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1
Functions of
Financial
Management
Chapter
McGraw-Hill/Irwin
Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
What is finance?
• Finance is the study of how people and businesses
evaluate investments and raise capital to fund
them.
• Finance is study best deals with the sources
funding (best mix of capital structure) of
corporations with best uses of momey
(investments)
• Finance is a field that deals with the study of
investments. It includes the dynamics of assets and
liabilities over time under conditions of different
degrees of uncertainty and risk. .
1-2
Finance is the art and science of
managing wealth.
It is about making decisions regarding
what assets to buy/sell and when to
buy/sell these assets.
Its main objective is to make individuals
and their businesses better off.
9-3
Copyright © 2006 Pearson Addison-
Wesley. All rights reserved.
Three Questions Addressed
by the Study of Finance:
1. What long-term investments should the firm
undertake? (capital budgeting decisions)
2. How should the firm fund these
investments? (capital structure decisions)
3. How can the firm best manage its cash
flows as they arise in its day-to-day
operations? (working capital management
decisions)
Why Study Finance?
•
Top 3 Types of Financial Management
Decisions :help to achieve the financ
-ial goals
Type # 1. Investment Decisions:
(i)Long-term investment decision : The long-term investment decision
is referred to as the capital budgeting
(ii)Short-term investment decision: the short-term investment decision
as working capital management.
Type # 2. Financing Decisions:
financing decision is not only concerned with how best to finance new
assets, but also concerned with the best overall mix of financing
for the firm
Type # 3. Dividend Decision:
The third major financial decision relates to the disbursement of
profits back to investors who supplied capital to the firm. The term
dividend refers to that part of profits of a company which is distributed
by it among its shareholders
1-6
Working capital:
•The cash available for day-to-day operations of
an organization.
•The amount of money a company has on hand,.
• Working capital is frequently used to measure a
firm's ability to meet current obligations.
1-7
Investment Decisions
1-10
Value of the Stock
market value (price)
What is Financial
Management?
The business function involving:
– Managing daily financial
activities-cash inflows and
outflows
– Choosing long-term
investments of value and
obtaining the funds to pay for
them
– Managing the risks taken
by the firm
Relationship between Finance,
Finance
Economics and Accounting
• Economics provides structure for decision
making in many important areas
− Provides a broad picture of economic environment
• Accounting provides financial data in various
forms
– Income statements
– Balance sheets
– Statement of cash flows
• Finance links economic theory with the numbers of
accounting
1-15
• Social: Knowledge of the composition(structure) of the
society and knowledge of customs and traditions.
• Study Cultural Differences :For example :Fitness may be big
business in the United States, but it’s unlikely to have the same draw in
certain Middle Eastern countries. You need to understand cultural
differences that could affect your business’s viability. Research the
culture surrounding the product or service you’ll be selling to ensure
that there’s a market and a need for it
• Politics: the activities associated with the governance of a
country or area, especially the debate between parties
having power.
Security and political stability
1-16
PPT 1-5
If you want to read the financial statements you need to understand many
economic factors, such as:
1-18
What is th Financial Management? What are the Functions and Activities
of Financial Management?
Financial Management
Financial management or business finance
is concerned with managing an entity’s
money
Functions:
– Allocate funds to current and fixed assets
– Obtain the best mix of financing alternatives
– Develop an appropriate dividend policy within
the context of the firm’s objectives
1-19
Functions and Activities PPT 1-9
of Financial Management
Functions involve:
– raising funds for the firm at minimal cost and acceptable risk
– investing those funds in company assets so as to earn an
attractive return given acceptable risks
Activities include:
– Working Capital Management
• short-term (S/T) financial decisions (<1 year)
• ex., managing cash and other current assets
– Capital Budgeting
• long-term (L/T) financial decisions (>1 year)
• ex., purchasing a new machine in the future
– Financing decisions (capital structure)
structure
• how to raise money: loans? leases? shares? bonds?
Financial Management Decisions
• Capital budgeting
– What long-term investments or projects should
the business take on?
• Capital structure
– How should we pay for our assets?
– Should we use debt or equity?
• Working capital management
– How do we manage the day-to-day finances of
the firm?
1-21
What is Corporate Finance?
Corporate Finance addresses the
following three questions:
Current
Liabilities
Current Assets
Long-Term Debt
Fixed Assets
1 Tangible
Shareholders’
2 Intangible Equity
Functions of the Financial Manager
1-24
Corporate Finance
1-25
Financial Manager
1-26
1-27
Treasurer Controller
• Managerial compensation
– Incentives can be used to align management and
stockholder interests
– The incentives need to be structured carefully to make
sure that they achieve their goal
• Corporate control
– The threat of a takeover may result in better
management :
Carl Icahn – buys a major stake in company that is poorly run.
Improves operations by firing bad managers. Some managers are
motivated to do better and everybody benefits. Company value
goes up which in return maxes profits of shareholders .
1-28
1.2 The Corporate Firm
• The corporate form of business is the
standard method for solving the problems
encountered in raising large amounts of
cash.
• However, businesses can take other
forms.
PPT 1-14
• Public corporations’
shares are available
for purchase on the
market for the general
public
• The shares in a
private corporation are
held by a small group
of individuals and are
not sold to the public
Forms of Business Organization
1-32
Sole Proprietorship
• Advantages • Disadvantages
– Easiest to start: is – Limited to life of
the easiest business structure to
form (you only need to get a owner
license or permit and register
your business with your local – Equity capital
government) (hence its
popularity) limited to owner’s
– Least regulated personal wealth
– Single owner – Unlimited liability:
Commitment goes
keeps all the profits beyond his shares to his
– Taxed once as own money
• Advantages • Disadvantages
– Two or more – Unlimited liability
owners • General
partnership
– More capital
• Limited partnership:
available
– Partnership
– Relatively easy to
dissolves when
start
one partner dies or
– Income taxed once wishes to sell
as personal – Difficult to transfer
income
ownership
A business venture with two or more owners
1-34
Corporation
• Advantages • Disadvantages
– Limited liability – Separation of
– Unlimited life ownership and
– Separation of management
ownership and – Double taxation
management (income taxed at
– Transfer of the corporate rate
and then dividends
ownership is easy
taxed at the
– Easier to raise
personal rate)
capital
A corporation
is a separate legal entity
1-35
What The Goals of Financial Management ? How to increase market share price?
1-36
The Goals of Financial Management PPT 1-7
– Attracts capital
– Provides employment
– Offers benefits to the society
1-38
The Agency Problem
• Agency relationship
– Principal hires an agent to represent his/her
interests
– Stockholders (principals) hire managers (agents)
to run the company
• Agency problem
– Conflict of interest between principal and
agent
1-39
For Example:
• Shareholders of a company appoint managers to
look after the proceedings of the company and earn
profits on their behalf.
• The shareholders expect the managers to
distribute all the profits to the shareholders. But the
managers sensing their own growth and salary
expectation try to retain the profits for future as a
safe side. This can lead to principle agent
problem. It is one of the most noticed problems in
the current situation when most companies are not
being managed by the owners themselves
1-40
Corporate Governance
• Agency theory
– Examines the relationship between the owners
and managers of the firm
– Conflict of interest between principal and
agent
• Institutional investors
– Have more to say about the way publicly
owned companies are managed
1-41
Financial Markets
• A financial market is a market in which
people trade financial securities,
commodities, and other fungible items of
value at low transaction costs and at prices
that reflect supply and demand.
• Securities: include stocks and bonds, and
commodities include precious metals or
agricultural products
1-42
Financial Markets
• Cash flows to the firm :Suppose we start with the firm
selling shares of stock and borrowing money to raise cash.
Cash flows to the firm from the financial markets (A).
The firm invests the cash in current and fixed assets (B).
These assets generate cash (C), some of which goes to pay
corporate taxes (D). After taxes are paid, some of this cash
flow is reinvested in the firm (E). The rest goes back to the
financial markets as cash paid to creditors and shareholders
• Primary vs. secondary markets
– Dealer vs. auction markets
– Listed vs. over-the-counter securities
• NYSE
• NASDAQ
1-43
Types of financial markets
• Capital markets : which consist of:
• Stock markets, which provide financing through the issuance of shares
or common stock, and enable the subsequent trading thereof.
• Bond markets, which provide financing through the issuance of bonds, and
enable the subsequent trading thereof.
• Commodity markets, which facilitate the trading of commodities.
• Money markets, which provide short term debt financing and investment.
• Derivatives markets, which provide instruments for the management
of financial risk.[1]
• Futures markets, which provide standardized forward contracts for trading
products at some future date;
• Insurance markets, which facilitate the redistribution of various risks.
• .
Foreign exchange markets, which facilitate the trading of foreign exchange
1-44
The Role of Financial Markets
• Financial markets are indicators of
maximization of shareholder value and
the ethical or the unethical behavior that
may influence the value of the company
• Participants in the financial market range
over the public, private, and government
institutions
– Public financial markets
– Corporate financial markets
1-45
Structure and Functions
of the Financial Markets
• Money markets
− Deals with short-term securities that have a
life of one year or less
− Securities in these markets include:
− Commercial paper sold by corporations to finance
their daily operations, or certificates of deposit with
maturities of less than 12 months sold by banks
1-46
Structure and Functions
of the Financial Markets (cont’d)
• Capital markets
– Defined as those where securities have a life of
more than one year
– Long-term markets
– Securities include:
• Common stock
• Preferred stock
• Corporate and government bonds
1-47
Allocation of Capital Market
1 - Primary market
•The primary market is the part of the capital market that deals with
issuing of new security finance securities.
• Companies, governments or public sector institutions can obtain
funds through the sale of a new stock or bond issues through primary
market. through the sale of new stock through an initial public offering
(IPO).
– When a corporation uses the financial markets
to raise new funds, the sale of securities is
made by way of a new issue
1-48
2 - Secondary market
A secondary market is a market where investors purchase
securities or assets from other investors, rather than from
issuing companies themselves
•When the securities are sold to the public
(institutions and individuals)
•Financial managers are given feedback about
their firms’ performance
1-49
'Risk-Return Tradeoff'
1-50
Return Maximization
and Risk Minimization
• Investors can choose risk level that meets
their objective and maximizes return for that
given level of risk
• Companies that are rewarded with high-
priced securities can raise new funds in
the money and capital markets at a lower
cost compared to competitors
• Firms pay a penalty for failing to perform
competitively
1-51
PPT 1-8
Profitability Risk
Profitability Risk