Introduction to Financial
Management
 2011 - Mohamed A. Ayadi
Learning Objectives






Know the basic types of financial management
decisions and the role of the financial manager
Know the financial implications of the different forms
of business organization
Know the goal of financial management
Understand the conflicts of interest that can arise
between owners and managers
Understand the various types of financial markets and
financial institutions
Understand current trends in financial markets
© 2011 - Mohamed A. Ayadi
2
Lecture Outline






Definitions and Issues
Role of the Firm
Types of Assets
Role of the Financial Officer
Business Structures
Financing the Firm
© 2011 - Mohamed A. Ayadi
3
Contd.





The Role of Financial Markets
Financial Intermediaries
Goals of Financial Management
Agency Problem and Control of the Firm
Trends in the Finance Field
© 2011 - Mohamed A. Ayadi
4
Why Learn Finance ?

Finance is mainly about the allocation
of scarce resources over time and
uncertainty

Financial decisions are faced by
households and firms
© 2011 - Mohamed A. Ayadi
5
Households


Households holds both real and
financial assets
Households have to decide whether to
- buy or lease a car,
- buy or rent a house,
- invest their retirement money.
© 2011 - Mohamed A. Ayadi
6
Assets and Liabilities of Households
7
Firms

Firms need to decide whether:
- to adopt a new project,
- issue debt or equity,
- pay dividends or repurchase some of
their shares,
- hedge risks with options or futures.
© 2011 - Mohamed A. Ayadi
8
Finance Contributions


Finance is intellectually challenging and
interesting!
Three Nobel Prices in Economics have been
awarded for contributions in Finance:
 Markowitz and Sharpe (Capital Asset Pricing
Model),
 Modigliani and Miller (Capital Structure),
 Black, Scholes, and Merton (Option pricing).
© 2011 - Mohamed A. Ayadi
9
Areas of Finance
 Corporate Finance
 Investments
 Financial Institutions
 International Finance
© 2011 - Mohamed A. Ayadi
10
Corporate Finance



Corporate finance deals with decisions to be made
by the Chief Financial Officer (CFO) regarding
uses and sources of capital.
Uses of capital are notably investment decisions
about real and financial assets (capital budgeting),
as well as dividend policy.
Sources of capital are mainly debt and equity
which the CFO chooses to issue (the capital
structure decision).
© 2011 - Mohamed A. Ayadi
11
Contd.

The study of the answers to the following
questions:
 What long-term investments should we make?
 Where will we get the funds to pay for our
investments?
 How will we collect from customers and pay
our bills?
 How can a company best manage the risks it
faces?
© 2011 - Mohamed A. Ayadi
12
Balanced Sheet View of the Firm
Current
Assets
Capital
Budgeting
Fixed
Assets
NWC
Current
Liabilities
Liquidity
Management
Long-Term
Debt
Stockholders’
Equity
Long-Term
Financing
In Other Words

The capital budgeting decision

The capital structure decision

The net working capital (NWC) decision

The risk management decision
© 2011 - Mohamed A. Ayadi
14
Capital Budgeting

What fixed assets or long-term investment projects
should the firm pursue?



This question concerns the left-hand side of the
balance sheet.
A job of the financial manager is to make sure that the
firm invests in projects that generate more cash than
they cost.
Financial projections are only as good as the numbers
financial managers have to work with.
© 2011 - Mohamed A. Ayadi
15
Liquidity Management



How should the firm manage its NWC, and how
can it ensure that it always has sufficient cash to
meet obligations?
This concerns the upper portion of the balance
sheet.
Questions include:



How much cash on hand is needed to pay bills?
How much raw material should be ordered?
How much credit should be extended to customers?
© 2011 - Mohamed A. Ayadi
16
Financing

Concerns the right-hand side of the balance sheet.
Big-picture questions. These sorts of decisions are
generally made by the top financial officer in the firm,
such as a CFO.

Capital structure: What mix of debt, equity and
internally-generated versus external capital should the firm
use?

Dividends: How should the company return cash to
shareholders?
© 2011 - Mohamed A. Ayadi
17
The Flow of Cash

Concerns the right-hand side of the balance sheet.
Big-picture questions. These sorts of decisions are
generally made by the top financial officer in the firm,
such as a CFO.

Capital structure: What mix of debt, equity and
internally-generated versus external capital should the firm
use?

Dividends: How should the company return cash to
shareholders?
© 2011 - Mohamed A. Ayadi
18
Cash Flows to/from the Firm
© 2011 - Mohamed A. Ayadi
19
Role of the Firm
The firm needs real assets and faces 2
major decisions:
 Investment decision (or capital budgeting)
How much to invest and in what projects?
 Financing decision
How to raise the funds needed for the
investment?
© 2011 - Mohamed A. Ayadi
20
Types of Assets

Real Assets
Machines, factories, patents, and offices

Financial Assets
Claims to the income generated by the real assets

Financial Markets
Markets where financial assets are traded
© 2011 - Mohamed A. Ayadi
21
Then…

The firm should invest in a project when value
returned exceeds cost

Project value comes from profits
 At different points in the future (time)
 With different degrees of uncertainty or risk

Finance is the study of the effects of time and
uncertainty on value
© 2011 - Mohamed A. Ayadi
22
Role of the Financial Manager


Financial managers try to answer some or all of
these questions
The top financial manager within a firm is usually
the Chief Financial Officer (CFO)
 Treasurer – oversees cash management, capital
expenditures and financial planning
 Controller – oversees taxes, cost accounting,
financial accounting and data processing
© 2011 - Mohamed A. Ayadi
23
Business Structures

Three major forms in North-America
 Sole proprietorship
 Partnership



General
Limited
Corporation

In other countries, corporations are also called joint
stock companies, public limited companies and
limited liability companies
© 2011 - Mohamed A. Ayadi
24
Sole Proprietorship & Partnerships





Difficult to obtain large amounts of capital
Unlimited liability
 In a limited partnership, only for the g.p.
Limited Life (people usually die)
Inexpensive to form
No corporate income tax (just personal
taxes)
© 2011 - Mohamed A. Ayadi
25
Corporations






A legal fiction; separate from its owners and
managers
Unlimited life
Easy transferability of ownership (liquidity)
Limited liability
Better access to capital
Double taxation (e.g. of dividends in U.S.)
© 2011 - Mohamed A. Ayadi
26
Corporate Organizational Form

The Corporation is characterized by the
Separation of Ownership and Control
 Who owns the firm?
 Who runs the firm?

View the Firm as a Nexus of Contracts between
Interested Parties
 Shareholders, creditors, customers, suppliers,
employees, etc...
© 2011 - Mohamed A. Ayadi
27
An International Perspective
© 2011 - Mohamed A. Ayadi
28
Goals of Financial Management



What should be the company’s goal when making financial
decisions?
Possible goals – Maximize what?
Customer satisfaction, sales revenues, share value, profits,
…?
Maximize Resources Available to Corporate Managers?
Provide Stable Employment and be a good ‘Corporate
Citizen’?
Value Maximization is the ultimate goal
© 2011 - Mohamed A. Ayadi
29
Contd.
Three equivalent goals of financial
management:
 Maximize shareholder wealth
 Maximize share price
 Maximize firm value
© 2011 - Mohamed A. Ayadi
30
Shareholders vs. ‘Stakeholders’

Does maximizing shareholder wealth imply taking
extreme positions toward other claimants? Does such a
firm:
 Hire employees in the ‘day labor’ market, with
absolutely no implication of continued employment?
 Refuse to ever make charitable contributions?
 Try to get as much profit as possible in every customer
transaction?

Maximizing shareholder wealth in fact requires a careful
balancing of interests.
© 2011 - Mohamed A. Ayadi
31
Value Creation

Value is Created when the Firm Invests in Assets that
Generate more Cash than they Cost


Value = f (Size, Timing, Risk of Cash Flows)
Cash Flows = f (Investment and Financing Policies)

Steps for Sound Financial Decision Making




Identification Of Cash Flows
Size Of Cash Flows
Timing Of Cash Flows
Risk Of Cash Flows
© 2011 - Mohamed A. Ayadi
32
The Agency Problem &
the Control of the Firm



The relationship between stockholders and
management is called agency relationship
This occurs when one party (principal) pays
another (agent) to represent them
The possibility of conflict of interest
between the parties is termed the agency
problem
© 2011 - Mohamed A. Ayadi
33
Contd.


Goals of shareholders:
Maximize shareholder value
Goals of management:
Survival, independence and self-sufficiency,
size (high growth, large market share, asset
under control), perks, managerial
compensation, and wealth
© 2011 - Mohamed A. Ayadi
34
Ways to Reduce Agency Costs
 Better monitor (committed board, large
shareholders monitoring)
 Managerial incentives
 Relate compensation to performance
 Stock options (about a third of CEO’s pay)
 Stock ownership by management
 Outside monitoring: the market for corporate
control (takeover threat)
© 2011 - Mohamed A. Ayadi
35
Executive Compensation
36
Corporate Social Responsibility
•
•
•
Wealth maximization does not preclude the
firm from being socially responsible at the
corporate level
Assume we view the firm as producing both
private and social goods
Then shareholder wealth maximization
remains the appropriate goal in governing
the firm
© 2011 - Mohamed A. Ayadi
37
Corporate Governance
•
•
Corporate 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.
© 2011 - Mohamed A. Ayadi
38
Board of Directors
•
Typical 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; and
Oversee operating plans, capital budgets, and
financial reports to common shareholders.
CEO/Chairman roles commonly same person
in US, but separate in Britain (US moving in
this direction).
© 2011 - Mohamed A. Ayadi
39
Organization of the Financial
Management Function
Board of Directors
President
(Chief Executive Officer)
Executive Vice
President
(Operations)
Executive Vice
President
(Finance - CFO)
Executive Vice
President
(Marketing)
Organization of the Financial
Management Function
EVP of Finance
Vice President (Treasurer)
• Capital Investment
• Cash Management
• Commercial/investment banking
relationships
• Credit Management
• Dividend Disbursement
• Financial Analysis/Planning
• Investor Relations
• Mergers and Acquisitions
• Pension Management
• Insurance/Risk Management
• Tax Analysis/Planning
Controller
• Cost Accounting
• Cost Management
• Data Processing
• General Ledger
• Government Reporting
• Internal Control
• Preparing Financial Statements
• Preparing Budgets
• Preparing Forecasts
Financing the Firm


Internal Financing:
Retained Earnings
External Financing:
 Debt Financing: Bank loans, Bonds,
Commercial paper, and Leases
 Equity Financing: Common stocks and
Preferred stocks
© 2011 - Mohamed A. Ayadi
42
Role of the Financial Markets

The Financial Officer raises capital in the
Financial Markets

Role of the FM: Channel assets from savers to
investors

How the funds are channeled?
Direct investment (e.g. IPO)
Financial Intermediaries
© 2011 - Mohamed A. Ayadi
43
Financial Intermediaries

An intermediary collects savings from
individuals and channel the funds to firms
that use the money to finance their
investments

Examples: Commercial banks, investment
banks, insurance companies, stock mutual
funds, and venture capital firms
© 2011 - Mohamed A. Ayadi
44
Financial Institutions and
Financial Markets

Financial Institutions:
Banks, trust companies, credit unions,
insurance companies, pension funds, mutual
funds, investment dealers, brokerage firms

Financial Markets:
Money markets vs. Capital markets
Primary markets vs. Secondary markets
© 2011 - Mohamed A. Ayadi
45
Financial Intermediaries
Canadian Chartered Banks
46
Financial Intermediaries
Canadian Mutual Fund Assets
47
Money vs. Capital Markets


Money market:
The market in which short term (1 year or less)
securities are bought and sold. It is a dealer
market, i.e. dealers buy and sell from their
inventories
Capital market:
The market for long-term debt and equity shares.
It is primarily a brokered market, i.e. brokers
match up buyers and sellers
© 2011 - Mohamed A. Ayadi
48
Global Finance Community
© 2010 - Mohamed A. Ayadi
49
Trends in Financial Markets &
Management

Financial Engineering
Development and creation of new securities and financial
products and processes

Derivative Securities
Options, Futures, and other securities



Advances in Technology – i.e. E-business
Deregulation
Corporate Governance Reform
© 2011 - Mohamed A. Ayadi
50
Conclusion

Two perspectives will be explored in this
course:
 A study of corporate financial
management key issues and tools
 A study the valuation process of financial
assets and capital budgeting projects
© 2011 - Mohamed A. Ayadi
51