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Chapter 1

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  • 1. Chapter 1 <ul><li>The Roles and Objectives of Financial Management </li></ul>
  • 2. Introduction <ul><li>This chapter introduces the financial management process of the typical firm. It looks at the financial manager, the field of finance, financial decisions and their implications, and the daily questions faced by the firm’s financial management. </li></ul>
  • 3. A GENERAL LOOK AT FINANCE <ul><li>Finance is the art and science of managing money </li></ul>
  • 4. <ul><li>How is finance related to other fields of study? </li></ul><ul><li>What are the goals and objectives of financial managers? </li></ul><ul><li>How has the finance field evolved? </li></ul><ul><li>How is the finance field changing today? </li></ul>Questions Faced in Finance
  • 5. THERE ARE THREE MAJOR AREAS OF FINANCE <ul><ul><li>Investments -- Concerned with analyzing potential investments (including Real Estate) in order to achieve a certain rate of return consistent with a desired level of risk. Return on Investment </li></ul></ul><ul><ul><li>Financial institutions and markets -- Concerned with the management of financial institutions like commercial banks, insurance companies, etc. Also concerned with analyzing financial markets and predicting interest rates. </li></ul></ul>
  • 6. AREAS OF FINANCE --continued <ul><ul><li>Business finance or corporate finance or managerial finance which is concerned with the management of the “non-financial” corporation. Primarily concerned with the “for profit” organization, but same principles apply to the “not for profit” organization. </li></ul></ul><ul><li>This course is concerned with managerial finance, but we will get into the other areas. That is, at times, we will assume the role of a banker or investor . </li></ul>
  • 7. What Activities are Involved in Managerial Finance <ul><li>Investment of funds or capital budgeting </li></ul><ul><ul><li>Risk versus Return </li></ul></ul><ul><ul><li>Real Options </li></ul></ul><ul><li>Working capital management </li></ul><ul><ul><li>Amount of cash to hold </li></ul></ul><ul><ul><li>Amount of credit to grant </li></ul></ul><ul><ul><li>Amount of inventory to hold </li></ul></ul><ul><ul><li>Where to obtain short term capital </li></ul></ul><ul><li>Acquisition of funds - Financing </li></ul><ul><ul><li>Debt versus equity </li></ul></ul><ul><ul><li>Long term debt versus short term debt </li></ul></ul><ul><ul><li>Lease versus own </li></ul></ul>
  • 8. Activities in Finance -continued <ul><li>Distribution or Dividend Decision </li></ul><ul><li>Financial planning </li></ul><ul><li>Others </li></ul><ul><ul><li>Mergers and acquisitions </li></ul></ul><ul><ul><li>Bankruptcies </li></ul></ul><ul><ul><li>Spin-offs </li></ul></ul><ul><ul><li>Leverage buy-outs (LBO) </li></ul></ul><ul><ul><li>Valuations </li></ul></ul><ul><ul><ul><li>EVA and MVA </li></ul></ul></ul>
  • 9. In Making Financial Management Decisions, What is Our Goal? <ul><li>Some Possibilities </li></ul><ul><ul><li>Maximize revenue </li></ul></ul><ul><ul><li>Maximize profits </li></ul></ul><ul><ul><li>Maximize EPS </li></ul></ul><ul><ul><li>Minimize losses </li></ul></ul><ul><ul><li>Others </li></ul></ul>
  • 10. Owner’s Wealth Maximization (OWM) or Stockholders’ Wealth Maximization (SWM) Objective of the financial manager NOT profit maximization Does not consider time value of money or cash flows or risk Objective of Financial Management ( FM )
  • 11. Principal Forms of Business Organizations are: <ul><li>Sole proprietorship </li></ul><ul><li>Partnership </li></ul><ul><li>Corporation </li></ul>
  • 12. Sole Proprietorship <ul><li>Owned by one person </li></ul><ul><li>Easy formation advantage </li></ul><ul><li>Unlimited liability disadvantage </li></ul><ul><li>Difficulty raising funds disadvantage </li></ul><ul><li>Represent 75 percent of all businesses </li></ul><ul><li>Account for less than 6% of the dollar volume </li></ul><ul><li>Check out small business info from the SBA </li></ul><ul><li>http://www.sba.gov/ </li></ul>
  • 13. Partnership <ul><li>Owned by two or more persons </li></ul><ul><li>Classified as general or limited </li></ul><ul><li>Partnership dissolves when a general partner dies </li></ul><ul><li>General partner has unlimited liability </li></ul><ul><li>Limited partner’s liability limited by partnership agreement </li></ul>
  • 14. Corporation <ul><li>Limited liability </li></ul><ul><li>Permanency </li></ul><ul><li>Flexibility </li></ul><ul><li>Ability to raise capital </li></ul><ul><li>Legal entity </li></ul><ul><li>Have a board of directors </li></ul><ul><li>Owners are stockholders </li></ul><ul><li>Easy marketability of shares of ownership </li></ul>Dartmouth College Case
  • 15. Optimal Form of Organization Influenced by <ul><li>Cost </li></ul><ul><li>Complexity </li></ul><ul><li>Liability </li></ul><ul><li>Continuity </li></ul><ul><li>Raising capital </li></ul><ul><li>Decision making </li></ul><ul><li>Tax considerations </li></ul>
  • 16. Board of Directors <ul><li>Stockholders elect a board of directors </li></ul><ul><li>Board of directors then elect the officers </li></ul><ul><ul><li>Chairman of the board </li></ul></ul><ul><ul><li>Chief executive officer (CEO) </li></ul></ul><ul><ul><li>Chief operating officer (COO) </li></ul></ul><ul><ul><li>President </li></ul></ul><ul><ul><li>Chief financial officer (CFO) </li></ul></ul><ul><ul><li>Vice presidents </li></ul></ul><ul><ul><li>Treasurer </li></ul></ul><ul><ul><li>Secretary </li></ul></ul>Management
  • 17. Major Advantage of Corporation is Limited Liability <ul><li>We will assume in this course that we are working with corporations </li></ul><ul><li>Ownership is represented by common stock (CS) </li></ul><ul><li>Our objective is to maximize the long term value of the common stock (this is the same as OWM or SWM) </li></ul><ul><ul><li>MVA and EVA </li></ul></ul>
  • 18. Three Basic Factors Determine C/S Market Value <ul><li>1) Amount of </li></ul><ul><li>2) Timing of </li></ul><ul><li>3) Risk of </li></ul>Expected cash flows Also, interest rates and tenor of the market
  • 19. Risk-Return Tradeoff <ul><li>We will assume that firms and investors are risk averse </li></ul><ul><li>“ There is no such thing as a free lunch” </li></ul><ul><li>“ Do you want to sleep well or eat well?” </li></ul>
  • 20. SWM <ul><li>Considers the timing and risk of the benefits from stock ownership </li></ul><ul><li>Determines that a good decision increases the price of the firm's common stock ( c/s ) </li></ul><ul><li>Is an impersonal objective </li></ul><ul><li>Is concerned for social responsibility and ethics </li></ul>
  • 21. Social Responsibility <ul><li>Ethical issues will constantly confront financial managers as they achieve the goal of the firm ( SWM ). </li></ul><ul><li>Avoid personal conflicts </li></ul><ul><li>Maintain confidentiality </li></ul><ul><li>Be objective </li></ul><ul><li>Act fairly </li></ul><ul><li>(essentially, treat others as you would have </li></ul><ul><li>them treat you) </li></ul>Managers Must
  • 22. Conditions Affecting Market Value <ul><li>Economic environment factors </li></ul><ul><li>Managerial Decisions -- Which will determine </li></ul><ul><ul><li>Expected cash flows </li></ul></ul><ul><ul><li>Risk of expected cash flows </li></ul></ul><ul><ul><li>Timing of expected cash flows </li></ul></ul><ul><li>Conditions in financial markets </li></ul><ul><ul><li>Interest rates </li></ul></ul><ul><ul><li>Tenor of the market </li></ul></ul>
  • 23. Stockholders elect a board of directors Board of directors then hire management ( officers )
  • 24. Who Manages? <ul><li>Board of directors deals with broad policy </li></ul><ul><li>3 to 5 year strategic plan </li></ul><ul><li>Management makes most of the decisions </li></ul><ul><li>Day-to-day decisions following the strategic plan </li></ul>
  • 25. Stockholder Rights <ul><li>Dividend </li></ul><ul><li>Voting </li></ul><ul><li>Asset </li></ul><ul><li>Preemptive </li></ul>
  • 26. Priority of Corporate Securities <ul><li>Bonds (highest) </li></ul><ul><li>Preferred stock </li></ul><ul><li>Common stock (C/S) (lowest) </li></ul><ul><li>Major corporate Web sites </li></ul><ul><li>http://www. bankofamerica .com/ </li></ul><ul><li>http://www. ge .com/ </li></ul><ul><li>http://www. ibm .com/us/ </li></ul><ul><li>http://www. wachovia .com </li></ul>
  • 27. <ul><li>Problem created by separation of </li></ul><ul><li>Management maximizes </li></ul><ul><li>their own welfare instead </li></ul><ul><li>of the owners wealth </li></ul>Owners (shareholders) Management and Employees Job Security One Agency Relationships / Problems
  • 28. Job Security <ul><li>Management decisions based on retaining management rather than SWM </li></ul><ul><li>Example–A decision to retain suppliers rather than selecting new suppliers providing higher quality or lower cost </li></ul><ul><li>Why–If the transition is mishandled management will be scrutinized but if no change is made the issue will be ignored </li></ul>
  • 29. Agency Costs <ul><li>A. Management incentives (e.g. stock options) </li></ul><ul><li>B. Monitor performance (e.g. auditing) </li></ul><ul><li>C. Owners protection (e.g. bonding) </li></ul><ul><li>D. Complex Organizational Structures </li></ul>Pervasive Trends Flatten organization structures to cut costs Incorporate Technology in Managing Eliminate “Back Office” Operations
  • 30. <ul><li>Agency Problem created by separation of </li></ul><ul><li>Owners </li></ul>Management A second and similar Agency problem Owners Creditors Protective covenants in loan agreements
  • 31. Agency Problem between Stockholders and Creditors <ul><li>Creditor’s return is limited (fixed) by interest rate on debt </li></ul><ul><li>Stockholders have limited liability and potential for unlimited returns. They are willing and rewarded for taking risks. </li></ul>
  • 32. Examples of Protective Covenants <ul><li>Limitations on </li></ul><ul><ul><li>common stock dividends </li></ul></ul><ul><ul><li>the type of investments </li></ul></ul><ul><ul><li>divestitures </li></ul></ul><ul><ul><li>additional debts </li></ul></ul><ul><ul><li>poison puts </li></ul></ul>
  • 33. Competitive Factors Influencing C/S Market Value <ul><li>New entrants </li></ul><ul><li>Substitute products </li></ul><ul><li>Bargaining power of buyers </li></ul><ul><li>Bargaining power of suppliers </li></ul><ul><li>Rivalry among current competitors </li></ul>
  • 34. Cash Flow Concept Used for <ul><li>Financial analysis </li></ul><ul><li>Planning </li></ul><ul><li>Resource allocation </li></ul>External sources Cash Internal sources CF does not equal accounting profit
  • 35. Shareholder Wealth Maximizing Is a Market Concept and Results in <ul><li>Maximizing PV of E(R) </li></ul><ul><li>Measured by Market Value of C/S </li></ul>
  • 36. NPV of an Investment <ul><li>NPV = PV of future cash inflows minus PV of cash outflows </li></ul><ul><li>The NPV of an investment represents the contributions of that investment to the value of the firm and affects the Stockholders’ Wealth Maximization (SWM) </li></ul><ul><ul><li>EVA and MVA </li></ul></ul>
  • 37. Small Business Vs. Large Corporations Fundamental concepts are the same
  • 38. Small Business <ul><li>1) Not the dominant firm in the industry </li></ul><ul><li>2) Tend to grow more rapidly </li></ul><ul><li>3) Limited access to financial markets </li></ul><ul><li>4) Lack management resources </li></ul><ul><li>5) Have a high failure rate </li></ul><ul><li>6) Stock is not publicly traded </li></ul><ul><li>7) Poorly diversified </li></ul><ul><li>8) Owner/manager frequently the same </li></ul>
  • 39. Treasurer’s Activities <ul><li>Management of cash and marketable securities </li></ul><ul><li>Capital Budgeting </li></ul><ul><li>Financial Planning </li></ul><ul><li>Credit Analysis </li></ul><ul><li>Investor Relations </li></ul><ul><li>Pension Fund Management </li></ul>
  • 40. Controller’s Activities <ul><li>Financial Accounting </li></ul><ul><li>Cost Accounting </li></ul><ul><li>Taxes </li></ul><ul><li>Data Processing </li></ul>
  • 41. <ul><li>Economics </li></ul><ul><li>Accounting </li></ul><ul><li>Marketing </li></ul><ul><li>Production </li></ul><ul><li>Human Resources </li></ul><ul><li>Quantitative Analysis </li></ul><ul><li>MIS </li></ul>Disciplines Impacting Finance Finance
  • 42. Professional Organizations <ul><li>Financial Executives International </li></ul><ul><li>Institute of Chartered Financial Analysts </li></ul><ul><li>Financial Management Association </li></ul><ul><li>Credit Management Association </li></ul><ul><li>Institute of Certified Financial Planners </li></ul><ul><li>Institute of Management Accountants </li></ul>
  • 43. Exciting Career Opportunities in Finance <ul><li>Certified Cash Manager </li></ul><ul><li>Credit Manager </li></ul><ul><li>Vice President of Finance (CFO) </li></ul><ul><li>Director, Investor Relations </li></ul><ul><li>Assistant Treasurer </li></ul><ul><li>Tax Manager </li></ul><ul><li>Financial Planner </li></ul><ul><li>Banker </li></ul><ul><li>Financial Analyst </li></ul><ul><li>Mutual Fund Manager </li></ul><ul><li>Account Executive, Security Broker </li></ul><ul><li>Mortgage Analyst </li></ul><ul><li>Investment Banker </li></ul><ul><li>Real Estate Analyst </li></ul><ul><li>Insurance Broker </li></ul>Check out http://www. careerpath .com/

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