Introduction to
Financial Management
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What is Financial Management?
• Financial Management is about money
– where does it come from?
– what do organisations do with it?
– how can they use it efficiently?
– how can they control for risk?
• Organisations can be …
– small, medium-sized or large
– public or private
– state-owned industry
– partnerships
– charities
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Sources vs. Uses of Funds
Uses
Sources
Land
Banks
Capital markets
cash
Venture capital
Buildings
Equipment
Labour
Private investors
Working Capital
cash
cash
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Types of Funds
• Equity (= ordinary shares)
– shareholders entitled to pro rata share
of residual cash flows after company has
met all of its liabilities
Equity
Earnings
after Interest
and Tax
paid to shareholders
as dividends
retained by firm
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Types of Funds cont.
• Familiar types of debt
– short-term loans e.g. overdraft,
suppliers, deferred taxes
– medium-term or long-term loans e.g.
bank loans, mortgages, leases
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Types of Funds cont.
• Less familiar types of debt
– debentures
– preference shares
– warrants
– Convertibles
What are these?
Why do firms need to issue so many
different types of funds?
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Key Points
• Check your understanding of
buzzwords
• Get help from an expert
• Check the sources of funds for
future employers, large suppliers &
customers
– Will/can they pay you???
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Goals of the Firm
• A firm has many stakeholders
– shareholders, lenders, managers,
employees, suppliers, customers, and
society (via taxes and the environment)
• What should be the financial goal(s) of
firm?
– maximise profit?
• difficulty is … definition of “profit”
is subject to accounting conventions
– hence, use cash flows, not profit
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Goals of the Firm cont.
• Shareholders own firm’s residual cash
flows after all liabilities have been
paid
– suggests financial goal of firm
should be to maximise shareholder
wealth
– but how do we compare cash flows
that occur at different dates in the
future?
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Major Themes of Financial Man’t
• Trade-off between risk and return
– investors prefer more wealth to less wealth, but
are risk-averse
– hence, return required by investors:
risk-free return
compensates investors
for deferred consumption
Required
return
Risk-free
rate
risk premium
depends on
amount of risk
Risk
premium
Risk
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Major Themes cont.
• Opportunity cost of capital
– shareholders can invest in capital markets
for themselves
– so … managers should invest only in
projects that provide higher return than
that available in the capital markets for
the same level of risk
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Project Appraisal
Comparing the
value of
different
contracts
Choosing new
equipment
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Value Creation
• The main objective of project is creation of value for its
stakeholders.
• Value is created
• The private sector main objective is value creation for
their owners (stock holders). This is in terms of wealth
maximization.
• The public sector attempts to maximize social benefits.
• Value creation is the guiding principle through out this
discussion. That is any project must be able to create
value
Massood Samii, MIT OpenCourseWare
– financially by creating net cash flow
– socially by creating social benefit.
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• In accounting all the costs and revenues are explicit, in
finance and economics, they are both explicit and implicit.
– Explicit cost are the accounting costs that are realized.
For example, labour cost, energy costs, and material.
– Implicit costs are those costs that are hidden.
– One such a cost is the difference between revenue and
revenue from best alternative investment . For example if
we make A amount of investment and we receive X amount
of return but an alternative investment would create Y
return, where Y>X, from economic point of view there is a
loss equal to Δ = Y-X. In accounting term there is a profit
of X.
Massood Samii, MIT OpenCourseWare
Explicit and Implicit Cost
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• Social cost–benefit analysis centres on the difference
between explicit and implicit cost.
– Social cost are costs that are incurred by society. A
firm may be dumping waste into a river. From the
firm’s point of view there is zero cost associated
with waste disposal. However, the social cost of the
firm’s operation (from a societal point of view) is
very high since they either have to clean the water
(a cost for the society) or have polluted water.
– Social benefits may also be different to private
benefits.
Massood Samii, MIT OpenCourseWare
Social Cost-Benefit
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Introduction
• How should a business evaluate an
investment in new plant, equipment, … i.e. a
new “project”?
– are the expected future cash flows
worth more than the initial cost?
• Need to …
– estimate annual incremental cash flows
associated with the project
– discount these cash flows back to the
starting date for the project
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Introduction cont.
• Discounting reflects both timing and uncertainty
of future cash flows
• For a stream of expected future cash flows C1, C2,
…, CT and initial investment I, net present value
(NPV) of investment equals:
C1
C2
CT
NPV   I 

 ...
T
2
1 R 1 R 
1 R 




• NPV rule for capital investment
– if capital is not rationed, accept all
projects with NPV > 0
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Incremental Cash Flows
• Which cash flows should be included in project
appraisal?
• After-tax cash flows that are incremental to
project
• Difference (hence incremental) in firm’s cash
flows between two mutually-exclusive scenarios:
• “project goes ahead”
vs. “project does not go ahead”
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What to include …
• Opportunity costs
– cost of fixed assets (land, buildings, machinery)
purchased to undertake project
– market value of fixed assets that could be put
to alternative uses e.g. let or sold
– management time spent on project
• Changes in Working Capital
– WC is capital (cash, inventory, …) needed to run
project over short term
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What to include cont.
• Taxes
– cash-flow savings from capital allowances on
buildings and equipment
– opportunity cost of capital is reduced because
interest payments on debt are corporate-tax
deductible
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What NOT to include …
• Sunk costs
– costs already incurred and not recoverable e.g. R&D
costs
• Accounting allocations
– overheads
– depreciation of fixed assets
– accruals or other accounting devices for smoothing
costs and revenues
• Cash flows that are neither costs nor revenues associated
with the investment
– interest payments on debt
– dividends paid to shareholders
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• Each period revenue is forecast
• Each period cost is determined
• Difference between cost and revenue is gross
return
• Determine taxable income by subtracting
depreciation
• Subtract tax
• Add back depreciation
• Discount cash flow to present time take into
account proper discount rate
Massood Samii, MIT OpenCourseWare
Cash flow analysis
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Discount rate
• What is the correct discount rate R?
• Opportunity cost of capital
– after-tax rate of return that investors could
obtain for themselves by investing initial
amount I instead in a well-diversified portfolio
of financial securities with same level of risk as
project
• Financial markets provide benchmark rate of
return because they are highly efficient at pricing
securities
• We will learn how to estimate R in the lecture on
Cost of Capital
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Inflation
• Nominal vs. real cash flows
– nominal cash flows C1, C2, … CT are measured in
money of future date
– real cash flows c1, c2, … cT are measured in
money of today, and reflect future purchasing
power of cash flows
• If expected annual inflation rate over next T
years equals i%, then:
CT  cT  1  i 
T
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Inflation cont.
• Nominal vs. real rates of return
– nominal rate R reflects growth in nominal
amount of money
– real rate r reflects growth adjusted for
expected inflation rate i
• Fisher relationship:
1 R  (1 r)  (1 i)
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Nominal
and Real Interest Rates
• What is the real rate of interest, r,
if the nominal rate of interest R is
7% and inflation, i, is 3%?
1 R  (1 r)  (1 i)
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Inflation and Discounting
• Can work in either nominal or real terms provided
we are consistent
– i.e. discount nominal cash flows at nominal rate
– or discount real cash flows at real rate:
CT
T

1 R 



cT
1 r


T


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Inflation and Discounting cont.
• But … not all cash flows inflate at the same rate
– cost of labour typically inflates faster than
cost of materials
– capital allowances on new buildings and
equipment are not index-linked
• In practice, therefore, discounting is best done in
nominal terms
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Taxes and Discounting
• Discount rate R used in project appraisal equals rate of
return that investors can obtain for themselves by
investing instead in well-diversified portfolio of
financial securities of same risk as project
• Rate of return on stock-market investments is
calculated after …
– company has paid corporation tax on its profits
– shareholders have paid personal taxes on dividend
income and capital gains
• Hence, we must use an after-tax cost of capital to
discount incremental, after-tax cash flows associated
with the project
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Capital Allowances
• Company investing in a new project can take advantage
of capital allowances
• Inland Revenue specifies writing-down schedule
– 25% reducing-balance over economic life of new
equipment
– 4% straight-line over each of 25 years for new
buildings
• Capital allowances lead to lower tax bills and therefore
increased after-tax cash flows
N.B. Capital allowances are not index-linked
- do not increase in line with inflation
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Example: no inflation
End of Year
0
1
2
3
4
5
Investment
Equipment
-2800
100
Inventory
-1000
1000
-300
300
-4100
1400
Monetary WC
Operating CF
Revenue
See next
slide
2000
2000
2000
2000
2000
Expenditure
-1000
-1000
-1000
-1000
-1000
Operating CF
1000
1000
1000
1000
1000
210
-143
-182
-211
-234
-131
-3890
858
818
789
766
2269
Corp. Tax
After-Tax CF
NPV @ 9%
212
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End of Year
0
1
2
3
4
5
2800
2100
1575
1181
886
664
700
525
394
295
221
564
1000
1000
1000
1000
1000
Writing-down schedule
Book Value
Cap. Allowance @25%
Tax calculations
Operating CF
Cap. Allowance
-700
-525
-394
-295
-221
-564
Taxable Income
-700
475
606
705
779
436
Corp. Tax @ 30%
-210
143
182
211
234
131
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Where do Positive NPVs come from?
• Recall NPV rule
– if capital is not rationed, accept projects for
which rate of return exceeds cost of capital
– in other words … if NPV > 0
• If NPV > 0, project is said to earn an economic
rent
• What kind of project has a positive NPV?
• In a perfectly competitive market, all assets are
priced so that NPV = 0
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Where do Positive NPVs come from?
cont.
• In real life, markets for real (as opposed
to financial) assets (e.g. product markets
or labour markets ) may be less than
perfectly competitive
• Economic rents occur if firm enjoys some
competitive advantage
– monopoly power
– competitors cannot imitate firm’s lead
technology because of lack of expertise,
development time, patent protection, …
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Real Options …or what DCF leaves out
• Discounted cash flow (DCF) techniques
– NPV of stream of expected future cash
flows C1, C2, … CT resulting from initial
investment I is given by:
C1
C2
CT
NPV   I 


...

T
2
1 R
1 R 
1 R 




– treats initial investment I as “set-instone”
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Real Options …cont.
• Real projects are rarely once-and-for-all
decisions
– may be subsequent opportunities to
expand, contract, postpone, abandon, …
project
• Managerial flexibility i.e. ability to wait for
additional information that will inform
decision e.g. to commit (further) funds, is
valuable
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Real Options
• Examples of managerial flexibility include
– expanding site (future growth option)
– mothballing a project (postponement option)
– closing down operations early (abandonment
option)
– power station that can run on gas or coal
(switching option)
• They differ from a financial option because they
involve a real asset
• Such projects are said to include real options
– these can be valued using established
techniques for pricing financial options
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Real Options cont.
• Buy land for a housing development at
£100 per m2
• Contract includes option to buy adjacent
land at £105 per m2 in 2 years time
• This is a ‘call option’
• Real options can mean that a project can be
become financially feasible if market
conditions change
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Summary
• Need to estimate
– expected incremental (after-tax) cash flows
– (after-tax) cost of capital
• Either discount nominal expected cash flows at nominal rate, or real
expected cash flows at real rate
– since inflation does not impact all cash flows uniformly work in
nominal terms or use different inflation rates
• Competitive advantage is the source of positive NPVs
– but difficult to sustain this advantage
• Discounted cash-flow (DCF) techniques are “static”
– assume that initial investment is “now or never”
– ill-suited for capturing value of flexibility
• Where managerial flexibility is important
– Try to estimate the value of the ‘real’ options
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