash Flow (FCF) 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)

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

Determinants of a Firms Value

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

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

Calculation of WACC

Funds(1)

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

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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Factors Affecting the Cost of Money

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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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)

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Risks Associated with Investing Overseas

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)

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

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

International trade deficit is financed by borrowing from foreign sources which drives up r

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Four Golden Rules of Finance

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

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Agency Relationships

An agency relationship exists whenever

stockholders (principals) hire managers

(agents) to act on their behalf

Within corporations, agency relationships

exist between:

Stockholders and managers, and

Stockholders and creditors

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Agency Problems and Costs

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

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Stockholders Vs. Managers

Managers are naturally inclined to act in their own best interests

How to increase personal wealth, job security,

fringe benefits, and lifestyle

But the following factors affect managerial behavior:

The threat of firing

The threat of hostile takeover

Structuring managerial incentives

Legal forces--fraud and fiduciary misconduct laws1-50

Stockholders 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

Stockholders Vs. Creditors

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Set of Contracts Model of the Firm

Preferred

Stockholders

Managers

The FirmCommon

Stockholders

Communities

Creditors

Governments

Customers

Suppliers

Society

Banks

Environment

Bondholders

Employees

concepts of financial management 2014

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