introduction - fm

8/2/2019 Introduction - FM

http://slidepdf.com/reader/full/introduction-fm 1/18

An Overview of Financial

Management



The Balance-Sheet Model

of the Firm

Current

Assets

Fixed Assets

1 Tangible

2 Intangible

Total Value of Assets:

Shareholders

’ Equity

Current

Liabilities

Long-TermDebt

Total Firm Value to Investors:




of the Firm

Current

Assets

Fixed Assets

1 Tangible

2 Intangible

Shareholders

’ Equity

Current

Liabilities

Long-Term

Debt

What long-

terminvestmentsshould thefirm engagein?

The Capital Budgeting Decision




of the Firm

How can the

firm raise the

money for the

requiredinvestments?

The Capital Structure Decision

Current

Assets

Fixed Assets

1 Tangible

2 Intangible

Shareholders

’ Equity

Current

Liabilities

Long-Term

Debt




of the Firm

How much

short-term cashflow does acompany needto pay its bills?

The Net Working Capital Investment Decision

Net

WorkingCapital

Shareholders

’ Equity

Current

LiabilitiesCurrent

Assets

Fixed Assets

1 Tangible

2 Intangible

Long-Term

Debt



Corporate Finance Functions

Financial Management

Capital-Raising(Financing)

Capital Budgeting

Risk Management

Corporate Governance



Relationship with Accounting

• The firm’s finance (treasurer) and accounting (controller)

functions are closely-related and overlapping. In smallerfirms, the financial manager generally performs bothfunctions

• One major difference in perspective and emphasis between

finance and accounting is that accountants generally use theaccrual method while in finance, the focus is on cash flows .

• Finance and accounting also differ with respect to decision- making . While accounting is primarily concerned with the

presentation of financial data, the financial manager isprimarily concerned with analyzing and interpreting thisinformation for decision-making purposes



TEN PRINCIPLES OF FM1. Risk Return Trade off: We wont take any additional risk

unless we expect to be compensated with additional return.2. Time Value of Money: A dollar received today is worth

more than a dollar received in the future

3. Cash-Not Profits-Is King

4. Incremental Cash Flows-It’s only what changes thatcounts

5. The curse of competitive markets- Why its hard to findexceptionally profitable projects

6. Efficient Capital Markets- The markets are quick and theprices are right; there fore wealth maximization is a goodobjective of FM



7. The Agency Problem- Managers wont work for owners

unless it’s in their best interest. 8. Taxes bias business decisions

9. All risks are not equal, some risks can be diversified away,and some cannot

10. Ethical behavior is doing the right thing, and ethicaldilemmas are everywhere in Finance



DECISIONS, RETURN, RISK,

AND MARKET VALUE

Capital Budgeting

Decisions

Capital StructureDecisions

Dividend

Decisions

Working Capital

Decisions

Return

Risk

Market Value of

the Firm



THE OBJECTIVE OF

CORPORATE FINANCE



Characteristics of a Good Objective Function

• It is clear and unambiguous

• It comes with a clear and timely measure that can be used toevaluate the success or failure of decisions.

• It does not create costs for other entities or groups that erase firm-specific benefits and leave society worse off overall. As an

example, assume that a tobacco company defines its objectiveto be revenue growth.



First Principles

• Invest in projects that yield a return greater than the minimum

acceptable hurdle rate.

– The hurdle rate should be higher for riskier projects and reflectthe financing mix used - owners’ funds (equity) or borrowed

money (debt)

– Returns on projects should be measured based on cash flows

generated and the timing of these cash flows; they should also

consider both positive and negative side effects of these projects.• Choose a financing mix that minimizes the hurdle rate and matches

the assets being financed.

• If there are not enough investments that earn the hurdle rate, return

the cash to stockholders.

– The form of returns - dividends and stock buybacks - will

depend upon the stockholders’ characteristics.

Objective: Maximize the Value of the Firm



The Classical Objective Function

STOCKHOLDERS

Maximizestockholderwealth

Hire & firemanagers- Board- Annual Meeting

BONDHOLDERSLend Money

ProtectbondholderInterests

FINANCIAL MARKETS

SOCIETYManagers

Reveal

informationhonestly andon time

Markets are

efficient andassess effect onvalue

No Social Costs

Costs can betraced to firm



Another Way of Presenting this is...

Stockholders hire managers to run their firms for them

Managers set aside their interests and maximize stock prices

Stockholder wealth is maximized

Firm Value is maximized

Societal wealth is maximized

Because stockholders have absolute power to hire and fire managers

Because markets are efficient

Because lenders are fully protected from stockholder actions

Because there are no costs created for society

Why Stock Price Maximization Works



Maximizing stock prices as opposed to

firm value

• Stock price is easily observable and constantly updated(unlike other measures of performance, which may not be aseasily observable, and certainly not updated as frequently).

• If investors are rational (are they?), stock prices reflect thewisdom of decisions, short term and long term,instantaneously.

• The stock price is a real measure of stockholder wealth, sincestockholders can sell their stock and receive the price now .



What can go wrong?

STOCKHOLDERS

Managers puttheir interestsabove stockholders

Have little controlover managers

BONDHOLDERSLend Money

Bondholders canget ripped off

FINANCIAL MARKETS

SOCIETYManagers

Delay badnews or

providemisleadinginformation

Markets make

mistakes andcan over react

Significant Social Costs

Some costs cannot betraced to firm



The Counter Reaction

STOCKHOLDERS

Managers of poorlyrun firms are puton notice.

1. More activistinvestors2. Hostile takeovers

BONDHOLDERS

Protect themselves

1. Covenants2. New Types

FINANCIAL MARKETS

SOCIETYManagers

Firms are

punishedfor misleadingmarkets

Investors and

analysts becomemore skeptical

Corporate Good Citizen Constraints

1. More laws2. Investor/Customer Backlash

introduction - fm

Documents