An Overview of Financial Management (bdh) Jan 10 1 Financial Management Department Primary Financial Management Activities in a Corporation Strategic Decisions Capital Budgeting Decision Investment Decision What assets to acquire? How much to invest? (Not in Isolation) Composition Decision (Debt vs. Equity) Plant & Equipment Working Capital Debt Maturity Decision (Long vs. Short) Decide how should assets be financed? Stakeholder Benefit Return vs. Risk Trade-off Decision Equity (Stocks)BondsOther

An Overview of Financial Management (bdh) Jan 10 2 The Main Finance Career Categories: Financial Management (This is the main focus of this course)  (You work for any company)  Decide how to “finance” the firm; i.e. figure out how to come up with the funds needed to pay for day-to-day operations and long-term improvements/expansion  how much debt to issue & carry  how much equity (stock) to issue  how much earnings to retain/how much dividend to pay out  manage short-term assets and liabilities  minimize the cost of financing  Increase the firm’s cash flows through investments in securities and other financial assets  Minimize risk to cash flows  Implied in the above tasks is the ability to asses the value of financial assets Financial & Investment Services (Focus of advanced finance courses)  (You work for an investment/brokerage firm, full service bank, mutual fund company or an insurance company)  3 main functions:  sales of financial services and products  analysis of individual securities and portfolios  manage investment portfolios  Financial consulting (providing the Financial Management services listed above)

An Overview of Financial Management (bdh) Jan 10 3 There’s Only Two Things That Finance People Do:  Rearranging/Translating/Exchanging Cash Flows Over Time:  Exchanging a single cash flow (now) for a series of cash flows (in the future)  getting a personal loan or issuing corporate debt  entering into a mortgage  selling securities (receive lump sum in exchange for paying stock dividends & bond interest payments in the future)  Exchanging a series of cash flows (in the future) for a single cash flow (now)  retiring a loan or corporate debt  paying off a mortgage  buying securities (pay a lump sum payment in exchange for stock dividends & bond interest in the future)  Converting today’s dollars into equivalent future value  Converting future dollars into equivalent present value (in terms of “today’s” dollars)  Choosing the best/most advantageous arrangement/timing of cash flows (making financial decisions)  Speculation (exchanging a cash flow for the possibility of receiving a larger one sometime in the future)  Capital gain appreciation/growth: buying a financial asset and hoping it growths in value  Dealing in derivative securities (forwards, futures & options) What’s a Security?  Managing Risk  Identifying risk to cash flows  Assessing risk to cash flows  Mitigate risk to cash flows

An Overview of Financial Management (bdh) Jan 10 4 The Difference Between Finance and Accounting Finance:  Focused on the future (How to pay for what we want in the future)  Must deal with uncertainty (must use probability statistics)  Primarily concerned with deciding how to acquire, generate and distribute assets & capital resources  Strategic decision making Accounting:  Focused on the past (How did we pay for what we have)  Very little uncertainty (the past is certain)  Primarily concerned with keeping track of how assets and capital are paid for & allocated/distributed  Limited decision making Risk: Definitions:  Webster’s: a hazard; a peril; exposure to loss or injury  The chance that an outcome other than that which was expected will occur  The chance that an outcome other than that which was desired will occur (i.e. lose money)(this is the ”finance” definition)  Risk = Uncertainty of future cash flows

An Overview of Financial Management (bdh) Jan 10 5 Primary Finance Axioms:  As far as the finance world is concerned, any asset (stocks, bonds, a project, a company, etc.) has positive value today (the “present value” of an asset) only if it gets more valuable in the future:  it generates future positive cash flows and/or…..  it appreciates in value over time This is because Finance is focused on the future  Risk affects value:  Risk Aversion: given two securities equally priced but with different degrees of risk, the rational investor would choose the one with lower risk  Valuation Implications: →all else being equal, a security whose cash flows are more certain is more valuable than a security with relatively less certain cash flows →if two securities offer the same ROR, the riskier one is priced lower if the seller of that security wants anybody to buy it (the less riskier one is priced higher)  ROR Implications:if two securities are priced the same, the riskier one must offer higher expected returns if the seller of that security wants anybody to buy it  The timing of cash flows matters; cash received sooner is better:  it can be utilized (invested) sooner to produce additional income  restore liquidity sooner

An Overview of Financial Management (bdh) Jan 10 6 Review of Some Important Basic Concepts (this stuff is not in your book) Difference Between Price and Value  The value of a financial asset is based upon expected future cash flows  this is the “theoretical value”, “fair market value”, “true market price”, “true market value”, “intrinsic value” or “no-arbitrage price”  it is what the asset should be worth based on fundamental financial and accounting valuation principles (much more on this later)  The price (“market price” or “real market price”) of something is  what the seller wants you to pay for it  what the “real” market allows (based on Laws of Supply / Demand)  Price is usually not equal to fair market value:  “fair market value” is the value of something based on theory and does not include profit  “price” is based on market/economic forces (supply and/or demand) and usually includes profit, transaction costs, etc.  What makes the fair market value of something change?  change in expected/estimated future cash flows  change in future cash flow discount rate (more on this later)  What makes the price of something change?  the same things that make fair market value change  market forces (supply & demand) Profit  It is the difference between Market Price and Value  Profit = Market Price - Value  Profit = Sales Price – COGS (Accounting Definition)

An Overview of Financial Management (bdh) Jan 10 7 Profit (continued)  In the case of an investment: Profit = Available market price at the end of the holding period - Price paid at the beginning of the holding period (i.e. you buy a security, you hold it for a while, its price changes, you sell it) Percent (%) Profit or Rate of Profit  The percentage increase in the price (or value) of a financial asset  May involve time  Also Called:  Return  Percent Return (% Rtn)  Rate of Return (ROR)  Yield  Return on Investment (ROI)  General Equation: Profit / Investment  ROR may be thought of as rate of wealth creation Rate of Profit Examples: 1) (Spot Transaction) A lawn mower manufacturing company charges $300 for a lawn mower that cost $270 to produce and ship. What is the return on this product? Return = (Sales price - COGS) / COGS = ($300 - $270) / $270 = $30 / $270 = = 11.11% = % Profit = % Rtn = ROR = Yield = ROI Profit Investment

An Overview of Financial Management (bdh) Jan 10 8 Percent (%) Profit or Rate of Profit (continued) 2) (Investment Transaction) A year ago you bought 100 shares of Intel stock for a total of $4,329. Today you sold that 100 shares for $4,489. What was your return? Return = (New Price - Old Price) / Old Price = ($4,489 - $4,329) / $4,329 = $160 / $4,329 = = 3.696% The equation (New-Old)/Old is not unique to finance: Example 1: The temperature at dawn was 24 o and at 3:00 pm it was 56%. By how much did the temperature change in percent? Answer: %  Temperature: (New-Old)/Old = (56 o – 24 o )/24 o (Note:  = change) = = 133% Check Answer: 24 o ( ) = 24 o (2.3333) = 56 o Example 2: At the beginning of 2005 the population of Albuquerque was 450,000. At the end of 2005 the population was 461,200. What was the percent change in population? %  Population = (New – Old)/Old = (461, ,000)/ 450,000 = = 2.489% Check Answer: 450,000( ) = 461,200; The general equation to find the value of some variable increased by some percent is: New = Old(1 + %  ) Profit Investment

An Overview of Financial Management (bdh) Jan 10 9 Alternate Form of % Profit Equation: (New Price – Old Price) / Old Price = New Price Old Price Old Price Old Price = New Price/Old Price – 1  In Finance, we are more concerned with Rate of Return (%) than we are with Profit ($) Consider these two investment options: A) Invest $5,000 now and receive $5,500 in one year B) Invest $100,000 now and receive $108,000 in one year Find Profit: Profit A = $5,500 - $5,000 = $500 Profit B = $108,000 - $100,000 = $8,000 Find Rate of Return (ROR): ROI A = ($5,500 - $5,000) / $5,000 = 0.10 = 10% ROI B = ($108,000 - $100,000) / $100,000 = 0.08 = 8% Point:  Opt B has a higher total dollar profit but Opt A was actually more profitable because it produced more money with respect to the amount of money invested  In other words, a higher proportion of Opt A’s investment was “returned” as profit (10% as opposed to 8%)  Investments expressed as Rates of Return can be compared on the same basis and without bias. -