fm- chapter one.ppt

8/14/2019 FM- CHAPTER ONE.ppt

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JIMMA UNIVERSITYCOLLEGE OF BUSINESS AND ECONOMICS

MSc in Accounting & Finance

Advanced Financial Management

Acct 612

Instructor: Arega Seyoum Asfaw (PhD)Academic Year: 2013/2005


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CHAPTER ONE1. INTRODUCTION TO FINANCIAL MANAGEMENT &

ANALYSISIntroduction

Financial management is generally defined as the

managementof capital resources and usesin order to

achieve a desired goal. Financial management is that managerial activity which is

concerned with theplanningand controllingof the firms

financial resources.

The role of the financial manager is to ensure that there iscapitalsufficient enough to finance activities, and this capital

is available at the right amount, at the right time, and at the

lowest cost.


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Relations of Finance with Economics

The field of finance is closely related to economics. The

financial manager must understand the economic framework

within which his firm is operating, and also be able use

economic theories as guidelines for efficient business

operation.

Financial management is, in effect, applied economics

because it is concerned with the allocation of a companys

scarce financial resources among competing choices.


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The wide array of topics under the title finance may be

categorized under three broad sub-headings: Business

Finance, Investment Analysis, and Financial Markets.

Financial management deals with the management of a firms

principal activitiesinvesting in assets and raising funds to

pay for those assets.

A financial managers job is to determine how these crucial

activities (investing & financing) may best be carried out. In

doing so, the financial manager typically will use dataprepared and presented by accountants.


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Whereas the accountants focus is on the careful and correct

preparation of financial data, the financial managers focus is

on using that data as an inputin making decisions.

Furthermore, accountants typically rely on an accounting

methodthat recognizes revenues at the time of sale and

expenses when incurred, while financial managers emphasize

the actual inflows and outflows of cash.


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Investment Analysis

Refers to the study of the analysisand managementoffinancial securities.

It is concerned with the evaluation of securities (usually stocks

& bonds) from the perspective of investors.Financial Markets

Are markets where firms issue and investors buy and sellfinancial securities.

These markets range from specialized businesses that assistcorporations in selling their securities to large secondarymarkets where investors can buy and sell the stocks and othersecurities of major corporations.


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These markets involve a variety of financial intermediaries

and middlemen such as investment bankers and stockbrokers.

The study of these markets and financial intermediaries is the

study offinancial markets.


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Financial Institutions and Financial Markets

Firms that require funds from external sources can obtain them in

three ways: (i) through a financial institution in the form of loan, (ii)

through financial markets, and (iii) through private placement.

Financial Institutions

Financial institutions are intermediariesthat channel the savings of

individuals, businesses, and governments into loans or investments.

These are institutions (public or private) that raise funds (from thepublic or other institutions) and invests them in financial assets

such as deposits, loans, and bonds.


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Functions of Financial Institutions

(1) They play as intermediary role in transferring funds from

surplus economic unit (savers & investors) to those in need

of the funds (deficit economic units).

(2) Provide liquidity i.e., the presence of financial institutions

facilitates the flow of monies through the economy.


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Types of Financial Institutions There are two types of financial institutions viz., depository

financial institutions and non-depository financial institutions.

Depository Financial Institutionsare financial institutions

that accepts deposits and channels the money into lendingactivities.

o Depository institutions such as banks and credit unions pay

interest on deposits and use the deposits to extend loans.

Non-depository Financial Institutionslike insurancecompanies, brokerage firms, and mutual fund companies,

sellfinancial products.

o Non-depository financial institutions fund their investment

activities through the sale of securities orinsurance.


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Common types of financial institutions are listed below:

o Brokerage firm, securities firmstock brokers act as an

intermediary between buyers and sellers of securities. In

return for the services they provide, they charge a fee.

o Insurance Company, insurance underwriter, insurers,

underwritersare financial institutions that sell insurance.

o Pension fund -a financial institution that collects regular

contributions from employers and employees to provide

retirement benefit to employees.


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o Investment Company, investment firm, investment trust fund

is a financial institution that sells shares to individuals and

invests in securities issued by other companies.

o Finance Companiesare financial institutions (often affiliated

with a holding company or manufacturer) that makes loan toindividuals or businesses.

o Credit Uniona cooperative depository financial institution

whose members can obtain loans from their combined savings.

o

Agent banka bank that acts as an agent for a foreign bank.o Commercial Banka financial institution that accepts deposits

and makes loans and provides other services for the public.


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o Merchant Banka credit card processing bank where

merchants receive credit for credit card receipts less a

processing fee.

o Acquirera bank gaining financial control over another

financial institution through a payment in cash or an exchangeof stock.

o Thrift Institutiona depository financial institution intended to

encourage personal savings and home buying.


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Generally, financial institutions are required to operate within

established regulatory guidelines. This is because any failure

in financial institutions will have a contagious effect on the

payment system and the whole economy.

Therefore, due to their sensitivity and their potential far-reaching consequences, there are guidelines which they have

to observe in their operations.

Thus, every country has its own central or national bank

responsible for regulating and supervising financialinstitutions operating in an economy.

In Ethiopia, such regulatory body is the National Bank of

Ethiopia.


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Financial Markets

Financial markets could mean:

(1) the market in which financial assets (such as stock &

bonds) are created or transferred.

(2) The coming together of buyers and sellers to trade

financial products, i.e., stocks and bonds are traded

between buyers and sellers in a number of ways including

the use of stock exchanges; directly between buyers and

sellers, etc.


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Financial markets provide a forum in which suppliers of funds

and those who need funds can transact business directly.

Financial markets can be bothprimaryand secondarymarkets

for debt and equity securities.

Primary market refers to a market in which new, as opposed

to previously issued, securities are traded.

This is the only time that the issuing company actually

receives money for its stock.


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There are three ways in which a corporation may raise capital

in the primary market:

(i) Public Issueinvolves sales of securities to members

of the general public (its also called initial public

offering (IPO).

(ii) Rights Issueinvolves raising capital from existing

shareholders by offering additional securities to them

on a preemptive basis.

(iii) Private Placementa way of selling securities privately to asmall group of investors.


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Once the newly issued securities are in the publics hands, itthen begins trading in the secondary market.

Secondary markets are markets in which existing, alreadyoutstanding, securities are traded among investors.

The corporation whose shares are being traded is not involvedin the secondary market transaction and, thus, does notreceive any funds from such a sale.

The proceeds from the sale of a share of IBM stock in thesecondary market go to the previous owner of the stock, notto IBM. That is because the only time IBM ever receivesmoney from the sale of one of its securities is in the primarymarkets.


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In general, financial markets facilitate:

o The raising of capital (in the capital markets),

o The transfer of risk (in the derivatives markets); and

o International trade (in the currency markets).


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Types of Financial Markets

The financial markets can be divided into different types as

follows:

a) Capital Markets which consists of: Stock marketswhich provide financing through the

issuance of shares or common stock and enable the

subsequent trading thereof.

Bond marketswhich provide financing through the

issuance of bonds, and enable the subsequent trading thereof.


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b) Commodity marketwhich facilitate the trading of commodities.

c) Money marketwhich is a market for short-term, highly liquid

debt instruments are traded.

d) Derivatives marketwhich provide instruments for the

management offinancial risk. Futures markets, which provide standardized forward contracts for trading

products at some future date.

e) Insurance marketwhich facilitate the redistributionof various

risks.

f) Foreign exchange marketwhich facilitate the trading of foreign

currencies.


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Derivative Products

During the 1980s and 1990s, a major growth in financialmarkets is the trading of derivative products, or derivativesfor short.

In the financial markets stock prices, bond prices, currencyrates, interest rates, and dividends go up and down, creatingrisk.

Derivative products are financial products which are used tocontrol risk or unexpectedly exploit risk.

The major participants in this markets are hedgers(who wantto manage price movement risk) and speculators(who takerisk in expectation of profit).


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Primary vs. Secondary Markets

The primary market is that part of the capital markets that

deals with the issuance of new securities.

Companies, governments or public sector institutions can

obtain funding through the sale of a new stock or bond issue.

This is typically done through a syndicate of securities dealers.

The process of selling new issues to investors is called

underwriting. In the case of new stock issue, this sale is an

initial public offering (IPO).


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Features of Primary Markets

1) It is a market for new long-term capital.

2) The securities are issued by the company directly to

investors.

3) The company receives the money and issue new security

certificates to the investors.

4) Primary issues are used by companies for the purpose of

setting up new business or for expanding or modernizing

the existing business.


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5) The primary market performs the crucial function of

facilitating capital formation in the economy.

6) It does not include certain other sources of new long-

term external finance, such as loans from financialinstitutions. Borrowers in the new issue market may be

raising capital for converting private capital into public

capital; this is known as going public.


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Corporations engage in two types of primary market

transactions:public offerings andprivate placements.

A public offering, as the name suggests, involves selling

securities to the general public, while a private placement is a

negotiated sale involving a specific buyer.

By law, public offering of debt and equity securities must be

registered with the authority entrusted with such

responsibility.


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Registration requires the firm to disclose a great deal ofinformation before selling any securities. The accounting,legal, and selling costs of public offerings can be considerable.But, on the other side, it enables the firm to have access to a

large marketthe public at largeand thus raise large sum ofmoney.

Partly to avoid the various regulatory requirements and theexpense of public offerings, debt and equity are often soldprivately to large financial institutions such as life insurance

companies or mutual funds. Such private placements do nothave to be registered with the authoritative body and do notrequire the involvement of underwriters.


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Secondary Markets

It is the financial market for trading of securities that have already

been issued in an initial private or public offering.

Once a newly issued stock is listed on a stock exchange,investors

and speculatorscan easily trade on the exchange, as market makersprovide bids and offers in the new stock.

This market is a market on which an investor purchases an asset

from another investor rather than an issuing corporation. A good

example is The New York Stock Exchange (NYSE). All stock exchanges are part of the secondary market, as investors

buy securities from other investors instead of an issuing company.


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Money Market vs. Capital Market

Financial markets can also be classified in terms of the

maturity period of the securities traded. The two key financial

markets are the money market and the capital market.

Money Marketis the market for short-term securities, i.e.,

securities that have a maturity period of one year or less.

Capital Marketis the market for long-term financial

securities (usually bonds and stocks).


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Real vs. Financial Assets

Real assets: can be tangibleor intangible.

Plant, machinery, office, factory, furniture and building are

examples of tangible real assets, while technological know-

how, technological collaborations, patents and copy rights are

intangible real assets.

The firm sells financial assets or securities, such as shares and

bonds or debentures, to investors in capital markets to raise

necessary funds.

Financial assets also include lease obligations and borrowings

from banks, financial institutions and other sources.


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Funds applied to assets by the firm are called capital

expendituresor investment. The firm expects to receive return

on investment and distribute return as dividendsto investors.


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Equity vs. Borrowed Funds

There are two types of funds that a firm can raise: equity

funds and borrowedfunds.

A firm sells shares (stock) to acquire equity funds. Shares

represent ownership rights of their holders.

Buyers of shares are called shareholders, and they are the

legal owners of the firm whose shares they hold.

Shareholders invest their money in the shares of a company in

the expectation of a return on their invested capital.

The return on the shareholders capital consists of dividend

and capital gain.


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Shareholders can be of two types: ordinary (or common)and

preference.

Preference shareholders receive dividend at a fixed rate, and

they have apriorityover ordinary shareholders.

Preference shareholders also have preferential right over

assets of a firm when the firm is liquidated.

The payment of dividends to shareholders is not a legal

obligation; it depends on the discretion of the board of

directors.


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Equity funds can also be obtained by a company by retaining

a portion of earningsavailable for shareholders. This method

of acquiring funds internally is called earnings retention.

Retained earnings are undistributed profits of equity capital;

they are, therefore, rightfully a part of the equity capital.

The retention of earnings can be considered as a form of

raising new capital.


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Retained earnings are used as a source of financing for the

following reasons:

a) to alleviate problem of financing from common stock

b) when there is difficulty to raise capital from external

sourcesc) when there is high cost of issuing additional shares

d) to save the companys cash which could be paid as a cost of

capital.


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Another important source of securing capital is creditorsor

lenders.

Lenders are not the owners of a company. They make money

available to the firm on a lending basis and retain title to the

funds lent.

The return on loans or borrowed funds is called interest.

The amount of interest is allowed to be treated as expense for

computing corporate income taxes; thereby provide a tax

shieldto the firm.


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Financial Management Decisions

The functions of raising funds, investing them in assets and

distributing returns earned from assets to shareholders are

respectively known asfinancing, investmentand dividend

decisions.

While performing these functions, a firm attempts to balance

cash inflows and outflows. This is called liquiditydecision; and

added to the list of important finance decisions.


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Important finance functions or decisions include:

1. Investment (or long-term asset-mix) Decision

Investment or capital budgeting involves the decision of allocation

of capital or commitment of funds to long-term assets that would

yield benefits in the future.The two important aspects of investment decision are: (a)

evaluation of theprospective profitability of new investments,

and (b) the measurement of a cut-off rate against which the

prospective return of new investments could be compared.

Future benefits of investments are difficult to measure and cannotbe predicted with certainty. Because of the uncertain future,

investment decisions involve risk. Investment proposals should,

therefore, be evaluated in terms of both expected return and risk.


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2. Financing (Capital Structure) Decision

Financing decision involves the financial manager decide when,whereand how to acquire funds to meet the firms investmentneeds.

The central issue before him or her is to determine theproportionof equity and debt. The mix of debt and equity is known as thefirms capital structure.

The financial manager must strive to obtain the best financing mixor the optimum capital structure for his/her firm.

The firms capital structure is considered to be optimumwhen themarket value of shares is maximized. The use of debt affects thereturn and risk of shareholders; it may increase the return onequity funds but it always increases risk.


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A proper balance will have to be struck between return

and risk. When the shareholders return is maximized with

minimum risk, the market value per share will be

maximized and the firms capital structure would be

considered optimum.


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3. Working Capital (Liquidity) DecisionThe third question concerns working capital management.

Working Capital refers to the firms short-term assets and

liabilities.

Managing the firms working capital is a day-to-day activity thatensures the firm has sufficient resources to continue its

operations and avoid costly interruptions.

Some of the questions about working capital that must be

answered are:

a) how much cash and inventory should be kept on hand?

b) should there be a credit sale? If so, at what terms, and to whom

shall it be extended?

c) how will any needed short-term financing be obtained?


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Goal of the Firm: Profit vs. Wealth

If we were to consider possible financial goals we might come

up with many ideas such as the following:

Survival

To avoid financial distress and bankruptcy

Beat competition, maintain control, achieve flexibility

Maximize sales or market share

Minimize costs & risks

Maximize profits

Maintain steady earnings growth [i.e., maximization of earnings

per share & maximization of RoE].


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The goals listed above are all different, but they tend to fallinto two groups. The first of these which involves sales,market share, and cost control relates to increasing

profitability. Whereas the goals involving bankruptcy,avoidance, stability and safety relates in some way tocontrolling risk.

Unfortunately, there is some trade-offs between the goals ofprofitability & risk. The pursuit of profitability normallyinvolves some element of risk, thus it is not possible to

maximize both safety and profitability simultaneously.What we need, therefore, is a goal that encompasses both of

these factors.


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Profit Maximization Would profit maximization serve as a goal of the firm?

If we investigate profit maximization as a goal of the firm, it failswith respect to the following operational infeasibilities:

1) It is vague because the definition of the term profit is

ambiguous. Does it mean an absolute figure expressed in Birr or a rate of profitability?

Does it mean short-term or long term profit?

Does it refer profit before tax or after tax?

Does it refer total profit or profit per share?

2) It ignores the time dimension of financial decision. It does not make a distinction between returns received at different time periods.

3) It ignores the risk dimension of the financial decision Risk & returns are positively correlated. A figure that maximizes profit might

generate excessive risk & thereby a lower stock price.


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The goal of profit maximization, for example, compares

investment alternatives by examining their expected values or

weighted average profits. Whether one project is riskier than

another does not enter into these calculations. In reality,

projects differ a great deal with respect to risk characteristics,and to ignore these differences in the practice of financial

management can result in incorrect decisions.


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Finally, and possibly most important, accounting profits fail to

recognize one of the most important costs of doing business.

When we calculate accounting profits, we consider interest

expense as a cost of borrowing money, but we ignore the cost

of the funds provided by the firms stockholders. We have tothink that, what if the firms stockholders, could earn 12%

with the same money in another investment of similar risk?

Should the firms managers accept the investment because it

will increase the firms profits?


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Therefore, if we are to base financial decisions on a goal, that

goal must be precise, not allow for misinterpretation, and deal

with all the complexities of the real world.

For the reasons given, the goal of maximizing profits usually is

not the same as maximizing market price per share. Themarket price of a firm's stock represents the valuethat

market participants place on the company.


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Shareholders Wealth Maximization (SWM)

The objective of shareholders wealth maximization (SWM) is

an appropriate and operationally feasible criterion to choose

among the alternative financial actions.

It provides a clear measure of what financial management

should seek to maximize in making investment and financing

decisions on behalf of owners (shareholders).

Shareholders wealth maximization means maximizing the net

present value (or wealth) of a course of action toshareholders.


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The net present value of a course of action is the difference

between the present value of its benefits and the present

value of its costs.

A financial action that has a positive NPV crates wealth for

shareholders and, therefore, desirable. A financial actionresulting in negative NPV should be rejected since it would

destroy shareholders value.


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The objective of shareholders wealth maximization addresses

the questions of the timingand risk of the expected benefits.

These problems are handled by selecting an appropriate rate

(the shareholders opportunity cost of capital) for discounting

the expected flow of future benefits. It is important to emphasize that benefits are measured in

terms of cash flows, not in terms of the accounting profits.

The wealth maximization principle implies that the

fundamental objective of a firm is to maximize the marketvalue of existing shareholders common stock.


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The Agency Relationship

If you are the sole owner of a business, then you make thedecisions that affect your own well-being. But what if you are afinancial manager of a business and you are not the sole owner? Inthis case, you are making decisions for owners other than yourself;

you, the financial manager, are an agent.

An agent is a person who acts forand exerts powers ofanotherperson or group of persons.

The person (or group of persons) the agent represents is referred toas theprincipal. The relationship between the agent and his or herprincipal is an agency relationship.

There is an agency relationship between the managers and theshareholders of corporations.


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Problems with the Agency Relationship

In an agency relationship, the agent is charged with the

responsibility of acting for the principal. Is it possible the

agent may not act in the best interest of the principal, but

instead act in his or her own self-interest? Yesbecause theagent has his or her own objective of maximizing personal

wealth.


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In a large corporation, for example, the managers may enjoy manyfringe benefits, such as golf club memberships, access to privatejets, and company cars. These benefits (also called perquisites, orperks) may be useful in conducting business and may help attractor retain management personnel, but there is room for abuse.

What if the managers start spending more time at the golf coursethan at their desks? What if they use the company jets for personaltravel? What if they buy company cars for their teenagers to drive?The abuse of perquisites imposes costs on the firmand ultimatelyon the owners of the firm. There is also a possibility that managerswho feel secure in their positions may not bother to expend theirbest efforts toward the business. This is referred to as shirking, andit too imposes a cost to the firm.


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Finally, there is the possibility that managers will act in their

own self-interest, rather than in the interest of the

shareholders when those interests clash. For example,

management may fight the acquisition of their firm by some

other firm even if the acquisition would benefit shareholders. Why? In most takeovers, the management personnel of the

acquired firm generally lose their jobs.


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Many managers faced this dilemma in the merger mania of the1980s. So what did they do? Among the many tactics,

Some fought acquisition of their firmswhich they labeledhostile takeoversby proposing changes in the corporatecharter or even lobbying for changes in state laws todiscourage takeovers.

Some adopted lucrative executive compensation packages called golden parachutesthat were to go into effect if they

lost their jobs.

Such defensiveness by corporate managers in the case of takeovers,

whether it is warranted or not, emphasizes the potential for conflictbetween the interests of the owners and the interests ofmanagement.


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Costs of the Agency Relationship

There are costs involved with any effort to minimize the

potential for conflict between the principals interest and the

agents interest. Such costs are called agency costs, and they

are of three types: monitoring costs, bonding costs, andresidual loss.


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(1) Monitoring Costs - are costs incurred by the principalto monitoror limitthe actions of the agent.

In a corporation, shareholders may require managers toperiodically report on their activities via audited

accounting reports, which are sent to shareholders. Theaccountants fees and the management time lost inpreparing such reports are monitoring costs.

Another example is the implicit costincurred whenshareholders limit the decision-making power of

managers. By doing so, the owners may miss profitableinvestment opportunities; the foregone profit is amonitoring cost.


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The board of directors of corporation has afiduciary duty

to shareholders; that is the legal responsibility to make

decisions (or to see that decisions are made) that are in

the best interests of shareholders. Part of that

responsibility is to ensure that managerial decisions arealso in the best interests of the shareholders. Therefore, at

least part of the cost of having directorsis a monitoring

cost.


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(2) Bonding Costs: are incurred by agents to assure

principals that they will act in the principals best interest.

The name comes from the agents promise or bondto

take certain actions.

A manager may enter into a contract that requires him orher to stay on with the firm even though another company

acquires it; an implicit cost is then incurred by the

manager, who foregoes other employment opportunities.


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(3) Residual Loss: despite using monitoring andbonding

devices, there may still be some divergence between the

interests of principals and those of agents. The resulting

cost, called the residual loss, is the implicit cost that

results because the principals and the agents interestscannot be perfectly aligned.


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Motivating Managers: Executive Compensation One way to encourage management to act in shareholders best

interests, and so minimize agency problems and costs, is throughexecutive compensationhow top management is paid.

There are several different ways to compensate executives,

including:Salary. The direct payment of cash of a fixed amount per

period.

Bonus. A cash reward based on some performance measure,say earnings of a division or the company.

Stock appreciation right. A cash payment based on theamount by which the value of a specified number ofshares has increased over a specified period of time(supposedly due to the efforts of management).


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Performance shares. Shares of stock given to theemployees, in an amount based on somemeasure of operating performance, such asearnings per share.

Stock option. The right to buy a specified number

of shares of stock in the company at astated pricereferred to as an exercise priceat some time in the future. The exercise pricemay be above, at, or below the current marketprice of the stock.

Restricted stock grant. The grant of shares of stock tothe employee at low or no cost, conditional onthe shares not being sold for a specified time.


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The basic idea behind stock options and restricted stock

grantsis to make managers owners, since the incentive to

consume excessive perks and to shirk are reduced if managers

are also owners.

As owners, managers not only share the costs of perks andshirks, but they also benefit financially when their decisions

maximize the wealth of owners. Hence, the key to motivation

through stock is not really the value of the stock, but rather

ownership of the stock.

fm- chapter one.ppt

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