Chapter 1

The Role and Environment of Financial Management

Copyright 2009 Pearson Prentice Hall. All rights reserved.

Course Outline
Topics Introduction of the Subject Tax Structure and Business Decisions Time Value of Money Financial Statement Analysis Working Capital Management Chapter number Chapter 1 Chapter 2 Chapter 3 Chapter 6 Chapter 8

Capital Budgeting
Cost of Capital

Chapter 13
Chapter 15

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Learning Goals
1. Define finance, its major areas and opportunities available in this field, and the legal forms of business organization. 2. Describe the managerial finance functions (key activities) and its relationship to economics and accounting. 3. Differentiation between Bonds and Shares 4. Differentiation between Preference Shares and Common Shares.

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Learning Goals (cont.)

5. Explain the goal of the firm, corporate governance, the role of ethics, and the agency issue. 6. Understand financial institutions and markets, and the role they play in managerial finance

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What is Finance?
Finance can be defined as science and art of managing money. It is a process which shows that how people allocate their resources over some future period to make it grow. Finance is concerned with the process where institutions, markets, and instruments involved in the transfer of money among individuals, businesses, and governments.
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Major Areas & Opportunities in Finance: Financial Services Financial Services is the area of finance concerned with the design and delivery of advice and financial products to individuals, businesses, and government. Career opportunities available in the fields of banking, financial consultancy, investments, real estate and insurance.

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Major Areas & Opportunities in Finance: Managerial Finance

Managerial finance is concerned with the duties of the financial manager in the business firm. The financial manager actively manages the financial affairs of any type of business, whether private or public, large or small, profit-seeking or not-for-profit. They are also more involved in developing corporate strategy and improving the firms competitive position.

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Major Areas & Opportunities in Finance: Managerial Finance (cont.)

Increasing globalization has complicated the financial management function by requiring them to be proficient in managing cash flows in different currencies and protecting against the risks inherent in international transactions. Changing economic and regulatory conditions also complicate the financial management function.

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Figure 1.1 Corporate Organization

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Table 1.3 Career Opportunities in Managerial Finance

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Table 1.1 Strengths and Weaknesses of the Common Legal Forms of Business Organization

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The Managerial Finance Function

The importance of the managerial finance function depends on the size of the firm. In small companies, the finance function may be performed by the company president or accounting department. As the business expands, finance typically evolves into a separate department linked to the president as was previously described in Figure 1.1.
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The Managerial Finance Function: Relationship to Economics The field of Finance is actually an outgrowth of Economics. In fact, Finance is sometimes referred to as Financial Economics. Financial managers must understand the economic framework within which they operate in order to react or anticipate to changes in conditions.
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The Managerial Finance Function: Relationship to Economics (cont.) The primary economic principal used by financial managers is marginal cost-benefit analysis which says that financial decisions should be implemented only when added benefits exceed added costs.

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The Managerial Finance Function: Relationship to Accounting The firms Finance (treasurer) and Accounting (controller) functions are closely-related and overlapping. In smaller firms, the financial manager generally performs both functions.

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The Managerial Finance Function: Relationship to Accounting (cont.) One major difference in perspective and emphasis between Finance and Accounting is that accountants generally use the Accrual Method while in Finance, the focus is on cash flows i.e. the Cash basis of Accounting. The significance of this difference can be illustrated using the following simple example.

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The Managerial Finance Function: Relationship to Accounting (cont.)

The ABC Corporation experienced the following activity last year:
Sales Costs $100,000 (1 yacht sold, 100% still uncollected) $ 80,000 (all paid in full under supplier terms)

Now contrast the differences in performance under the accounting method versus the cash method.

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The Managerial Finance Function: Relationship to Accounting (cont.)

INCOME STATEMENT SUMMARY ACCRUAL Sales Less: Costs Net Profit/(Loss) $100,000 (80,000) $ 20,000 $ CASH 0 (80,000) $(80,000)

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The Managerial Finance Function: Relationship to Accounting (cont.)

Finance and accounting also differ with respect to decision-making. While accounting is primarily concerned with the presentation of financial data, the financial manager is primarily concerned with analyzing and interpreting this information for decision-making purposes. The financial manager uses this data as a vital tool for making decisions about the financial aspects of the firm.

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Functions or Activities of Financial Manager

Concerns the acquisition, financing, and management of assets with some overall goal in mind.

Figure 1.2 Financial Activities or Functions

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Investment Decisions
Most important of the three decisions.
What is the optimal firm size? What specific assets should be acquired? Whether current or fixed assets or both. What assets (if any) should be reduced or eliminated?

Investing Activities
WORKING CAPITAL MANAGEMENT Involves the managing of current assets and current liabilities. CAPITAL BUDGETING Making investment in fixed assets is called Capital Budgeting. It involves the decision-making process regarding: o What to invest? o When to invest? o Why to invest?
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Financing Decisions
Determine how the assets (LHS of Balance Sheet) will be financed (RHS of Balance Sheet). What is the best type of financing? Debt or Equity. What is the best financing mix? What is the best dividend policy?

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. It consists of almost 60% of total assets.

Bonds and Shares

Bonds

Points of distinction among:

Common Shares

Preference Shares

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BONDS vs. COMMON SHARES

EVENTS BONDS COMMON SHARES

STATUS

Debt instrument and shown as long term liability of the business Interest is paid to Bondholders

Owner of the business, shown under the head of Shareholders Equity Dividend is paid to Shareholders Dividend is fluctuating in nature

RETURN

RATE OF RETURN

Fixed interest rate

DURATION

Bonds are issued for a stipulated Shares are perpetual, means period period for issue of shares is not mentioned More risky for company Less risky for company

RISK FACTORE

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BONDS vs. SHARES cont---

EVENTS

BONDS

COMMON SHARES

PAYMENT AT THE TIME OF LIQUIDATION

VOTIN RIGHT ROLE IN DECISION MAKING

The first payment is made to Bondholders out of the assets realized

Bondholders have no voting right No role in decision making process.

The Common Shareholders are paid at the end

Shareholders enjoy the voting right As owner of the business, the shareholders play important role in decision making process of the company. Dividend is Taxable

TAX FACTOR

No tax payment involved on the payment of interest , it is tax deductible.

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Copyright 2009 Pearson Prentice Hall. All rights reserved.

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COMMON SHARES VS PREFERNCE SHARES

EVENTS COMMON SHARES PREFERNCE SHARES

STATUS

Real owner of the business

Hybrid equity

RETURN

Fluctuating dividend

Fixed dividend is paid to Preference shareholders

DURATION

Perpetual ,issued for unlimited time period

Perpetual but sometimes call provision is added.

RISK FACTORE

Minimum risk for company

Carry medium level risk for the company 1-30

COMMON SHARES VS PREFERNCE SHARES

EVENTS

COMMON SHARES

PREFERNCE SHARES

PAYMENT AT THE TIME OF LIQUIDATION

Paid at the end

paid ahead of Common Shares

VOTIN RIGHT

Bondholders enjoy the voting right

Dont enjoy the voting right

ROLE IN DECISION MAKING

As owner of the business, the shareholders play important role in decision making process of the company.

No role in decision making process.

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As an investor which one you will prefer?

It depends upon: o Your risk profile o Financial position o Age o Health condition o Level of responsibilities

Copyright 2009 Pearson Prentice Hall. All rights reserved.

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As an investor which one you will prefer?

If your financial position is good, enjoying good health, low responsibility level and willing to take risk, then go for Common Shares. On the contrary, due to more responsibilities, you want to play safe, need fixed income at the end of specified period, go for Bonds. Remember, these are not the Hard and Fast Rules Better to have a mixture of both to adjust the risk factor.
Copyright 2009 Pearson Prentice Hall. All rights reserved.

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GOALS OF FINANCIAL MANAGERS Stability

1
Consider Total yield

4
Time Value of Money

Looking Back
Risk factor

Looking Forward

3
Quality of benefits

Chaos

Goal of the Firm: Maximize Profit???

Which Investment is Preferred?
Earnings per share (EPS) Investment Rotor Valve $ $ Year 1 1.40 $ 0.60 $ Year 2 1.00 $ 1.00 $ Year 3 0.40 $ 1.40 $ Total (years 1-3) 2.80 3.00

Profit maximization fails to account for differences in the level of cash flows (as opposed to profits), the timing of these cash flows, and the risk of these cash flows.

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Goal of the Firm: Maximize Shareholder Wealth!!!

Why? Because maximizing shareholder wealth properly considers cash flows, the timing of these cash flows, and the risk of these cash flows. This can be illustrated using the following simple stock valuation equation: level & timing of cash flows

Share Price = Future Dividends Required Return

risk of cash flows

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Goal of the Firm: Maximize Shareholder Wealth!!! (cont.) The process of shareholder wealth maximization can be described using the following flow chart:
Figure 1.3 Share Price Maximization

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Factors ignored in profitability concept

Only dividend is considered, whereas, capital gain is ignored. Timings of returns is not considered. Quality of benefits is not given the due importance Risk involved must be evaluated properly.
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Total return on shares

Dividend which distribution out of the profit available. Capital gain you can get by selling the shares in the Stock Exchange Market. Gordons formula Total Yield = Dividend Yield + Capital Yield

Copyright 2009 Pearson Prentice Hall. All rights reserved.

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Timings of return
PROJECT A PROJECT B

Year 1 Year 2 Year 3 TOTAL

Rs. 20,000 15,000 10,000 45,000

Rs. 10,000 15,000 20,000 45,000

Which one is better, A or B ?

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Risk factor
PROJECT A PROJECT B

Highly Risky

Rs. 120,000

Less Risky
TOTAL RETURN 120,000

Rs. 120,000
120,000

Which one is better, A or B ?

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Quality of returns
PROJECT A PROJECT B

Boom period

Rs. 20,000

Rs. 18,000

Normal period
Depression TOTAL

15,000
10,000 45,000

15,000
12,000 45,000

Which one is better, A or B ?

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The Modern Corporation

Modern Corporation
Shareholders Management

There exists a SEPARATION between owners and managers.

Goal of the Firm: What About Other Stakeholders?

Stakeholders include all groups of individuals who have a direct economic link to the firm including employees, customers, suppliers, creditors, owners, and others who have a direct economic link to the firm. The "Stakeholder View" prescribes that the firm make a conscious effort to avoid actions that could be detrimental to the wealth position of its stakeholders. Such a view is considered to be "socially responsible."

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Corporate Governance
Corporate Governance is the system used to direct and control a corporation. It defines the rights and responsibilities of key corporate participants such as shareholders, the board of directors, officers and managers, and other stakeholders. The structure of corporate governance was previously described in Figure 1.1.
Copyright 2009 Pearson Prentice Hall. All rights reserved.

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Individual versus Institutional Investors

Individual investors are investors who purchase relatively small quantities of shares in order to earn a return on idle funds, build a source of retirement income, or provide financial security. Institutional investors are investment professionals who are paid to manage other peoples money.

They hold and trade large quantities of securities for individuals, businesses, and governments and tend to have a much greater impact on corporate governance.

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The Role of Ethics: Ethics Defined

Ethics is the standards of conduct or moral judgmenthave become an overriding issue in both our society and the financial community Ethical violations attract widespread publicity Negative publicity often leads to negative impacts on a firm

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The Role of Ethics: Considering Ethics

Robert A. Cooke, a noted ethicist, suggests that the following questions be used to assess the ethical viability of a proposed action:
Does the action unfairly single out an individual or group? Does the action affect the morals, or legal rights of any individual or group? Does the action conform to accepted moral standards? Are there alternative courses of action that are less likely to cause actual or potential harm?

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The Role of Ethics: Considering Ethics (cont.)

Cooke suggests that the impact of a proposed decision should be evaluated from a number of perspectives:
Are the rights of any stakeholder being violated?
Does the firm have any overriding duties to any stakeholder? Will the decision benefit any stakeholder to the detriment of another stakeholder? If there is a detriment to any stakeholder, how should it be remedied, if at all? What is the relationship between stockholders and stakeholders?

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The Role of Ethics: Ethics & Share Price Ethics programs seek to:
reduce litigation and judgment costs maintain a positive corporate image build shareholder confidence gain the loyalty and respect of all stakeholders

The expected result of such programs is to positively affect the firm's share price.
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The Agency Issue: The Agency Problem

Whenever a manager owns less than 100% of the firms equity, a potential agency problem exists.

In theory, managers would agree with shareholder wealth maximization.

However, managers are also concerned with their personal wealth, job security, fringe benefits, and lifestyle. This would cause managers to act in ways that do not always benefit the firm shareholders.

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The Agency Issue: Resolving the Problem Market Forces such as major shareholders and the threat of a hostile takeover act to keep managers in check. Agency Costs are the costs borne by stockholders to maintain a corporate governance structure that minimizes agency problems and contributes to the maximization of shareholder wealth.
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The Agency Issue: Resolving the Problem (cont.) Examples would include bonding or monitoring management behavior, and structuring management compensation to make shareholders interests their own.

A stock option is an incentive allowing managers to purchase stock at the market price set at the time of the grant.

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The Agency Issue: Resolving the Problem (cont.) Performance plans tie management compensation to measures such as EPS growth; performance shares and/or cash bonuses are used as compensation under these plans.

Recent studies have failed to find a strong relationship between CEO compensation and share price.

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Financial Institutions & Markets

Firms that require funds from external sources can obtain them in three ways:
through a bank or other financial institution through financial markets through private placements

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Financial Institutions & Markets: Financial Institutions

Financial institutions are intermediaries that channel the savings of individuals, businesses, and governments into loans or investments. The key suppliers and demanders of funds are individuals, businesses, and governments. In general, individuals are net suppliers of funds, while businesses and governments are net demanders of funds.
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Financial Institutions & Markets: Financial Markets

Financial markets provide a forum in which suppliers of funds and demanders of funds can transact business directly. The two key financial markets are the money market and the capital market. Transactions in short term marketable securities take place in the money market while transactions in longterm securities take place in the capital market.
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Financial Institutions & Markets: Financial Markets (cont.)

Whether subsequently traded in the money or capital market, securities are first issued through the primary market. The primary market is the only one in which a corporation or government is directly involved in and receives the proceeds from the transaction. Once issued, securities then trade on the secondary markets such as Stock Exchange .

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Figure 1.4 Flow of Funds

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The Money Market

The money market exists as a result of the interaction between the suppliers and demanders of short-term funds (those having a maturity of a year or less). Most money market transactions are made in marketable securities which are short-term debt instruments such as T-bills and commercial paper. Money market transactions can be executed directly or through an intermediary.
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The Capital Market

The capital market is a market that enables suppliers and demanders of long-term funds to make transactions.

The key capital market securities are bonds (long-term debt) and both common and preferred stock (equity).
Bonds are long-term debt instruments used by businesses and government to raise large sums of money or capital. Common stock are units of ownership interest or equity in a corporation.

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Capital Gains

A capital gain results when a firm sells an asset such as a stock held as an investment for more than its initial purchase price. The difference between the sales price and the purchase price is called a capital gain.

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