Lecture 1 Framework of Financial Decision Making 1 Learning Outcomes ➢ Understand the role of business finance ➢ Explain the relationship between business finance and accounting ➢ Understand business objectives ➢ Understand risk and business finance ➢ Understand financial decision-making ➢ Understand the role of financial institutions and the types of financial places where financial instruments are traded ➢ Explain conflicts of interest : the ‘agency’ problem 2 Business Finance All businesses face the problem of how to achieve the organisational goals using the limited resources available to them. In business finance, the key resource is money and business needs to utilise this resource to maximise benefits for the owners of the company. The key financial decisions to make are: ➢ Investment decisions – Returns/Profits ➢ Financing decisions – Costs 3 Differences between Accountant and Finance Manager Accountant • Accrual • Preparation of Financial Statement Financial Manager • Cash Flow • Analysing & Interpreting Information for DECISION MAKING 4 Accounting Profits vs Cash flows Accounting Profits It may seem logical that the more profitable the company is, the better the financial health of that company. This assumes that profits booked by the firm can be realised when the firm collects the liabilities owed to it. Cash flows Accounting profits are not cash flows. They are what the company generates and uses during a period. It is important for firms to have strong cash flows, which can then allow them to pay their suppliers and employees in cash. 5 Organisational Goal : Why wealth maximisation rather than profit maximisation is the business’ objective Accounting Profits Cash Flow 6 Cash Flow Considerations Level Cash Flows Timing Risk PREFER HIGH VS LOW PREFER EARLY VS LATER PREFER LESS RISKY 7 Wealth Management Three reasons why wealth management via using cash flows is a better goal than profit maximisation: 1. Wealth management considers real level of cash flows instead of accounting earnings. 2. Wealth management considers the timing of the cash flows, recognizing the time value of money where cash to be received earlier is more valuable than cash to be received later. 3. Wealth management considers the risk of these cash flows, where a higher discount rate is applied to the cash flows if the risk of receiving these cash flows are higher. This would make the total discounted cash flows to be smaller, reflecting the risk involved. 8 Maximising the Share Price = Maximising Wealth! Wealth Share price The firm’s wealth is divided by the number of shares owned by the shareholders, and this is represented by the share price. As such, the wealth of the firm’s owners are measured by the share price of the firm. As such, the higher the share price, the wealthier are the owners. 9 Other Business Objectives The financial objective of the firm is to : ➢ Maximise shareholders’ wealth i.e. maximise the market value of the firm The non-financial objectives are to : ➢ Provide for the welfare of employees ➢ Contribute to the welfare of society as a whole ➢ Provide a service to the community e.g. charitable organisation 10 Relationship between risk and return High Risk Low Risk Expect High Return Accept Low Return 11 Relationship between risk and return The concept of risk and return is an important pillar in Finance: ➢ If we invest in a high risk investment, we EXPECT a high return. ➢ If we invest in a low risk investment, we ACCEPT a low return. If we take on more risk, we expect to be compensated with a higher return. For example, we expect the returns from the shares to be higher than what we would receive from low-risk investments like bank deposits. However, we should also be prepared for the share price to behave in a volatile manner, with the possibility of sustaining a huge loss. While we may expect the returns to be high from a risky investment, we should realise that the actual return can be very different from our expectations. 12 Key Decisions faced by the Financial Manager The role played by financial management is related to the major objective of maximising the shareholders’ wealth. In the context of this objective, there are two main types of decisions facing the financial management team: ➢ Investment decisions i.e. estimating the future cash flows including the amounts to be invested in machinery, stocks and working capital, selecting the suitable method of investment appraisal and monitoring the performance of the project to ensure that it continues to meet the investment criteria. ➢ Financing decisions i.e. assessing the effect of using different methods of short-term and long-term finance on the company’s value and profitability. 13 BALANCE SHEET Short-term CURRENT ASSETS CURRENT LIABILITIES Long-term FIXED ASSETS LONG-TERM FUNDS Making investment decisions Making financing decisions RETURNS COSTS 14 Key Decisions - Investment Decisions (1) Capital Budgeting Investment Decision • Asset Returns Purchase fixed assets • Accept • Reject To generate earnings for the firm, the firm needs to invest in fixed assets which will produce the goods needed for sale. The firm has to balance the risk and return of an investment before it commits its purchase of the fixed asset. 15 Key Decisions - Financing Decisions (2) Capital Raising Financing Decision • Costs Long-term finance To finance the purchase of fixed assets, the firm needs long-term financing from equity and debt holders. • Debt • Equity 16 Financial Market Environment Financial Institutions are intermediaries or middlemen which help channel savings of individuals, businesses and governments into loans or investments for those who require the funds. Examples are banks, finance companies, insurance companies and mutual funds. Financial institutions are important to businesses because they help to lend or invest in the firm which require the funds. 17 Financial Market Environment Financial markets are forums in which suppliers and demanders of funds can transact directly. They exist in order to allocate the savings of individuals, company and government to those who need them via the forces of supply and demand for a specific type of financial claim e.g. shares and bonds. In the absence of financial markets, savings may not be easily transferred to others who need the funds. 18 Types of Financial Markets Money Market The Money Market exists for the transaction of short-term financial instruments (i.e. maturity periods of 1 year or less) issued by high-credit rating borrowers, Examples of such instruments are U.S. Treasury bills, bankers’ acceptances, negotiable certificates of deposits and commercial paper. Capital Market The Capital Market on the hand, enables borrowers and lenders of long-term funds to perform transactions. The securities transacted are long-term (i.e. more than 1 year) instruments, eg. bonds, common shares and preferred shares. The difference between the two markets is the maturity period of the securities. 19 Types of Financial Markets Primary Markets Primary markets exist for securities that are offered to potential investors for the first time. This type of transaction increases the total stock of financial assets in the economy. Secondary Markets Secondary markets are where transactions in currently outstanding securities are performed, e.g. a SIA shareholder may sell his shares in the secondary market. All transactions after the initial purchase take place in the secondary market. They do not affect the total stock of financial assets that exist in the economy. 20 Types of Financial Markets Public Offerings To raise external capital, a company can make a public offering where both individuals and institutional investors have the opportunity to purchase the securities. Private Placements In a private placement or direct placement, the securities are offered and sold to a limited number of investors. The investment banking firm may act to find potential lenders and borrowers. The private placement market is a more personal market than its public counterpart. 21 The Financial Market Organised Security Exchanges The Organised Security Exchanges are formal organisations involved in the trading of securities. The benefits of Organised Security Exchanges include: ➢ Providing a continuous market for both corporation and investors resulting in a series of continuous security prices. ➢ Establishing and publishing fair security prices which are set by the supply and demand for the security. The security prices determined are also widely publicised. ➢ Helping business raise new capital. It is easier for firms to float new security offering as the continuous secondary market helps to determine competitive prices. 22 Agency Problems • Shareholder Owner Agent Market Forces Conflicts of interest between shareholders and management • Management • CEO • Directors • Shareholder activism • Threat of hostile takeover Arise in various contexts in business finance, for example making investments that are not in the best interests of shareholders 23 Agency Problems and Costs Agency costs • Aim: • Minimise agency problems • Types • Incentive plans • Performance plans Incentive plans Stocks options – If share price goes up, the share options would be worth more. Managers would have incentive to align their interests with shareholders. Performance plans We must pay managers well when they perform well. Cash bonus is based on performance targets such as EPS growth. 24 Agency Problems and Costs To encourage managers to align their interests with the shareholders, companies would resort to attractive compensation plans such as incentive and performance plans with share options and bonuses. These agency costs would be borne by the shareholders, with the hope that managers would act in the owners’ interest. However, there is no guarantee that a high compensation package will deliver results for the company. 25
