Introduction to Financial Management Dr: EL ILAM SI MOHAMED Chapter 1

Key Concepts and Skills Know the basic types of financial management decisions and the role of the financial manager Know the goal of financial management Know the financial implications of the different forms of business organization Understand the conflicts of interest that can arise between owners and managers

Chapter Outline Finance: A Quick Look Business Finance and The Financial Manager Forms of Business Organization The Goal of Financial Management The Agency Problem and Control of the Corporation Financial Markets and the Corporation www: This is a good place to show the students the web site that accompanies the book, including the various features that they can access for study purposes (study guide, quizzes, web links, etc.). Click on the “web surfer” icon to go directly to the site.

Basic Areas Of Finance Corporate finance Investments Financial institutions International finance Each of these topics will be discussed in more detail in the following slides. www: Several of the following slides will have hot links to a web site that provides information about different business jobs including descriptions, skills and traits, etc. The address is www.careers-in-business.com Video: Advice from recent graduates on what it takes to have a career in finance. The discussion on corporate finance is deferred until later in the chapter.

Investments Work with financial assets such as stocks and bonds Value of financial assets, risk versus return and asset allocation Job opportunities Stockbroker or financial advisor Portfolio manager Security analyst www: Clicking on the “web surfer” icon will take you to the Careers in Business Home Page. The “Money Management” option discusses careers as portfolio managers, mutual fund analysts, etc. The “Financial Planning” section discusses careers as financial consultants.

Financial Institutions Companies that specialize in financial matters Banks – commercial and investment, credit unions, savings and loans Insurance companies Brokerage firms Job opportunities www: Clicking on the “web surfer” icon will take you to the Careers in Business Home page. “Commercial Banking”, “Insurance” and “Investment Banking” all discuss job opportunities in the Financial Institutions area.

International Finance This is an area of specialization among all of the areas discussed so far It may allow you to work in other countries or at least travel on a regular basis Need to be familiar with exchange rates and political risk Need to understand the customs of other countries and speaking a foreign language fluently is also helpful

Why Study Finance? Marketing Accounting Management Personal finance Budgets, marketing research, marketing financial products Accounting Dual accounting and finance function, preparation of financial statements Management Strategic thinking, job performance and profitability Personal finance Budgeting, retirement planning, college planning, day-to-day cash flow issues Since this course is generally required of all business majors, it is important to emphasize that everyone needs to have a basic understanding of financial concepts so that they can communicate effectively within an organization. This is the same reason that everyone is required to take marketing courses, management courses, etc. It is important to speak the language of business, and that includes finance. Marketing Have to work within a budget Marketing research is often very important to financial analysts, those doing the research need to understand what information the analysts need so that they ask the right questions Marketing financial products – including entire companies through IPOs and seasoned equity offerings, as well as insurance and other basic financial products Accounting In smaller businesses, accountants often perform both the accounting and finance functions Prepare the financial statements that financial analysts rely on for information Management Business strategy – have to understand the goals of the business and how cash flow works Understand how job performance affects profitability Personal Finance For many students, emphasizing the personal finance issues whenever possible can make the material more relevant Decisions about 401K plans, saving for houses, cars, kids college, etc. can be discussed throughout the course Day-to-day decisions about consumption vs. saving can also be discussed within a finance framework

Business Finance Some important questions that are answered using finance What long-term investments should the firm take on? Where will we get the long-term financing to pay for the investment? How will we manage the everyday financial activities of the firm? Emphasize that “business finance” is just another name for the “corporate finance” mentioned under the four basic types. Students often get confused by the terminology, especially when different terms are used to refer to the same thing.

Financial Manager Financial managers try to answer some or all of these questions The top financial manager within a firm is usually the Chief Financial Officer (CFO) Treasurer – oversees cash management, credit management, capital expenditures and financial planning Controller – oversees taxes, cost accounting, financial accounting and data processing Video Note: This video looks at the changing role of the Chief Financial Officer (CFO) at the Fortune 500 company, Abbot Laboratories.

Financial Management Decisions Capital budgeting What long-term investments or projects should the business take on? Capital structure How should we pay for our assets? Should we use debt or equity? Working capital management How do we manage the day-to-day finances of the firm? Provide some examples of capital budgeting decisions, such as what product or service will the firm sell, should we replace old equipment with newer, more advanced equipment, etc. Be sure and define debt and equity. Provide some examples of working capital management, such as who should we sell to on credit, how much inventory should we carry, when should we pay our suppliers, etc.

Forms of Organization Three major forms in the united states Sole proprietorship Partnership General Limited Corporation S-Corp Limited liability company www: Clicking on the “web surfer” will take you to a web site that will provide a discussion about which form of business may be appropriate for an entrepreneur. The following pages will provide links to specific pages on the web site that provide additional information about the legal aspects of each form of business, as well as a discussion of the advantages and disadvantages. The address is: http://www.nolo.com/encyclopedia/sb_ency.html#Subtopic16

Sole Proprietorship Advantages Disadvantages Easiest to start Least regulated Single owner keeps all the profits Taxed once as personal income Disadvantages Limited to life of owner Equity capital limited to owner’s personal wealth Unlimited liability Difficult to sell ownership interest www: Click on the “web surfer” for more information about sole proprietorships. If you click on the “--Sole Proprietorship” link, you will be taken to an index that will provide a link to information about husband and wife sole proprietorships.

Partnership Advantages Disadvantages Two or more owners More capital available Relatively easy to start Income taxed once as personal income Disadvantages Unlimited liability General partnership Limited partnership Partnership dissolves when one partner dies or wishes to sell Difficult to transfer ownership www: Click on the “web surfer” for more information about partnerships. If you click on the “—Partnerships” link, you will go to an index that provides links to additional information about limited partnerships, partnership agreements and buy-sell agreements. Note that unlimited liability applies to all partners in a general partnership and only the general partners in a limited partnership Written agreements are essential due to the unlimited liability. Limited partners cannot be involved in the business or else they may be deemed as general partners.

Corporation Advantages Disadvantages Limited liability Unlimited life Separation of ownership and management Transfer of ownership is easy Easier to raise capital Disadvantages Separation of ownership and management Double taxation (income taxed at the corporate rate and then dividends taxed at personal rate) www: Click on the “web surfer” to go to a page that discusses corporations. If you click on the “—Corporations” link it will take you back to an index that provides links to additional information on corporations as well as limited liability corporations. Discuss how separation of ownership and management can be both an advantage and a disadvantage: Advantages You can benefit from ownership in several different businesses (diversification) You can take advantage of the expertise of others (comparative advantage) Easier to transfer ownership Disadvantage Agency problems if management goals and owner goals are not aligned The instructors manual provides additional discussion of limited liability companies and S-corporations

Goal Of Financial Management What should be the goal of a corporation? Maximize profit? Minimize costs? Maximize market share? Maximize the current value of the company’s stock? Does this mean we should do anything and everything to maximize owner wealth? Try and have the students discuss each of the goals above and the inherent problems of the first three goals: Maximize profit – Are we talking about long-run or short-run profits? Do we mean accounting profits or some measure of cash flow? Minimize costs – We can minimize costs today by not purchasing new equipment or delaying maintenance, but this may not be in the best interest of the firm or its owners. Maximize market share – This has been a strategy of many of the dot.com companies. They issued stock and then used it primarily for advertising to increase the number of “hits” to their web sites. Even though many of the companies have a huge market share (I.e. Amazon) they still do not have positive earnings and their owners are not happy. Maximize the current value of the company’s stock There is no short run vs. long run here. The stock price should incorporate expectations about the future of the company and consider the trade-off between short-run profits and long-run profits. The purpose of a for-profit business should be to make money for its owners. Maximizing the current stock price increases the wealth of the owners of the firm. This is analogous to maximizing owners’ equity for firms that do not have publicly traded stock. Non-profits can also follow the same principle, but their “owners” are the constituencies that they were created to help. The instructors manual provides a letter to stockholders that was written by former Coca-Cola CEO Roberto Goizueta. There is also a brief discussion of an article that appeared in Fortune magazine that discusses Coke vs. Pepsi and their different philosophies on business in the early 1990’s. Ethics Note: See the instructor’s manual for a discussion of Dow-Corning, silicone breast implants and the ethics involved with pursuing owners’ wealth at all costs.

The Agency Problem Agency relationship Agency problem Principal hires an agent to represent their interest Stockholders (principals) hire managers (agents) to run the company Agency problem Conflict of interest between principal and agent Management goals and agency costs Video Note: This video focuses on how one company handled the tough decision to cut jobs and managed to successfully increase shareholder value. It features ABT Co. in Canada. A common example of an agency relationship is a real estate broker – in particular if you break it down between a buyers agent and a sellers agent. A classic conflict of interest is when the agent is paid on commission, so they may be less willing to let the buyer know that a lower price might be accepted or they may elect to only show the buyer homes that are listed at the high end of the buyers price range. Ethics Note: The instructor’s manual provides a discussion of Gillette and the apparent agency problems that existed prior to the introduction of the sensor razor. Direct agency costs – the purchase of something for management that can’t be justified from a risk-return standpoint, monitoring costs. Indirect agency costs – management’s tendency to forgo risky or expensive projects that could be justified from a risk-return standpoint.

Managing Managers Managerial compensation Corporate control Incentives can be used to align management and stockholder interests The incentives need to be structured carefully to make sure that they achieve their goal Corporate control The threat of a takeover may result in better management Other stakeholders Incentives – discuss how incentives must be carefully structured. For example, tying bonuses to profits might encourage management to pursue short-run profits and forego projects that require a large initial outlay. Stock options may work, but there may be an optimal level of insider ownership. Beyond that level, management may be in too much control and may not act in the best interest of all stockholders. The type of stock can also affect the effectiveness of the incentive. Corporate control – ask the students why the threat of a takeover might make managers work towards the goals of stockholders. Other groups also have a financial stake in the firm. They can provide a valuable monitoring tool, but they can also try to force the firm to do things that are not in the owners’ best interest.

Work the Web Example The Internet provides a wealth of information about individual companies One excellent site is finance.yahoo.com Click on the web surfer to go to the site, choose a company and see what information you can find!

Figure 1.2

Financial Markets Cash flows to the firm Primary vs. secondary markets Dealer vs. auction markets Listed vs. over the counter securities NYSE NASDAQ Video Note: This video discusses how capital is raised in financial markets and shows an open-outcry market at the Chicago Board of Trade. Discuss the cash flows to the firm. You might have students turn to Figure 1.2 in their book to see an illustration of the cash flows. The main point is that cash comes into the firm from the sale of debt and equity. The money is used to purchase assets. Those assets generate cash that is used to pay stakeholders, reinvest in additional assets, repay debtholders and pay dividends to stockholders. Students are often confused by the fact that the NASDAQ is an OTC market. Explain that the NASDAQ market site is just a convenient place for reporters to show how stocks are moving, but that trading does not actually take place there. See the instructor’s manual for a discussion of an October 1999 BusinessWeek article concerning the move by the NYSE and the NASDAQ towards becoming for-profit companies and the possible impact on investors. www: Click on the NYSE and NASDAQ hyperlinks to go to their web sites

Quick Quiz What are the four basic areas of finance? What are the three types of financial management decisions and what questions are they designed to answer? What are the three major forms of business organization? What is the goal of financial management? What are agency problems and why do they exist within a corporation?

Definitions and concepts Dr: EL ILAM SI MOHAMED Financial Management Definitions and concepts Dr: EL ILAM SI MOHAMED

Financial management, sometimes called financial operations or finance, is how an insurance company manages its resources to meet the company’s financial goals, especially the overall goals of solvency and profitability.

Organization of Financial Management Investment Committee Board of Directors Audit Committee Board of Directors Chief Financial Officer Financial Operations Chief Investment Officer Investment Operations Treasurer Treasury Operations Controller Accounting and Financial Reporting Chief Auditor Audit and Internal Control

Accounting and Financial Operations Accounting is a system or set of rules and methods for collecting, recording, analyzing, summarizing, and reporting financial information. Financial reporting is the process of presenting financial data about a company’s financial position. Operating performance, and flow of funds into and out of the company. In most of the insurance companies, the controller or comptroller is the head of accounting and financial reporting

Accounting and Financial Operations The primary responsibilities of the accounting and financial reporting function are to : Record, track and report on financial transactions Coordinate the budget process and oversee expense analysis Prepare financial statements and reports for external stakeholders Gather, record ,analyze and distribute financial information to company mangers

Treasury Operations Treasury Operations, manages the cash coming into and out of a company The treasurer oversees the maintenance and management of records and reports for all of an insurer’s cash transactions

Treasury Operations Treasuery operations include the following responsibilities: Cash Management-Oversees cash receipts and approves cash disbursements Bank relations and account administration- Set up bank accounts, reconciles bank statements Bank reconciliation-Records cash transactions and charges them to proper accounts Short term credit activities- invests excess cash in very short – term arrangements and arranges for very short term borrowing as needed Cash forecasting- Forecasts and tracks the movement of money into and out of the company Liquidity management- Manages cash on hand to meet contractual obligations by using liquidity

Investment Operations Investments are core insurance company operation. Typically, a CIO manages investment operations. The CIO is responsible for : Making recommendations to the board and implementing board directives Ensuring investment decisions are in line with investment policy and regulatory requirements Communicating to the accounting and actuarial areas the current and expected rates of return on the company’s investments

Audit and Internal Control By conducting audits of its financial and operational business activities , an insurer can objectively , and compliance with evaluate its operating procedures, management efficiency and compliance with specified rules and regulations

Audit and Internal Control The ongoing duties of an insurer’s audit committee include: Monitoring internal controls for financial operations Supervising and meeting with internal auditors to discuss their activities and findings Monitoring organizational activities to improve operating efficiencies Reporting the committee’s activities to the board of directors Reporting the committee’s activities in the annual report to stockholders and policy owners

Responsibilities of Financial Management (1) Setting Financial strategy (2) Managing risk (3) Managing the company’s solvency and profitability (4) Managing capital (5) Managing cash flows (6) Providing financial information to stakeholders

1) Setting Financial Strategy Financial strategies may be categorized as : 1) Aggressive 2) Conservative 3) combination of the above two Aggressive : A company that places a strong emphasis on taking risks that could enhance its profitability. For e.g. investing in relatively high- risk assets, developing many new and unusual products, implementing new distribution systems Conservative Financial Strategy: An insurer that places a strong emphasis on avoiding risks that could threaten its solvency generally pursues a conservative financial strategy. For e.g. …………….

2) Managing Risks Risk is the possibility that an investment might have an unexpected result. Common types of risks: Investment risk- is the possibility that an investor will fail to earn some or all of an expected return or will lose all or part of the original investment. Some important risks associated with investing are Market Risk : For e.g. real estate investment may lose value if the real estate market as a whole declines Interest-rate risk: For e.g. if the interest rate increase, bonds tend to lose market value Default-risk: The risk that a borrower will fail to repay the debt Liquidity –risk: for e.g. I the owner of property, such as shopping mall, should suddenly need cash quickly, the property may have to be sold for a price less than its true value Currency risk: the value of an insurer’s investments in a foreign country fluctuates with the value of that country’s currency

2) Managing Risks Operational Risk is a broad category of risks originating from inadequacies in an insurer’s operational areas or from external events affecting an insurer's operational areas. Two major types of operational risks are: Business process risk- For e.g. inefficient customer service processes might create long TAT Event Risk: For e.g. an earthquake might result in technology failures and an inability to run the business Product Risk : is the risk that a company’s [products might not sell as well or be as profitable as expected A) Pricing risk: For e.g. more insured might die than an insurer anticipated when pricing a life insurance product, so claims will be higher B) Policyholder behavior risk: For e.g. customer ‘s surrender patterns may be higher than an insurer anticipated

2) Managing Risks Risk management is the process of systematically identifying, assessing, and minimizing the negative impact of risk. To minimize the negative impact of these various risk across the organization, most insurers practice Enterprise Risk Management. ERM is a system that identifies and quantifies risks both from potential threats and potential opportunities and manages them.

3) Managing Solvency and Profitability The dual goals of financial management are to (1) protect solvency (2) increase profitability Pursuing profitability requires a certain amount of risk taking, whereas protecting solvency involves risk avoidance and stability Long term profitability enables an insurer to A) Provide funds for investments B) Pay policy dividends C) Pay cash dividends to stockholders and increase the attractiveness of the company’s stock to investors D) Generate high-quality ratings from insurance rating agencies E) Provide funds to develop products, expand product lines, for company expansion e.t.c

Capital= Assets – Liabilities 4) Managing Capital Financial managers attempt to increase the probability that the company will remain financially healthy by using the company’s capital appropriately Capital= Assets – Liabilities Benefits to an insurer of maintaining the strong capital position include: Greater ability to withstand difficult conditions such as bad economy Greater flexibility in its operations Greater ability to raise capital on favorable terms

Ways to Raise Capital? Ways to Use Capital?

5) Managing Cash Flows A cash flow is any movement of cash into or out of an organization A cash inflows include- 1) revenues from product sales 2) investment income 3) sales of existing assets 4) external financing A Cash outflow includes 1) payments to policy owners and beneficiaries 2) payment for operating expenses 3) purchase of new assets The basic goal for managing cash flows is to have enough assets available so that the insurer can pay its obligations as they come due and to invest the remaining assets wisely to earn favorable returns

6) Providing financial information to stakeholders Insurers provide information to stakeholders in the form of Financial statements Annual report Annual statements

6) Providing financial information to stakeholders A financial statement is a summary of a company’s financial condition on a specified date or its performance during a specified period. Two key financial statements are the income statement and the balance sheet The income statement shows a company’s revenues and expenses during a defined period, such as one quarter or one year, and shows weather the company experienced a profit or loss during that period. Revenues are amounts that a company earns from its business operations Expenses are amounts that a company spends to support its business operations The income statement also shows net income, which is calculated by subtracting expenses from revenues

6) Providing financial information to stakeholders Balance sheet, which lists the value of an insurer’s assets ,liabilities , and capital and surplus as of a specified date Annual Report is a financial document that an incorporated business issues to its stakeholders and other interested parties to report the business’s activities and financial performance for the preceding year. Annual Statement