Introduction to the basics of the field of financial management, its need, some terminologies and working.

1. Introduction to Financial
Management
Financial Management
Rajnder Singh Randhawa

2. Lecture 2:
Introduction to
Financial
Management
© SEM II: Rajinder
Singh Randhawa
2
Money itself is neither created nor destroyed,
its simply transferred from one perception to another.

4. Meaning: Financial Management
• Financial Management is an operational activity,
which is accountable for the effective utilization
of funds necessary for operations. One of the
primary objectives of financial management is to
maintain enough money to meet the necessary
current and capital expenditure, apart from
maximizing profits.
Lecture 2:
Introduction to
Financial
Management
© SEM II: Rajinder
Singh Randhawa
4

5. Most IMP
• Valuation of Assets
▫ Determining the value of an asset at different
points in time.
• Management of Assets
▫ Determining when/which assets to buy/sell.
• Time
▫ Money today is more than money later.
• Risk
▫ Uncertainty of occurrence of an event.
Lecture 2:
Introduction to
Financial
Management
© SEM II: Rajinder
Singh Randhawa
5

6. IMP Concepts
• ‘r’ refers to
▫ Interest Rate
▫ Cost of Capital
▫ Opportunity Cost
▫ Rate of Growth
▫ User Cost
• Securities means all the forms in which capital is
available.
• Investor is the one who provides capital.
• Risk free returns refers to interest on fixed
income securities.
Lecture 2:
Introduction to
Financial
Management
© SEM II: Rajinder
Singh Randhawa
6

7. IMP Concepts
• Compounding moves money forward in time
• Discounting moves money backward in time
▫ Multiplying by (1+r)m‐n = Dividing by (1+r)n‐m
Lecture 2:
Introduction to
Financial
Management
© SEM II: Rajinder
Singh Randhawa
7

8. Definition
• Corporate or Business Finance involves
balancing risk and profitability, while
attempting to maximize the entity’s wealth and
the value of its stock.
• It generally entails three decisions:
▫ Investment decision
▫ Financing decision
▫ Dividend decision
Lecture 2:
Introduction to
Financial
Management
© SEM II: Rajinder
Singh Randhawa
8

9. Three decisions
• Investment Decision = Purchase of Assets
• Financing Decision = Sale of Assets
• Dividend Decision = Profit distribution/retention
Lecture 2:
Introduction to
Financial
Management
© SEM II: Rajinder
Singh Randhawa
9

10. Nature of Financial Management
Company (Revenue
in billion)
Recent Investment Decision Recent Financing
Decision
Boeing ( $61) Began production of its 787 Dreamliner
aircraft, at a forecasted cost of more than
$10 billion.
The cash flow from Boeing’s
operations allowed it to repay some
of its debt and repurchase $2.8
billion of stock.
Toyota (¥ 26,289) In 2008 opened new engineering and
safety testing facilities in Michigan.
Returned ¥431 billion to
shareholders in the form of
dividends.
Wal-Mart ($406) In 2008 announced plans to invest over a
billion dollars in 90 new stores in Brazil.
In 2008 raised $2.5 billion by an
issue of 5-year and 30-year bonds.
Union Pacific ($18) Acquired 315 new locomotives in 2007. Largely financed its investment in
locomotives by long-term leases.
Wells Fargo ($52) Acquired Wachovia Bank in 2008 for$15.1
billion.
Financed the acquisition by an
exchangeof shares.
LVMH (€17) Acquired the Spanish winery Bodega
Numanthia Termes.
Issued a six-year bond in 2007,
raising 300 million Swiss francs.
Lenovo ($ 16) Expanded its chain of retail stores to cover
over 2,000 cities.
Borrowed $400 million for 5 years
from a group of banks.
Lecture 2:
Introduction to
Financial
Management
© SEM II: Rajinder
Singh Randhawa
10

11. Fundamental Principles of Finance
• There Is No Such Thing As A Free Lunch
• Other Things Equal, Individuals :
▫ Prefer more money to less (non-satiation)
▫ Prefer money now to later (impatience)
▫ Prefer to avoid risk (risk aversion)
• All Agents Act To Further Their Own Self-Interest
• Financial Market Prices Shift to Equalize Supply and Demand
• Financial Markets Are Highly Adaptive and Competitive
• Risk-Sharing and Frictions Are Central to Financial Innovation
Lecture 2:
Introduction to
Financial
Management
© SEM II: Rajinder
Singh Randhawa
11

12. Scope
• Determining the value of asset.
• Determining the rate of growth.
• Determining the mix of investments.
• Analyzing, planning and controlling the financial
affairs of the enterprise.
• Procurement of funds.
Lecture 2:
Introduction to
Financial
Management
© SEM II: Rajinder
Singh Randhawa
12

13. Objectives of Financial Management
• Profit Maximization
v/s
• Wealth Maximization
Lecture 2:
Introduction to
Financial
Management
© SEM II: Rajinder
Singh Randhawa
13

14. Profit Maximization
• Profit = Revenue – Cost
• Ultimate Goal of Company is Maximum Profit
• All Decision are Focused to this Direction
• Not the only Benefit Reaped by Shareholders
Lecture 2:
Introduction to
Financial
Management
© SEM II: Rajinder
Singh Randhawa
14

15. Wealth Maximization
• Considers both Return and Risk
• Shareholders Want to be Rich
• To Transform Wealth into Consumption
• Profit is Not the only Reason for Share Price Rise
Lecture 2:
Introduction to
Financial
Management
© SEM II: Rajinder
Singh Randhawa
15

16. Case
• Pharmaceutical products manufacturers typically spend vast
amounts of money on developing and testing new products. It is in
the nature of the industry that the time taken to bring a new drug to
the market can easily be ten years. A particular business that
stopped spending money on research and development would
enhance current profit because costs would be cut but revenues
arising from continuing to sell drugs developed in past years would
continue for the time being. Thus current profits would be buoyant
but the business would face a bleak future since there would be no
new drugs to replace the old ones.
Lecture 2:
Introduction to
Financial
Management
© SEM II: Rajinder
Singh Randhawa
16

17. Functional Areas of Finance
• Personal Finance
• Corporate Finance
• Public Finance
Lecture 2:
Introduction to
Financial
Management
© SEM II: Rajinder
Singh Randhawa
17

18. Functional Areas of Finance
• Personal Finance
▫ Financial Position
▫ Adequate Protection
▫ Tax Planning
▫ Investment and Accumulation Goals
▫ Retirement Planning
▫ Estate Planning
Lecture 2:
Introduction to
Financial
Management
© SEM II: Rajinder
Singh Randhawa
18

19. Functional Areas of Finance
• Corporate Finance
▫ Balancing Risk and Profitability
▫ Maximizing Entity’s Wealth and Stock Value
▫ Managing the Working Capital
▫ Measure the Performance of Portfolio
Lecture 2:
Introduction to
Financial
Management
© SEM II: Rajinder
Singh Randhawa
19

20. Functional Areas of Finance
• Public Finance
▫ Related to Sovereign States & its entities
▫ Identification of required expenditure
▫ Source of that entities revenue
▫ Debt Issuance for Public Works Projects
Lecture 2:
Introduction to
Financial
Management
© SEM II: Rajinder
Singh Randhawa
20

21. Role of Finance Managers
• Mobilization of Funds
• Deployment of Funds
• Control over the Funds
• Risk – Return Tradeoff
Lecture 2:
Introduction to
Financial
Management
© SEM II: Rajinder
Singh Randhawa
21

22. Risk Return Trade-Off
• Amount of Return = Amount of Risk Undertaken
• Amt X of Loss is more Epochal than Amt X of Gain
• Risk Averse Instrument have High Demand Raising
the Price and Lowering the Returns.
• Risk Premium is the Higher Return gained over
Risk Free Returns.
Lecture 2:
Introduction to
Financial
Management
© SEM II: Rajinder
Singh Randhawa
22

23. Financial Management Process
• Assess Current Financial Position
• Define and Prioritizing Goals
• Financial and Investment Plan
• Implementation of the Plan
• Monitor, Evaluate and Adjust Performance
Lecture 2:
Introduction to
Financial
Management
© SEM II: Rajinder
Singh Randhawa
23

24. Measuring Value Creation
• EVA:-
▫ It is the Value Created in Excess of the Cost of
Capital
• MVA:-
▫ It is the Difference between Current Market Value
and Capital Actually Contributed by Investors
Lecture 2:
Introduction to
Financial
Management
© SEM II: Rajinder
Singh Randhawa
24

25. Economic Value Added (EVA)
• EVA = (r – WACC) x K
▫ R is the return on invested capital (ROIC)
▫ WACC is the expected average rate of return to all
security holders for financing
▫ K is the economic capital employed
• The idea is that value is created when the return
on the firm's economic capital employed is
greater than the cost of that capital.
Lecture 2:
Introduction to
Financial
Management
© SEM II: Rajinder
Singh Randhawa
25

26. Market Value Added (MVA)
• MVA = V – K
▫ V is the market value of the firm (Equity + Debt)
▫ K is the capital invested in the firm
• MVA is the present value of a series of EVA
values, discounted using cost of capital.
Lecture 2:
Introduction to
Financial
Management
© SEM II: Rajinder
Singh Randhawa
26

27. Thank You
Lecture 2:
Introduction to
Financial
Management
© SEM II: Rajinder
Singh Randhawa
27
References:
Principles of Corporate Finance
(Brealy, Myers & Alen)
MIT OCW – Finance Theory 1
Financial Management – I M
Pandey