lecture1-introduction to fm

7/31/2019 Lecture1-Introduction to FM

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INTRODUCTION TO

FINANCIAL MANAGEMENT

Syed Irfan Ahmed


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What is Financial Management?

Financial Management can be definedas:

The management of the financesof a business / organisation inorder to achieve financialobjectives

Or prudent use of business capitalto attain objectives


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Objectives

Taking a commercial business as the mostcommon organisational structure, the keyobjectives of financial management would

be to: Create wealth for the business

Generate cash, and

Provide an adequate return on investmentbearing in mind the risks that the businessis taking and the resources invested


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Key elements

There are three key elements to the process offinancial management:

(1) Financial Planning

Management need to ensure that enough funding isavailable at the right time to meet the needs of thebusiness. In the short term, funding may be neededto invest in equipment and stocks, pay employees andfund sales made on credit.

In the medium and long term, funding may berequired for significant additions to the productivecapacity of the business or to make acquisitions.


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Key elements

(2) Financial Control

Financial control is a critically importantactivity to help the business ensure that the

business is meeting its objectives. Financialcontrol addresses questions such as:

Are assets being used efficiently?

Are the businesses assets secure?

Do management act in the best interest ofshareholders and in accordance with businessrules?


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Key elements

(3) Financial Decision-making

The key aspects of financial decision-making relate toinvestment, financing and dividends:

Investments must be financed in some way

however there are always financing alternatives thatcan be considered. For example it is possible to raisefinance from selling new shares, borrowing frombanks or taking credit from suppliers

A key financing decision is whether profits earned bythe business should be retained rather thandistributed to shareholders via dividends. If dividendsare too high, the business may be starved of fundingto reinvest in growing revenues and profits further.


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What does a financial manager do?

Financial management is a distinct area of businessmanagement - i.e. financial manager has a key role inoverall business management

Prudent or rational use of capital resources -proper

allocation and utilization of funds Careful selection of the source of capital -

Determining the debt equity ratio and designing aproper capital structure for the corporate

Goal achievement - ensuring the achievement of

business objectives viz. wealth or profit maximization.


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What does a financial manager do?

Overall the financial manager deals with:-

Performing the regular finance functions includingfinancial planning including assessing the fundsrequirement, identifying and sourcing funds,

allocation of funds and income and controlling theuse or utilization of funds towards achieving theprimary goal of profit/wealth maximization.

Performing the non-recurring functions including,though not exclusively, the preparation of financialplan at the time of promotion of the business

enterprise, financial readjustment during liquiditycrisis, valuation of enterprise at the time of merger orreorganization and such other episodic activities ofgreat financial implications.


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Goal of FinancialManagement

Maximization of owners wealthA. Maximize firm value

B. Agency relationship

1. Principals

2. Agentsa. Moral hazard: Agents surreptitiously act inown best interest

b. Conflicts of interest

(1) grant oneself large salary increases

(2) pursue less profitable pet projects

(3) unethical accounting

(4) fight a merger that may be inshareholders best interest

(5) excessive perquisites


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c. Agency costs

(1) monitoring costs

(2) opportunity costs

d. Minimization of conflicts

(1) compensation plan

(a) should be determined by

outside directors

(b) adequate salary

(c) bonus plans(2) bad publicity

(3) legal liability

(4) hostile takeover


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C.Social responsibility: anti-pollutiondevices, fair hiring practices, productsafety

1. Cost/benefit analysis2. Society benefits

a. Efficient, low cost products

b. New products desired byconsumers

c. Good locations & times

d. Efficient, courteous service


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Raising CapitalI. Financial Markets

A. Primary versus secondary?

1. Use Investment bankers

2. Target Organized exchanges

a. Major

b. Regional

3. Trade in Over-the-counter market

4. ECNs


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Raising Capital5. Financial intermediaries

a. Deposit types / Commercial banks

b. Life insurance companies

c. Pension funds

d. Mutual funds

B Money markets vs. capital markets

Other markets to think about.

C Spot vs. Futures

D Public vs. Private

E REAL vs. Financial


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INTEREST RATE = COST OFMONEY

A. Fisher equation

1. Nominal rfr = real rfr + expected inflation

2. Example 1: Assume the real risk-free rate hasaveraged 2% in recent years and the one-yearTreasury security is yielding 8%. What doesthis imply expected inflation is for the year?

3. Example 2: Assume inflation is expected to be3%, 3.2%, and 3.6% in the next three years,

respectively. The real risk-free rate hasaveraged 2%. What rate would you expect toobserve on a 3-year Treasury security?


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INTEREST RATE = COST OF MONEY

4. Example 3: The expected inflation ratesfor the next 2 years are 1% and 1.2%,respectively. A 3-year Treasury note is

yielding 5%, and the real risk-free ratehas averaged 2% in recent years. Whatdoes this imply the expected rate ofinflation in year three is?


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5. TIPS: Treasury Inflation Protected Securities(1997)

a. Coupon fixed; face value adjusted forinflation

b. Difference in yields between non-indexed T-bond and TIPS of same maturity proxiesfor expected annual inflation rates over the period.

B. Factors affecting cost of money

1. Production opportunities:

2. Time preferences for consumption3. Expected inflation

4. Risk


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C.Nominal interest rate=real risk-free rate

+expected inflation (inflation premium)

+default risk premium+ liquidity premium+maturity risk premium

We can also add

+ country risk+ exchange rate risk

But why have we added?


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D. Factors affecting supply and demand conditions

1. Monetary policy tools

a. Discount rate

b. Reserve requirement

c. Open market operations

2. Fiscal policya. Government spending

b. Taxation

c. Deficit management


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E. Term structure of interest rates

1. Relationship between yield and time to

maturity

2. Yield curves* Normal yield curve/positive yield curve(short-term yields < longer term yields)

* Abnormal yield curve/negative yield curve(short-term yields > longer term yields)

* Flat yield curve (no difference between sort-term yields and long-term yields)

What does Pure expectations theory say??


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Pure Expectations Hypothesis

The PEH contends that the shape ofthe yield curve depends on investors

expectations about future interestrates.

If interest rates are expected toincrease, L-T rates will be higher

thanS-T rates, and vice-versa. Thus, theyield curve can slope up, down, oreven bow.


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Sole proprietorship

Partnership

Corporation

Alternative Forms of

Business Organization


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Advantages: Ease of formation

Subject to few regulations

No corporate income taxes

Disadvantages: Limited life

Unlimited liability Difficult to raise capital

Sole Proprietorship


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A partnership has roughly the sameadvantages and disadvantages as asole proprietorship.

Partnership


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Advantages: Unlimited life

Easy transfer of ownership

Limited liability

Ease of raising capital

Disadvantages:

Double taxation Cost of set-up and report filing

Corporation

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