financial managemet mba lect 1

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LECTURE NO 1 THE ROLE OF FINANCIAL MANAGEMENT

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THE ROLE OF FINANCIAL MANAGEMENT

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Page 1: Financial managemet mba lect 1

LECTURE NO 1

THE ROLE OF FINANCIAL MANAGEMENT

Page 2: Financial managemet mba lect 1

WHAT IS FINANCE ??? Finance is the science of funds management.

Finance includes saving money and often includes lending money. The field of finance deals with the concepts of time, money, and risk and how they are interrelated. It also deals with how money is spent and budgeted.

Page 3: Financial managemet mba lect 1

WHAT IS BUSINESS FINANCE?

Raising and managing of funds by business organizations.

Page 4: Financial managemet mba lect 1

THE ROLE OF FINANCIAL MANAGEMENT

What is Financial Management? The Goal of the Firm Corporate Governance Organization of the Financial

Management Function

Page 5: Financial managemet mba lect 1

WHAT IS FINANCIAL MANAGEMENT?

Concerns the acquisition, financing,

and management of assets with some overall goal in mind.

Page 6: Financial managemet mba lect 1

INVESTMENT DECISIONSMost important of the three

decisions. What is the optimal firm size? What specific assets should be

acquired? What assets (if any) should be

reduced or eliminated? eg. How much of total cash is

devoted to cash or inventory?

Page 7: Financial managemet mba lect 1

FINANCING DECISIONSDetermine how the assets (LHS of

balance sheet) will be financed (RHS of balance sheet).

What is the best type of financing? What is the best financing mix?What is the best dividend policy (e.g.,

dividend-payout ratio)?How will the funds be physically

acquired? eg. Shortterm loan, long term lease

arrangement, stocks or bonds.

Page 8: Financial managemet mba lect 1

ASSET MANAGEMENT DECISIONS

How do we manage existing assets efficiently?

Financial Manager has varying degrees of operating responsibility over assets.

Greater emphasis on current asset management than fixed asset management.

Page 9: Financial managemet mba lect 1

WHAT IS THE GOAL OF THE FIRM?

Maximization of Shareholder Wealth!

Value creation occurs when we maximize the share price for

current shareholders.

Page 10: Financial managemet mba lect 1

SHORTCOMINGS OF ALTERNATIVE PERSPECTIVES

Profit Maximization Maximizing a firm’s earnings

after taxes.Problems Could increase current profits while harming

firm (e.g., defer maintenance, issue common stock to buy T-bills, etc.).

Ignores changes in the risk level of the firm. Decrease in each owners share of profits i.e

earnings per share.

Page 11: Financial managemet mba lect 1

SHORTCOMINGS OF ALTERNATIVE PERSPECTIVES

Earnings per Share Maximization Maximizing earnings after taxes

divided by shares outstanding. Problems Does not specify timing or duration of

expected returns. Ignores changes in the risk level of the firm. Calls for a zero payout dividend policy.

Page 12: Financial managemet mba lect 1

STRENGTHS OF SHAREHOLDER WEALTH MAXIMIZATION

Takes account of: current and future profits and EPS; the timing, duration, and risk of profits and EPS; dividend policy; and all other relevant factors.

Thus, share price serves as a barometer for business performance

Page 13: Financial managemet mba lect 1

THE MODERN CORPORATION

There exists a SEPARATION between owners and managers.

Modern Corporation

Shareholders Management

Page 14: Financial managemet mba lect 1

ROLE OF MANAGEMENT

An agent is an individual authorized by another person, called the principal, to act in the latter’s behalf.

Management acts as an agent for the owners (shareholders) of the

firm.

Page 15: Financial managemet mba lect 1

AGENCY THEORYJensen and Meckling developed a

theory of the firm based on agency theory.

Agency Theory is a branch of economics relating to the behavior of principals and their agents.

Page 16: Financial managemet mba lect 1

AGENCY THEORYPrincipals must provide incentives

so that management acts in the principals’ best interests and then monitor results.

Incentives include, stock options, perquisites, and bonuses.

Page 17: Financial managemet mba lect 1

SOCIAL RESPONSIBILITY Wealth maximization does not

preclude the firm from being socially responsible.

Assume we view the firm as producing both private and social goods.

Then shareholder wealth maximization remains the appropriate goal in governing the firm.

Page 18: Financial managemet mba lect 1

CORPORATE GOVERNANCECorporate governance: represents

the system by which corporations are managed and controlled.Includes shareholders, board of

directors, and senior management.

Then shareholder wealth maximization remains the appropriate goal in governing the firm.

Page 19: Financial managemet mba lect 1

BOARD OF DIRECTORSTypical responsibilities:

Set company-wide policy;Advise the CEO and other senior

executives;Hire, fire, and set the compensation of

the CEO;Review and approve strategy, significant

investments, and acquisitions; andOversee operating plans, capital

budgets, and financial reports to common shareholders.

Page 20: Financial managemet mba lect 1

ORGANIZATION OF THE FINANCIAL MANAGEMENT FUNCTION

Board of Directors

President(Chief Executive Officer)

Vice PresidentOperations

Vice PresidentMarketing

VP ofFinance

Page 21: Financial managemet mba lect 1

THE BUSINESS AND FINANCIAL ENVIRONMENTS

The Business Environment The Financial Environment

Page 22: Financial managemet mba lect 1

THE BUSINESS ENVIRONMENT Sole Proprietorships Partnerships (general and limited) Corporations Limited liability companies

Page 23: Financial managemet mba lect 1

THE BUSINESS ENVIRONMENT Sole Proprietorship -- A business form

for which there is one owner. This single owner has unlimited liability for all debts of the firm.

Oldest form of business organization. Business income is accounted for on the

owner’s personal income tax form.

Page 24: Financial managemet mba lect 1

SUMMARY FOR SOLE PROPRIETORSHIP

Advantages Simplicity Low setup cost Quick setup Single tax filing on

individual form

Disadvantages Unlimited liability Hard to raise additional

capital Transfer of ownership

difficulties

Page 25: Financial managemet mba lect 1

THE BUSINESS ENVIRONMENT

Business income is accounted for on each partner’s personal income tax form.

Partnership -- A business form in which two or more individuals act as owners.

Page 26: Financial managemet mba lect 1

SUMMARY FOR PARTNERSHIP

Advantages Can be simple Low setup cost, higher

than sole proprietorship Relatively quick setup Limited liability for limited

partners

Disadvantages Unlimited liability for the

general partner Difficult to raise

additional capital, but easier than sole proprietorship

Transfer of ownership difficulties

Page 27: Financial managemet mba lect 1

THE BUSINESS ENVIRONMENT

An artificial entity that can own assets and incur liabilities.

Business income is accounted for on the income tax form of the corporation.

Corporation -- A business form legally separate from its owners.

Page 28: Financial managemet mba lect 1

SUMMARY FOR CORPORATION

Advantages Limited liability Easy transfer of

ownership Unlimited life Easier to raise large

quantities of capital

Disadvantages Double taxation More difficult to

establish More expensive to

set up and maintain

Page 29: Financial managemet mba lect 1

THE BUSINESS ENVIRONMENT

Business income is accounted for on each “member’s” individual income tax form.

Limited Liability Companies -- A business form that provides its owners (called “members”) with corporate-style limited personal liability and the federal-tax treatment of a partnership.

Page 30: Financial managemet mba lect 1

LIMITED LIABILITY COMPANY (LLC)

Limited liability Centralized management Unlimited life Transfer of ownership without other owners’

prior consent

Generally, an LLC will possess only the first two of the following

four standard corporation characteristics

Page 31: Financial managemet mba lect 1

SUMMARY FOR LLC

Advantages Limited liability Eliminates double

taxation No restriction on

number or type of owners

Easier to raise additional capital

Disadvantages Limited life

(generally) Transfer of

ownership difficulties (generally)

Page 32: Financial managemet mba lect 1

FINANCIAL ENVIRONMENT

Businesses interact continually with the financial markets.

Financial Markets are composed of all institutions and procedures for bringing buyers and sellers of financial instruments together.

The purpose of financial markets is to efficiently allocate savings to ultimate users.

Page 33: Financial managemet mba lect 1

TYPES OF FINANCIAL MARKETS

Primary market: in which newly issued securities are traded.

Secondary Market: in which previously issued securities are traded

Page 34: Financial managemet mba lect 1

TYPES OF FINANCIAL MARKETS

Money Market: In which securities having maturity less than one year are traded

Capital Market: In which securities having maturity more than a year are traded