EBA 6013 Principle of Finance)

Introduction to Finance

Outline

Finance as a resources Financial Decisions The Challenge of Financial Managers Financial Objectives Basic concepts in Finance Agency Relationship

Introduction to Finance

Finance is the financial resources available to business entity The management of this resources is delegated by the owners of the business to their employed managers. The managers then are concerned with acquiring, managing and financing the business entitys resources or assets (tangible or intangible) To pay for this business entity, managers may raise funds by selling shares to the public, issuing debt securities, borrowing from banks, leasing assets or using retained cash from business operations.

Financial Decisions

The objective of financial decisions is to maximize the shareholders wealth The higher the value of the business, the higher will be the shareholders wealth

Financial Decisions

Investment decisions, Financing decisions, Dividend decisions and Working Capital Management

Investment decisions involve in choosing from a long list of available projects to be undertaken and assets to be purchased Financing decisions involve in generating funds internally or externally to finance the investment Dividend decisions involve in returning some of the internal available fund to the owners (shareholders) Working Capital Management involve in ensuring the availability of fund in supporting day to day business operations

The Challenge.

Investment Decision (Capital budgeting) process of planning and managing a firms investments in fixed assets. The key concerns are the size, timing and riskiness of future cash flows. Financing Decision (Capital structure) mix of debt (borrowing) and equity (ownership interest) used by a firm. What are the least expensive sources of funds? Is there an optimal mix of debt and equity? When and where should the firm raise funds? Dividend Decision High or Low Dividend Policy? Working capital management managing short-term assets and liabilities. How much inventory should the firm carry? What credit policy is best? Where will we get our short-term loans?

The Financial Division

The Chief Financial Officer (CFO) or Vice-President of Finance coordinates the activities of the treasurer and the controller.

The controller handles cost and financial accounting, taxes and information systems. The treasurer handles cash management, financial planning and capital expenditures.

The Companys Overall Objective

Managers seek to maximize economic profit (ignoring the contribution by & distribution to owners) NOW, maximize the shareholders wealth. A policy of maximizing shareholders wealth will maximize shareholders utility Will there ever be a conflict of objectives then? -------- Agency Relationship (measured in term of agency costs)

Do Managers Always Act in the Share (stake) holders Interests? Shareholders technically have control of the firm, and dissatisfied shareholders can oust management via proxy fights, takeovers, etc. However, this is easier said than done. Staggered elections for board members often make it difficult to remove the board that appoints management. Poison pills and other anti-takeover mechanisms make hostile takeovers difficult to accomplish. Stakeholders are other groups, besides stockholders, that have a vested interest in the firm and potentially have claims on the firms cash flows. Stakeholders can include creditors, employees and customers.

Agency Relationship
The Agency Problem and Control of the Corporation Agency Relationships The relationship between share (stake)holders and management is called the agency relationship. This occurs when one party (principal) hires another (agent) to act on their behalf. The possibility of conflicts of interest between the parties is termed as the agency problem.

Agency costs direct costs compensation and perquisites for management indirect costs cost of monitoring and sub optimal decisions

Some Basic Concepts of Finance

Shareholders Value The companys financial objective is to maximize shareholders wealth The financial manager has to make financial decisions which add value to shareholders equity To finance companys investment, financial managers will need to issue securities such as shares and debt securities in financial markets. Therefore understanding how the financial markets work is a must

The actions of buyers and sellers of these securities in the financial markets will determine the price of these securities and also the value of the company

As an investor you may either consume or invest your wealth A risk averse may choose to invest in a debt securities for which they receive interest and repayment of the amount invested in the future date A risk seeker may prefer to consume companys share for which they may receive part of companys profits (in the form of dividend) in proportion to their ownership interest

The success of the companys investment will be judged by its ability to generate more cash than its original cash outlay on the investment, where it should be sufficient enough for the company to make the fixed interest payment to debtholders and repay the principal, and to pay dividends to its shareholders. Risk and Return from the investment must also be carefully analyze and weighted against the benefit of issuing shares and debt securities as means of financing.

Time, Uncertainty & Risk The value of an investment depends on the amount and timing of the cash flows generated by the investments. And this amount and timing of cash flows are not usually known with certainty. The timing of the cash flows received sometimes in the future is referred to as a concerned to the concept of time value of money The return received sometimes in the future will also be exposed to risk The relationship between risk and return need to be discussed in depth.

Market Efficiency and Capital Asset Pricing To finance an investment, a financial manager will issue securities in financial markets Their initial assumption is that these markets are efficient, i.e., composed of well-informed individuals Their trading activities cause prices to adjust instantaneously and without bias in response to new information Price changes are caused by the availability of new information and are not supposed to be caused by past price changes or other speculative factors

The concept of market efficiency means that we should expect securities and other assets to be fairly priced, given their expected risks and returns. E.g., higher risk, higher return (vice-versa) Share securities is more risky than Debt securities, the return for share investors are dividend and increase share prices while for debt investors are interest and increase in debt amount To get the best trade-off between risk and expected return, financial manager uses a model called CAPM (Capital Asset Pricing Model) and APT (Arbitrage Pricing Theory) Systematic (non-diversifiable) Risk vs Unsystematic (Diversifiable) Risk

Issues to be discussed further:

Capital Budgeting Risk & Return Analysis

Issues to be discussed later (Corporate Finance):

Understanding of the Financial Market Extension of Risk & Return using multiasset portfolio investment Financing Decision Dividend Decision Cost of Capital

Tutorial Questions
1. 2.

3.

4.

Distinguish between investment and financing decisions What are the main functions of financial managers What is the relationship between diversifiable and non-diversifiable risk? How does this distinction affect the reward that investors demand for bearing risk? What is meant by the terms agency relationship and agency costs?