BMP 3005 - 1st session .ppt

FOUNDATION YEAR
Regent College London

APPLIED BUSINESS FINANCE
Session 1 - Introduction

AGENDA
1. What Financial Management is?
2. The Goals of Financial Management in the New Millennium
3. The Role of Financial Managers
4. Agency Problems
5. Financial Decisions and Risk-Return Trade-Off

1. WHAT FINANCIAL MANAGEMENT IS?
Financial management refers to strategic planning, organising, directing,
and controlling the funds sourcing and its usage for maximizing the
shareholders' profit and value.
It also includes applying management principles to the financial assets of
an organisation, while also playing an important part in fiscal
management. Take a look at the objectives involved:
• Maintaining enough supply of funds for the organisation;
• Ensuring shareholders of the organisation to get good returns on their
investment;
• Optimum and efficient utilization of funds;

• Creating real and safe investment opportunities to invest in.
• Financial management is also made up of certain elements. These
include:
• The financial management department of any firm is handled by a
financial manager. This department has numerous functions such as:
• Calculating the capital required: The financial manager has to calculate
the amount of funds an organisation requires. This depends upon the
policies of the firm with regards to expected expenses and profits. The
amount required has to be estimated in such a way that the earning
capability of the organisation increases.

• Formation of capital structure: Once the amount of capital the firm
requires has been estimated, a capital structure needs to be formed. This
involves debt equity analysis in the short-term and the long-term. This
depends upon the amount of the capital the firm owns, and the amount
that needs to be raised via external sources.
• Investing the capital: Every organisation or firm needs to invest money in
order to raise more capital and gain regular returns. Hence, the financial
manager needs to invest the organisation’s funds in safe and profitable
ventures.

• Allocation of profits: Once the organisation has earned a good amount
of net profit, it is the financial manager’s duty to efficiently allocate it.
This could involve keeping a part of the net profit for contingency,
innovation, or expansion purposes, while another part of the profit can
be used to provide dividends to the shareholders.
• Effective management of money: This department is also responsible for
effectively managing the firm’s money. Money is required for various
purposes in the firm such as payment of salaries and bills, maintaining
stock, meeting liabilities, and the purchase of any materials or
equipment.

• Financial control: Not only does the financial manager have to plan,
organise, and obtain funds, but he also has to control and analyse the
firm’s finances in the short-term and the long-term. This can be done
using financial tools such as financial forecasting, ratio analysis, risk
management, and profit and cost control.

2. THE GOALS OF FINANCIAL MANAGEMENT
IN THE NEW MILLENNIUM
Typical goals of the firm include
1. Stockholder wealth maximization;
2. Profit maximization;
3. Managerial reward maximization;
4. Behavioral goals; and
5. Social responsibility.
Modern managerial finance theory operates on the assumption that the
primary goal of the firm is to maximize the wealth of its stockholders,
which translates into maximizing the price of the firm’s common stock.

• The other goals mentioned previously also influence a firm’s policy but
are less important than stock price maximization.
• Note that the traditional goal frequently stressed by economists profit
maximization—is not sufficient for most firms today.
• The focus on wealth maximization continues in current times. Two
important trends—the globalization of business and the increased use of
information technology—are providing exciting challenges in terms of
increased profitability and new risks.

Profit Maximization versus Stockholder Wealth Maximization (i)
• Profit maximization is basically a single-period or, at the most, a short-
term goal. It is usually interpreted to mean the maximization of profits
within a given period of time. A firm may maximize its short-term profits
at the expense of its long-term profitability and still realize this goal.
• In contrast, stockholder wealth maximization is a long-term goal, since
stockholders are interested in future as well as present profits. Wealth
maximization is generally preferred

Profit Maximization versus Stockholder Wealth Maximization (ii)
Wealth maximization considers;
1. wealth for the long term;
2. risk or uncertainty;
3. the timing of returns; and
4. the stockholders’ return.

Profit Maximization versus Stockholder Wealth Maximization (iii)
Table 1-1 provides a summary of the advantages and disadvantages of these two often conflicting goals.

Profit Maximization versus Stockholder Wealth Maximization (iv)
EXAMPLE 1.1
• Profit maximization can be achieved in the short term at the expense of
the long-term goal, that is, wealth maximization.
• For example, a costly investment may experience losses in the short term
but yield substantial profits in the long term.
• Also, a firm that wants to show a short-term profit may, for example,
postpone major repairs or replacement, although such postponement is
likely to hurt its long-term profitability.

Profit Maximization versus Stockholder Wealth Maximization (v)
EXAMPLE 1.2
• Profit maximization does not consider risk or uncertainty, whereas
wealth maximization does. Consider two products, A and B, and their
projected earnings over the next 5 years, as shown below.
£ £
£ £

Profit Maximization versus Stockholder Wealth Maximization (vi)
EXAMPLE 1.2
• A profit maximization approach would favor product B over product A.
• However, if product B is more risky than product A, then the decision is
not as straightforward as the figures seem to indicate.
• It is important to realize that a trade-off exists between risk and return.
Stockholders expect greater returns from investments of higher risk and
vice versa.
• To choose product B, stockholders would demand a sufficiently large
return to compensate for the comparatively greater level of risk.

3. THE ROLE OF FINANCIAL MANAGERS
The financial manager of a firm plays an important role in the company’s
goals, policies, and financial success. The financial manager’s
responsibilities include:
1. Financial analysis and planning: Determining the proper amount of
funds to employ in the firm, i.e., designating the size of the firm and its
rate of growth
2. Investment decisions: The efficient allocation of funds to specific
assets

4. Financing and capital structure decisions: Raising funds on as
favorable terms as possible, i.e., determining the composition of
liabilities
5. Management of financial resources (such as working capital)
6. Risk management: protecting assets by buying insurance or by
hedging.

In a large firm, these financial responsibilities are carried out by the
treasurer, controller, and financial vice president (chief financial officer).
• The treasurer is responsible for managing corporate assets and liabilities,
planning the finances, budgeting capital, financing the business,
formulating credit policy, and managing the investment portfolio. He or
she basically handles external financing matters.
• The controller is basically concerned with internal matters, namely,
financial and cost accounting, taxes, budgeting, and control functions.
• The chief financial officer (CFO) supervises all phases of financial activity
and serves as the financial adviser to the board of directors.

• The Financial Executives Institute (www.fei.org), an association of
corporate treasurers and controllers, distinguishes their functions as
shown in Table 1-2.

The financial manager can affect stockholder wealth maximization by
influencing
1. Present and future earnings per share (EPS)
2. The timing, duration, and risk of these earnings
3. Dividend policy
4. The manner of financing the firm

4. AGENCY PROBLEMS
An agency relationship exists when one or more persons (called principals)
employ one or more other persons (called agents) to perform some tasks.
Primary agency relationships exist (1) between shareholders and managers
and (2) between creditors and shareholders. They are the major source of
agency problems.
4.1. Shareholders versus Managers
• The agency problem arises when a manager owns less than 100 percent
of the company’s ownership.

4. AGENCY PROBLEMS
• As a result of the separation between the managers and owners,
managers may make decisions that are not in line with the goal of
maximizing stockholder wealth.
• For example, they may work less eagerly and benefit themselves in terms
of salary and perks. The costs associated with the agency problem, such
as a reduced stock price and various ‘‘perks,’’ is called agency costs.
• Several mechanisms are used to ensure that managers act in the best
interests of the shareholders: (1) golden parachutes or severance
contracts; (2) performance-based stock option plans; (3) the threat of
firing; and (4) the threat of takeover.

4. AGENCY PROBLEMS
4.2. Creditors versus Shareholders
• Conflicts develop if (1) managers, acting in the interest of shareholders,
take on projects with greater risk than creditors anticipated and (2) raise
the debt level higher than was expected. These actions tend to reduce
the value of the debt outstanding.

5. FINANCIAL DECISIONS AND RISK-RETURN
TRADE-OFF
• Integral to the theory of finance is the concept of a risk-return trade-off.
All financial decisions involve some sort of risk-return trade-off.
• The greater the risk associated with any financial decision, the greater
the return expected from it. Proper assessment and balance of the
various risk-return trade-offs available is part of creating a sound
stockholder wealth maximization plan.

TRADE-OFF
EXAMPLE 1.3
In the case of investment in stock, the investor would demand higher
return from a speculative stock to compensate for the higher level of risk.
• In the case of working capital management, the less inventory a firm
keeps, the higher the expected return (since less of the firm’s current
assets is tied up), but also the greater the risk of running out of stock and
thus losing potential revenue.

TRADE-OFF
EXAMPLE 1.3 (continuation)
• A financial manager’s role is delineated in part by the financial
environment in which he or she operates.
• Three major aspects of this environment are (1) the organization form of
the business; (2) the financial institutions and markets; and (3) the tax
structure.

TRADE-OFF
• In few words any financial manager
must decide balancing risk and
returns or profits.
• There is an inverse relationship
between these two atributes of any
investement (the image beside
shows this relationship for different
investment alrernatives).

END OF THIS
PRESENTATION –
THANK YOU FOR YOUR
ATTENTION

+44 (0)207 016 8000
info@rcl.ac.uk

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