What Is Finance?

An Overview of Financial
Management and the Financial
Environment

Finance is the art and science of managing

money

Science? In some situations, its fundamental

concepts, principles, theories, and models can be
applied universally to make decisions
Art? In some situations, precise models cannot be
created/used, rather intuition or insight or
creativity is used to make decisions

1
Financial Management (13th edt)
By E.F. Bringham and M.C. Ehrhardt
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What Is Corporate or Managerial

Finance?

What Is Finance?

At the personal level, finance is concerned

with individuals decisions about:

How much of their earnings they spend

How much they save
How they invest their savings

1-2

An important area of finance that deals with

The sources of funding,
The capital structure of firms,
The tools and analysis used to allocate financial

In a business context, finance involves:

resources, and

How firms raise money from investors

How firms invest money in to earn profits
How firms decide whether to reinvest profits in the
business or distribute them back to investors.

The actions taken to maximize the firms value

to the shareholders

Continued

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What Is Corporate or Managerial

Finance?

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Finance VS Economics & Accounting

Finance grew out of Economics and Accounting

Is concerned with the duties of the financial

manager working in a business
Helps financial managers administer the
financial affairs of all types of businesses
Tasks include:
Developing a financial plan
Evaluating proposed large expenditures
Raising money to finance the firms operations
Extending credit to customer
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Economics

Accounting

Finance

Provides structure
for decision making
and suggests that
assets value is
based on its ability
to generate CFs
now and in the
future

Deals with collection

and presentation of
financial data and
measures firms
performance

Deals with evaluating

accounting statement,
developing additional data,
and making decisions based
on associated risk and return
and makes plans for CFs to
maintain firms solvency

May be positive or
normative

Is backward looking and

deals with historical
data

Is forward looking and makes

analysis and decisions about
future

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Four Golden Rules of Finance

Finance Within the Organization

Board of Directors

Chief Executive Officer (CEO)

Chief Operating Officer (COO)

Chief Financial Officer (CFO)

Marketing, Production, Human

Resources, and Other Operating
Departments

Accounting, Treasury, Credit,

Legal, Capital Budgeting, and
Investor Relations

If it dont jingle, it dont count

Risk is the possibility that bad or good things
may happen
The greater the risk, the greater the expected
reward
A $1 today is worth more than a $1 tomorrow

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1-8

Basic Forms of Business Organization

Basic Forms of Business Organization

Sole Proprietorship

Owned by one person

Legal entity created by law

Operated for personal profit

Mandatory registration

Unlimited liability

Legally functions separate and apart from its

owners

Partnerships (general and limited)

Owners liability is limited to the amount of their

investment

Owned by two or more people

Operated for joint profit

Owners hold common stock, and ownership can be

transferred

Liable personally and collectively

Run by partnership deed

Corporations

Continued
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Corporation

Proprietorships and Partnerships

Advantages
Ease of formation

Advantages

Disadvantages

Subject to few regulations

Limited Liability

Double taxation

No corporate income taxes

Permanency

Disadvantages

Transferability of
ownership

Cost of set-up and

report filing

Difficult to raise capital

Better access to capital

markets

Unlimited liability

Separation of owners
from management

Limited life
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1-12

Separation of Ownership and

Control

Partnership Vs. Corporations

Board of Directors

Assets

Shareholders

Debt

Debtholders

Management

Equity

Corporation

Partnership

Liquidity

Shares can easily be

exchanged.

Subject to substantial
restrictions.

Voting Rights

Usually each share

gets one vote

Taxation

Double

General Partner is in
charge; limited
partners may have
some voting
Partners
payrights.
taxes

Reinvestment and
dividend payout

Broad latitude

Liability

Limited liability

Continuity

Perpetual life

on distributions.
All NCF is distributed
to partners.
General partners may
have unlimited liability.
Limited partners enjoy
limited liability.
Limited life

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Becoming a Public Corporation and

Growing Afterwards

Agency Problems, Agency Costs and

Corporate Governance

Initial public offering (IPO) of stock

Raises cash

Allows founders and pre-IPO investors to

harvest some of their wealth

Subsequent issues of debt and equity

Agency problem arises when managers act in

their own interests and not on behalf of owners
Agency costs arise from agency problems that
are borne by shareholders and represent a loss of
shareholder wealth
Corporate governance is the set of rules that
control a companys behavior towards its directors,
managers, employees, shareholders, creditors,
customers, competitors, and community
Can help control agency problems

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1-16

Types of Agency Problems

Mitigating Agency Problems

Type-I agency problem: The conflict of interests

between managers and stockholders (the classic
agency problem)

Type-II agency problem: When controlling

stockholders (families) have an incentive to extract
private benefits of control at the expense of minority
stockholders
Type-III agency problem: Stockholders through
managers could take actions to maximize stock price
that are detrimental to creditors
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Factors affecting managerial behavior:

The role of board of directors*

Managerial compensation packages

Direct intervention by shareholders

The threat of firing

The threat of takeover

Audited financial statements
Corporate governance code (soft laws)

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The Balance-Sheet Model of the Firm

Continued

Financial Management Decisions

Risk Management
What financial risks should we take on or hedge
out

Capital structure

How should we pay for our assets?

Should we use debt or equity or both?
From which source should we raise capital?

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Capital budgeting
What LT investments should we engage in?
Where, when & how to make LT investments?

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The Balance-Sheet Model of the Firm

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Financial Management Decisions

Continued

1-19

The Balance-Sheet Model of the Firm

Continued

The Balance-Sheet Model of the Firm

Capital Analysis
What is something worth?
How can we create value for the firm?

Working capital management

How do we manage the day-to-day CFs?
Continued

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Cash Flows Between the Firm and

Financial Markets

Capital Allocation Process

Transfers of capital between savers and users

Direct transfers--businesses issue securities like
commercial papers directly to savers
Indirect transfers--through investment banking
house (ICB, IDLC) which underwrites the issue
Indirect transfers--through a financial
intermediary where individual deposits money in
banks and banks make commercial loans to firms

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Types of Securities

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Types of Financial Markets

Financial securities are simply pieces of paper with

contractual provisions that entitle their owners to
specific rights and claims on specific CFs or values

Debt instruments typically have specified payments and

a specified maturity (capital market security, money
market security)

Equity instruments are a claim upon a residual value

Derivatives are securities whose values depend on the
values of some other traded assets (e.g. options, futures,
forward, etc.)

Spot markets are the markets where assets are

bought or sold for on-the-spot delivery (literally,
within a few days)
Futures markets are the markets where assets are
bought or sold for delivery at some future date, such
as 6 months or a year into the future
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Types of Financial Markets

Money markets are the markets for ST, highly liquid

debt securities (bankers acceptance, commercial
paper) with a maturity of less than 1 year
Capital markets are the markets for corporate
stocks and debt maturing more than a year in the
future

Mortgage markets deal with loans on residential,

agricultural, commercial, and industrial real estate

Consumer credit markets involve loans for autos,

appliances, education, vacations, and so on
Continued

Financial asset markets deal with stocks, bonds,

notes, mortgages, derivatives, and other financial
instruments

Continued

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Types of Financial Markets

Physical asset markets (called real asset

markets) are markets for such products as wheat,
autos, real estate, computers, and machinery

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Primary markets are the markets in which the

original security is directly sold to the public by the
issuer (corporation/government) with the help of
investment banking houses
IPO market is a subset of the primary market. Here
firms go public by offering shares to the public for
the first time
Secondary markets are the markets in which
existing, already outstanding securities are traded
among investors
Private markets are markets where transactions are
worked out directly between two parties
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The Primary objective of the

Corporation

The Primary objective of the

Corporation
Decision rule for managers: Only take actions
that are expected to increase the share price.

Which one?

Survive?
Avoid financial distress and bankruptcy?
Beat the competition?
Maximize sales or market share?
Maintain steady earnings growth?
Minimize costs?
Maximize profit!!!
Does this mean we should do anything and
everything to maximize profit?

Fig: Financial decisions maximizing stock price

Continued

Which Investment is Preferred?

Earnings per share (EPS)

Year 1

Year 2

Year 3

Total (years 1-3)

Rotor

1.40

1.00

0.40

2.80

Valve

0.60

1.00

1.40

3.00

SHAREHOLDER WEALTH MAXIMIZATION

The same as:

Maximizing market price of stock

Maximizing intrinsic value of stock

Maximizing value of the equity

Maximizing value of the firm

Profit maximization may not lead to the highest possible

stock price for at least three reasons:
1. Timing is importantthe receipt of funds sooner is preferred
2. Profits do not necessarily result in CFs available to stockholders
3. Profit maximization fails to account for risk

Continued

Continued
1-33

The Primary objective of the

Corporation

1-32

The Primary objective of the

Corporation

The Primary objective of the

Corporation

Investment

Continued

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1-34

Stock Prices and Intrinsic Value

Why best goal?

A comprehensive goal for the firm, its managers,

and employees

In equilibrium, a stocks price should equal its

true or intrinsic value
Intrinsic value is a long-run concept

This goal can be explored through EVA

To the extent that investor perceptions are incorrect, a

stocks price in the short run may deviate from its
intrinsic value

This goal avoids actions that prove to be

detrimental to stakeholders
This goal meets triple bottom line

Economic (generating monetary value)

Social (the impact of business on people inside and outside)

Ideally, managers should avoid actions that

reduce intrinsic value, even if those decisions
increase the stock price in the short run

Environmental (the total impact on natural environment)

Continued

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Determinants of Intrinsic Values and

Stock Prices
Managerial Actions, the Economic
Environment, Taxes, and the Political Climate

True Investor
Returns

True
Risk

Perceived
Investor Returns

Stocks
Intrinsic Value

Is Stock Price Maximization the Same

as Profit Maximization?
No,

despite a generally high correlation

amongst stock price, EPS, and CFs

Perceived
Risk

Current stock price depends on current as well as

future earnings and CFs
Some actions may cause earnings to increase, yet
cause the stock price to decrease and vice-versa

Stocks
Market Price

Market Equilibrium:
Intrinsic Value = Stock Price
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1-37

The Goal of Non-Business Firm

1-38

Three Basic Questions

To maximize the interests (benefits) of

stakeholders given a set of resources

The goal of a university:

Quality education for the students

Good management for the university

Right contribution to the society and to the country

Financially healthy condition

Do firms have any responsibilities to society

at large? YES! Shareholders are also
members of society
Should firms behave ethically? YES!
Is stock price maximization good or bad for
the society, employees, and customers?
YES, Good!

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Three Aspects of CFs Affecting An

Investments Value

Stock Price Maximization Increases

Social Welfare

To a large extent, the owners of stock are society

When a manager takes actions to maximize the stock price, this
improves the quality of life for most citizens as they are shareholders

Amount of expected CFs (bigger is better)

Timing of the CF stream (sooner is better)

Risk of the CFs (less risk is better)

Consumer benefits
Stock price maximization requires efficient, low-cost businesses that
produce high-quality goods and services at the lowest possible cost.

1-40

Employees benefits
Companies that successfully increase stock prices also grow and add
more employees, thus benefiting society
Consumer welfare is higher in capitalist free market economies than
in communist economies

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The Big Picture: The Determinants of

Intrinsic Value Using FCF and WACC
Sales
Revenue

Operating costs
and taxes

Free cash flow

(FCF)

Value =

Determinants of a Firms Value

Required investments
in operating capital

FCF

The cash available for distribution to all investors after

meeting all expenses and making required investment in
operations to support growth

FCF1
FCF2
FCF
+
+ +
(1 + WACC)1 (1 + WACC)2
(1+WACC)

WACC

The minimum return a company needs to earn to satisfy all

of its investors, including stockholders, bondholders, and
preferred stockholders (from investors perspective)

Weighted average
cost of capital
(WACC)
Market interest rates

Determined by the capital structure, interest rates, the firms

risk, and attitude toward risk

Firms debt/equity mix

Cost of debt

Market risk aversion

The cost of capital for the firm as a whole (from the firms
perspective)

Cost of equity

Firms business risk

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Calculation of WACC

1-44

The Cost of Money or Fund

Equity capital of $50,000 and the required rate of return is

12%.

Preferred stock of $10,000 and preferred dividend is 6%.

Bank loan of $20,000 @ 15% interest and tax rate is 40%.
Bonds of $20,000 @ 10% interest and tax rate is 40%.
Funds
(1)

Amount
(2)

Weight
(3)

Rate
(4)

WACC
(5)=(3)(4) (1-t)

Equity

$50,000

0.5

0.12

0.50.12=0.060

Pref Stock

$10,000

0.1

0.06

0.2.15(1-0.4) =0.006

Bank Loan

$20,000

0.2

0.15

0.2.15(1-0.4) =0.018

Bonds

$20,000

0.2

0.10

0.2.10(1-0.4) =0.012

Total

$50,000

1.0

For debt, it is the interest rate

For equity, it is the cost of equity consisting of
the dividends and capital gains stockholders
expect

0.096
1-45

Economic Conditions and Policies

Affecting the Cost of Money

Factors Affecting the Cost of Money

1-46

Production opportunities (the ability to turn

capital into benefits)

How open market operations influence the price of Tbills, loanable fund and interest rate

Inverse relation between T-bills price and interest rate

Time preferences for consumption (as

opposed to saving for future consumption)

Risk of return

Expected inflation

The policy of central bank

A low interest rates stimulates economy by allowing firms to

borrow fund at a low cost for new projects

The national budget deficit or surplus

Government borrowing by issuing new T-bills
The same impact
Continued

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1-48

Economic Conditions and Policies

Affecting the Cost of Money

Economic Conditions and Policies

Affecting the Cost of Money

The level of business activities

Interest rates and inflation rise prior to a recession and
fall afterwards
During recession:

International trade deficits or surpluses.

Trade deficit is financed by debt
Increased borrowing drives up interest rates
International investors are willing to hold country debt

Consumer demand slows, keeping companies from increasing

prices, which reduces price inflation
Companies also cut back on hiring, which reduces wage inflation
Less disposable income causes consumers to reduce their
purchases of homes and automobiles, reducing consumer
demand for loans

if and only if the risk-adjusted rate paid on this debt is

competitive

If the trade deficit is large relative to the size of the

Companies reduce investments in new operations, which reduce

their demand for funds
The cumulative effect is downward pressure on inflation and
interest rates
Continued

overall economy, it will hinder the central banks ability

to reduce interest rates and combat a recession
Continued

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Economic Conditions and Policies

Affecting the Cost of Money

International country risk

A particular countrys economic, political, and social

environment can increase the cost of money that is

invested abroad

Exchange Rate Risk

The value of an investment depends on what happens
to exchange rates.

This is known as exchange rate risk.

1-51