Part I: Introduction
Chapter 1: Overview of
Managerial Finance / Financial
Management
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1.1 Financial Management: An Intro.
The business function relating to the decisions
involving:




What long-term investments should you take on ? What lines
of businesses ? What sorts of buildings, machineries and
equipments? (Investment Decisions)
Where will you get the long-term financing to pay for your
investment? Will you bring in other owners or will you borrow
the money? (Capital Structure Decisions)
How will you manage your everyday financial activities such
as collecting from customers and paying suppliers? (Working
Capital Management Decisions)
How the profit earned by the business shall be allocated to the
owners? (Dividend Decisions)
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 Financial Management, broadly speaking is the study
of ways to answer these three questions.
 The maintenance and creation of economic value or
wealth.
 The study of investment decisions by corporations and
ways the investment is financed
 Finance uses accounting information together with
other information to make decisions that affect the
market value of the firm.
 Conducting all financial matters of the organization in
a way that ensures that funds are used in a proper and
efficient manner
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1.2 Financial Management Decisions
1.
2.
3.
4.
Capital Budgeting/ Investment Decisions (Part IV)
Capital Structure Decisions/ Financing Decisions (Part
V)
Working Capital Management Decisions (Part VI)
Dividend Decisions (Part V)
Dividend Decisions are also sometimes considered as
a part of Capital Structure Decisions.
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1. Capital Budgeting/ Investment Decisions




The process of planning and managing a firm’s longterm investments.
The types of investment opportunities that would
typically be considered depend in part on the nature of
the firm’s business.
Evaluating the size, timing, and risk of future cash flows
is the essence of capital budgeting.
The financial manager tries to identify investment
opportunities that are worth more to the firm than they
cost to acquire.
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2. Capital Structure Decisions


A firm’s capital structure is the specific mixture of
long-term debt and equity the firm uses to finance its
operations and long-term investments.
Two concerns of financial manager:
1. How much of debt and how much of equity should the firm
borrow? (the mixture chosen will affect both, the value and
the risk of the firm)- optimum debt-equity ratio
2. What are the least expensive sources of funds for the firm?


How the firm as a pie is sliced among creditors and
shareholders?
How and where to raise the money ?
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3. Working Capital Management Decisions





Working Capital refers to a firm’s short-term assets,
such as inventory, and its short-term liabilities, such as
money owed to suppliers (a/c receivables)
Day-to-day activity
Ensuring that firm has sufficient resources to continue
its operations.
To avoid costly interruptions.
Relevant issues:
• How much cash and inventory should we keep on hand?
• Should we sell in credit ? What should be credit policy?
• How shall we obtain needed
short-term financing?
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4. Dividend Decisions


Related to the decisions regarding allocation of profit
among the shareholders/owners.
What should be done with the profits of the firm ?
• Whether dividend should be distributed or not ?
• How much profit shall be kept in the form of retained
earnings?
• How much shall be ploughed back to the business?
• Does the distribution of dividend increase the value of the
firm ?
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Some Fundamental Principles

Before we begin to study financial management
in detail, there are two fundamental concepts that
must be understood:
• The right goal of the firm/financial mgt/manager
• The risk/return tradeoff

These two concepts underlie
technique that we will study
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major
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•All management decisions should help
to accomplish the goal of the firm!
•What should be the goal of the firm and
hence the goal of FM ?
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1.3 Goal of Financial Management

Possible Goals
1.
2.
3.
4.
5.
6.
Survive
Avoid financial distress
Beat the competition
Maximize sales of market share
Minimize costs
Maintain steady earnings growth
Controlling
Risk
Profitability
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Problems with such goals
 Maximize sales or market share
 By lowering price or relaxing credit terms ?
 Minimize cost
 Doing away with things like R & D ?
 Avoid distress and bankruptcy
 By never borrowing any money or never taking risk ?
 Survive
 What about growth ?
 Beat the competition
 Placing dependence of your activities on competitor’s actions
?
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Is it ?
Profit Maximization?
 Probably
most commonly cited goal
 But even this is not precise objective
WHY ?
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Issues regarding this goal


Do we mean profits this year ( current profit )?
If yes, then why not maximize profit by:
What about
risk from the
perspective of
shareholders
• Deferring maintenance
• Letting inventories run down
• Canceling all casualty and liability insurance policies so that the money
spent on premiums could go to profit instead.
• Taking other short-run cost cutting measures
• Shall we be overly concerned about short-term profits results rather than the longterm strategic positioning of the company ?


Ok fine ! Lets us refer to some sort of “long run” or “average”
profits.
Does it give clear definition of what are we trying to maximize ?
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Issues regarding this goal (contd…)

Do we mean something like accounting net income (NI)
or earnings per share (EPS) ?
• If yes, then these accounting numbers may be easily
manipulated.

What do we mean by long run ?
• This goal doesn’t tell us what the appropriate trade-off is
between current and future profits.
In the long run, we’re all DEAD !
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Incorrectness of this goal….

This goal is inadequate for at least three reasons:
• It ignores the time value of money
• It ignores risk
• It can lead to a preoccupation with short-term results
which, in turn, can lead to sub-optimal long-term
results
We need goal that encompasses both factors: safety and profit
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Correct Goal of the Firm/ FM
Shareholder’s Wealth Maximization
this is the same as:
a) Maximizing Firm Value
b) Maximizing Stock Price
Eureka !!!!!
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The Correct Goal of the Firm




The correct goal of the firm is to maximize shareholder
wealth (i.e., shareholder’s equity) or, equivalently, to
maximize the firm’s stock price.
By this we mean to imply that the managers of the firm
work for the shareholders
For this reason, they have a duty to make investments that
are expected to increase shareholder wealth
Further, they have a duty to take all investments that are
expected to increase shareholder wealth
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The Goal of U.S. West Inc.

From the U.S. West Annual Report to Shareowners
1988:
Our mission is to provide quality products and
services to customers in responsive and
innovative ways in order to create the highest
possible value for our investors through long-term
growth and profitability
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•The goal of the firm should be to
maximize the stock price!
• This is equivalent to saying the goal is to
maximize owners’ wealth.
• Note that the stock price is affected by
management’s decisions affecting both risk and
profit.
• Stock price can be maintained or increased only
when stockholders perceive that they are
receiving profits that fully compensate them for
bearing the risk they perceive.
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Shareholders’ Wealth Maximization





Good decisions increase the value of the stock, and
poor decisions decrease the value of the stock.
Financial manager should act in the shareholder’s best
interest by making decisions that increase the value of
the stock.
The goal of FM is thus, to maximize the current value
per share of the existing stock.
There is no ambiguity in the criterion, and there is no
short-run vs long-run issue.
We explicitly mean that our goal is to maximize the
current stock value (firm’s present value)
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Does it seem little strong and one-dimensional ?




But, remember, shareholders are residual owners.
They get what’s left after employees, suppliers and
creditors are paid their due.
If the stockholders are winning in the sense that the
leftover, residual portion is growing, it must be true that
everyone else is winning also.
How to identify those investments and financing
arrangements that favorably impact the value of the stock
?
That’s precisely what we will be studying in FM
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Is stock price maximization the same as
profit maximization?



No, despite a generally high correlation amongst
stock price, EPS, and cash flow.
Current stock price relies upon current earnings, as
well as future earnings and cash flow.
Some actions may cause an increase in earnings,
yet cause the stock price to decrease (and vice
versa).
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The Goal of Financial Management
 The primary financial goal is shareholder wealth
maximization, which translates to maximizing
stock price.
 Do firms have any responsibilities to society at large?
 Is stock price maximization good or bad for society?
 Should firms behave ethically?
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A more General Goal



What is the appropriate goal with firm without traded
stock ?
It is difficult to say what the value per share is at any
given time.
More generally it can be said that the goal is to
maximize the market value of the existing owner’s
equity.
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Goal
Objective
Advantages
(i) Easy to calculate
profits
Large
Profit
(ii)Easy to determine
amount of
maximization
the link between
profits
financial decisions
and profits.
Highest
Shareholders
market
Wealth
value of
Maximization
shares
(i) Emphasizes the
long term
(ii)Recognises risk of
uncertainty
(iii)Recognises the
timing of returns
(iv)Consider
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shareholders’
Disadvantages
(i) Emphasizes the short
term
(ii)Ignores risk or
uncertainty
(iii)Ignores the timing of
returns
(iv)Requires immediate
resources.
(i) Offer no clear
relationship between
financial decisions and
share price.
(ii)Can lead management
anxiety and frustration.
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1.4 The Risk/Return Tradeoff




Throughout financial theory, we assume that
individuals are risk averse
This means that individuals prefer less risk to
more risk
However, a risk averse individual will accept
almost any level of risk as long as they are
properly compensated
We assume that the risk-return tradeoff is a linear
function (there is no good evidence that it isn’t)
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The Risk/Return Tradeoff Graphically



Assume that there are two
projects: A and B
Project B is riskier than
project A
B
Therefore, we expect that
A
B will, on average over
time, earn a higher return
than A
Otherwise, nobody would
ever invest in B
Return

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A
B
Risk
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Risk-Return Tradeoff in Financial Decisions

Financial decisions often involve alternative courses of
action.
• Should the firm set up a plant which has a capacity of 1 Mln
tons or 2 Mln tons ?
• Should the debt-equity ratio of the firm be 2:1 or 1:1 ?
• Should the firm pursue a generous credit policy or niggardly
credit policy ?
• Should the firm carry a large inventory or a small inventory ?

Each of alternative actions has different risk-return
implications.
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Risk-Return Tradeoff (contd….)

In general, making financial decisions involves answering
following questions:
• What is the expected return ?
• What is the risk exposure ?
• Given the risk-return characteristics of the decision, how would it
influence value ?
Capital Budgeting Decisions
RETURN
Capital Structure Decisions
Dividend Decisions
Market Value
of the Firm
RISK
Working Capital Decisions
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1.5 Organization for the finance function

The responsibilities for financial management are dispersed
throughout the organization.
• The engineer, proposing a new plant, shapes the investment policy of the
firm.
• Marketing analyst provides inputs in the process for forecasting and
planning.
• Departmental managers, in general, are important links in the financial
control system of the firm.


However, many of the specialized jobs of the FM are attended by
specialist.
These tasks can be distributed between two key financial
functions viz Treasurership and Controllership
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Finance function in a Typical Business
Organization
Board of Directors
President
VP: Sales
VP: Finance
Treasurer
VP: Operations
Controller
Credit Manager
Cost Accounting
Inventory Manager
Financial Accounting
Capital Budgeting Director
Tax Department
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Hyperthetical Organization Chart for a Corporation
Board of Directors
Chairman of the Board and Chief Executive Officer (CEO)
President and Chief Operations Officer (COO)
Vice President and Chief Financial Officer (CFO)
Tresurer
Controller
Cash manager
Credit manager
Tax manager
Cost accounting manager
Capital expenditures
Financial planning
Financial accounting manager
Data processing manager
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Functions of the Treasurer and Controller
Treasurer
Controller
Obtaining Finance
Financial Accounting
Banking Relationship
Internal Auditing
Cash Management
Credit Administration
Taxation
Management Accounting
Capital Budgeting
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Role of The Financial Manager
(2)
(1)
Financial
manager
Firm's
operations
(4a)
Financial
markets
(4b)
(3)
(1) Cash raised from investors
(2) Cash invested in firm
(3) Cash generated by operations
(4a) Cash reinvested
(4b) Cash returned to investors
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Other functions of financial officers



Involvement in injecting financial discipline in corporate
management processes.
Monitoring the operations of the firm to achieve desired
financial results.
Guide and participate in tasks of planning, funds
allocation, and control so that the financial point of view
is sufficiently emphasized in the process of corporate
management.
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1.6 Agency Problem and the Control of the Corporation



Because managers work for the shareholders,
they are considered to be agents for the
shareholders.
Occasionally, managers may act in their own best
interest, rather than in the interest of their
shareholders
This is known as an agency problem
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Agency Problem




Shareholders
desire
wealth
maximization (at all cost?)
Do
managers
maximize
shareholder wealth?
Mangers
have
many
constituencies “stakeholders”
“Agency Problems” represent the
conflict of interest between
management and owners (within
the agency relationship)
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Agency relationships

An agency relationship exists whenever a
principal hires an agent to act on their behalf and
represent his/her interest.

Within a corporation, agency relationships exist
between:
• Shareholders and managers
• Shareholders and creditors
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Ownership vs. Management
Difference in Information




Stock prices and returns
Issues of shares and other
securities
Dividends
Financing
Different Objectives



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Managers vs. stockholders
Top mgmt vs. operating
mgmt
Stockholders vs. banks
and lenders
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Shareholders versus Managers


Managers are naturally inclined to act in their
own best interests.
But the following factors affect managerial
behavior:
•
•
•
•
Managerial compensation plans
Direct intervention by shareholders
The threat of firing
The threat of takeover
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Shareholders versus Creditors

Shareholders (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.
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Managers and Shareholder Interests

Tools to Ensure Management Pays Attention to
the Value of the Firm
• Manger’s actions are subject to the scrutiny of the board
of directors.
• Shirkers are likely to find they are ousted by more
energetic managers.
• Financial incentives such as stock options
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Solutions
Agency Problem Solutions
1 - Compensation plans – tied to financial performance in general
and oftentimes to share value in particular.
2 - Board of Directors- elected by shareholders, who, in trun hire
and fire management.
3 - Takeovers
4 - Specialist Monitoring
5 - Auditors
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Conflict between shareholders and Managers
Owners delegate operational control to agents.
Agents, the managers, have their own goals which may not be consistent with
those of shareholders.
Managers are monitored and selected by directors, who are elected by shareholders
Shareholders attempt to control managers by
Using incentives in employment contracts or pay with shares, stock options or
profit sharing : Agency cost
Agency costs are sum of
monitoring costs of the shareholders
costs of implementing the control devices
Exploiting a competitive labor market
Mounting a takeover offer and casting out the current managers
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Agency Costs

There are two types of costs associated with the agency
problem:
• Direct agency costs are the loss in shareholder wealth due to
managerial misconduct
• Direct agency cost come in two forms:
Corporate expenditure that benefits management but costs the
stockholders. Eg. Purchase of a luxurious and unneeded corporate jet.
 An expense that arises from the need to monitor management actions.
Eg. Paying external auditors.

• Indirect agency costs are the costs of avoiding the agency
problem
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Whose Company Is It?
** Survey of 378 managers from 5 countries
3
Japan
97
17
Germany
22
France
United Kingdom
78
71
29
United States
76
24
0
The Shareholders
83
20
40
60
80
100
120
% of responses
All Stakeholders
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Dividends vs. Jobs
** Survey of 399 managers from 5 countries. Which is more important...jobs or paying
dividends?
3
Japan
97
40
Germany
41
France
United Kingdom
59
89
11
United States
89
11
0
Dividends
60
20
40
60
80
100
120
% of responses
Job Security
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Control of Corporation
elections
Board of Directors
selections
Management
Shareholders
operations
Debt
Assets
Equity
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1.7 Relationship of Finance to Economics

Two important linkages:
• Macro-economic environment defines the settings within
which a firm operates
• Micro-economic theory provides the conceptual underpinning
for the tolls of financial decision making



Understanding of the macro-economic developments
sensitizes the financial manager to the opportunities
and threats in the environment.
Firm grounding in micro-economic principles sharpens
his analysis of decision alternatives.
In fact, finance is applied
micro-economics.
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Relationship of Finance to Accounting


In popular perception finance and accounting are often
considered indistinguishable or at least substantially
overlapping.
Differences and Relationship between the two:
• Score Keeping Vs Value Maximizing
• Accrual Method Vs Cash Flow Method
• Certainty Vs Uncertainty
“The accountant’s role is to provide consistently developed and easily
interpreted data about the firm’s past, present and future operations. The
financial manager uses these data either in raw form or after certain
adjustments and analyzes, as an important input to the decision-making
process”
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Something You Should Know
Before You Enter Into the subject of
FINANCIAL MANAGEMENT
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The Fundamental Principal of Finance
“A business proposal – regardless of whether it is a new
investment or acquisition of another company or a restructuring
initiative- raises the value of the firm only if the present value of
the future stream of net cash benefits expected from the proposal
is greater than the initial cash outlay required to implement the
proposal”
Investors
• Shareholders
• Lenders
Investors provide the initial cash
required to finance the business
proposal
The Business
Proposal
The proposal generates cash returns to investors
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Functional Areas Needed to Accomplish the Strategic
Plan
Examples…
Communication
Marketing
and Sales
Recruiting
People
Team
Support
What “results” must we accomplish in these areas? GOALS
By what “means” ($$$$$) are we going to accomplish these
“results” OBJECTIVES/STRATEGY
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•Important focal points in the study of
finance:
• Accounting and Finance often focus on different
things
• Finance is more focused on market values rather
than book values.
• Finance is more focused on cash flows rather than
accounting income.
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•Why is market value more important
than book value?
•
•
•
•
Book values are often based on dated values (historical costs)
For current assets, MV and BV might be somewhat similar.
For fixed assets, they’re different by far.
The MV of financial assets depends on things like its riskiness
and cash flows, neither of which have anything to do with
accounting.
• They consist of the original cost of the asset from some past time,
minus accumulated depreciation (which may not represent the
actual decline in the assets’ value).
• Maximization of market value of the stockholders’ shares is the
goal of the firm.
• Financial manager must beS.B.Khatri
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interested on MV than BV.57
Why is cash flow more important than
accounting income?
• Cash flow to stockholders (in the form of
dividends) is the only basis for valuation of the
common stock shares. Since the goal is to
maximize stock price, cash flow is more directly
related than accounting income.
• Accounting methods recognize income at times
other than when cash is actually received or
spent. (Accrual and Matching Principle)
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•One more reason that cash flow is
important:
• When cash is actually received is important,
because it determines when cash can be invested
to earn a return.
[Also: When cash must be paid determines when
we need to start paying interest on money
borrowed.]
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•Examples of when accounting income
is different from cash flow:
• Credit sales are recognized as accounting income,
yet cash has not been received.
• Depreciation expense is a legitimate accounting
expense
when
calculating
income,
yet
depreciation expense is not a cash outlay.
• A loan brings cash into a business, but is not
income.
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•More examples:
• When new capital equipment is purchased, the
entire cost is a cash outflow, but only the
depreciation expense (a portion of the total cost)
is an expense when computing accounting
income.
• When dividends are paid, cash is paid out,
though dividends are not included in the
calculation of accounting income.
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•Definitions: Operating income vs.
operating cash flow
• Operating income = earnings before interest and
taxes (EBIT).
• This is the total income that the company earned
by operating during the period. It is income
available to pay interest to creditors, taxes to the
government, and dividends to stockholders.
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•Operating cash flow:
• Operating cash flow
= EBIT + Depreciation - Taxes.
• This definition recognizes that depreciation
expense is subtracted in computing EBIT, though
it is not a cash outlay.
• It also recognizes that taxes paid is a cash outlay.
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Fund Flows via Market
Markets
Surplus Units
Deficit Units
Intermediaries
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Fund Flows via Intermediary
Markets
Surplus Units
Deficit Units
Intermediaries
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Fund Flows via Intermediary and
Market
Markets
Surplus Units
Deficit Units
Intermediaries
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Funds Flow via Markets and
Intermediaries
Markets
Surplus Units
Deficit Units
Intermediaries
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Funds Flow: Disintermediation
Markets
Surplus Units
Deficit Units
Intermediaries
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Thank you
THE END
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