Financial Management I BBA-II

Chapter 1 An Overview of Financial Management

Learning Objectives The purpose of this chapter is to give you an idea of what financial management is all about. Key aspects of this course would include: Forces that will affect financial management in future. The place of finance in a firm’s organization. The relationships between financial managers and their counterparts . The goals of a firm. The way financial managers can contribute to the attainment of these goals.

What is Financial Management? Concerns the acquisition, financing, and management of assets with some overall goal in mind.

Role of Financial Management Why is financial management important? The goal of the firm Organization of the financial management function

Investment Decisions Most important of the three decisions. Includes issues like: What is the optimal firm size? What specific assets should be acquired? What assets (if any) should be reduced or eliminated?

Financing Decisions Determine how the assets (LHS of balance sheet) will be financed by RHS of the balance sheet. Includes issues like: What is the best type of financing? What is the best financing mix? What is the best dividend policy? How will the funds be physically acquired?

Asset Management Decision How do we manage existing assets efficiently? Financial Manager has varying degrees of operating responsibility over assets. Greater emphasis on current asset management than fixed asset management.

What is the Goal of the Firm? Maximization of Shareholder wealth Value creation occurs when we maximize the share price for current shareholders.

Shortcomings of Alternative Perspectives A. Profit Maximization: Maximizing a firm’s earnings after taxes. Problems: Could increase current profits while harming firm (e.g., defer maintenance, issue common stock to buy T-bills, etc.). Ignores changes in the risk level of the firm.

B. Earnings Per Share Maximization: Maximizing earnings after taxes divided by shares outstanding. Problems: Does not specify timing or duration of expected returns. Ignores changes in the risk level of the firm. Calls for a zero payout dividend policy.

Strengths of Shareholder Wealth Maximization Takes account of: current and future profits and EPS; the timing, duration, and risk of profits and EPS; dividend policy; and all other relevant factors. Thus, share price serves as a barometer for business performance

The Modern Corporation There exists a SEPARATION between owners and managers. Modern Corporation Shareholders Management

Role of Management Management acts as an agent for the owners (shareholders) of the firm. An agent is an individual authorized by another person, called the principal, to act in the latter’s behalf.

Agency Theory Jensen & Meckling developed a theory of firm based agency theory. Agency theory is a branch of economics relating to behavior of principals & their agents. Principals must provide incentives so that management acts in principals’ best interests & then monitor results. Incentives include stock options, perquisites & bonuses.

Agency Relationships A potential conflict of interests between the agent (manager) and (1) the outside stockholders or (2) the creditors (debt holders)

Cont’d Stockholders versus managers Managerial compensation Direct intervention by shareholders The threat of firing. The threat of takeovers. Stockholders (through managers) versus creditors.

Career Opportunities in Finance Money & Capital markets: deals with securities markets and financial institutions. Investments: which focuses on the decisions made by both individual and institutional investors as they chose securities for their investment portfolios. Financial Management or Business Finance: involves decisions within the firms.

Role of Finance in a Typical Business Organization

Responsibility of Financial Staff Maximize stock value by: Forecasting and planning Investment and financing decisions Coordination and control Transactions in the financial markets Managing risk Note: The key responsibility of financial staff is to align the goals of the corporation with the maximization of its stock price. Will be covered in following slides.

Financial Management in the New Millennium The effect of changing technology (Information technology). Globalization Improvement in transportation and communication has lowered shipping costs. Increased demand of low cost, high quality products. Increased costs of developing new products due to R&D expenditures. International markets have opened new avenues for new and existing products.

Forms of Business Organization Sole proprietorship Partnership Corporation

Sole proprietorships & Partnerships Advantages Ease of formation Subject to few regulations No corporate income taxes Disadvantages Difficult to raise capital Unlimited liability Limited life

Corporations Advantages Disadvantages Unlimited life Easy transfer of ownership Limited liability Ease of raising capital Disadvantages Double taxation Cost of set-up and report filing

Managerial Actions to Maximize Shareholder Wealth Dividend Policy Decisions DOES IT MAKE SENSE TO TRY TO MAXIMIZE EARNINGS PER SHARE????

Major Factors Affecting Stock Price Projected cash flows to shareholders Timing of the cash flow stream Riskiness of the cash flows

Factors that Affect Level & Riskiness of Cash Flows Decisions made by financial managers: Investment decisions Financing decisions (the relative use of debt financing) Dividend policy decisions The external environment

Business Ethics Do it Yourself