Part I: Introduction

1

Part I: IntroductionPart I: Introduction

Chapter 1: Overview of Managerial Finance /

Financial Management

S.B.Khatri - AIM

2

1.1 Financial Management: An 1.1 Financial Management: An Intro.Intro.

The business function relating to the decisions involving:

What long-term investments should you take on ? What lines of businesses ? What sorts of buildings, machineries and equipments? (Investment Decisions)

Where will you get the long-term financing to pay for your investment? Will you bring in other owners or will you borrow the money? (Capital Structure Decisions)

How will you manage your everyday financial activities such as collecting from customers and paying suppliers? (Working Capital Management Decisions)

How the profit earned by the business shall be allocated to the owners? (Dividend Decisions)S.B.Khatri - AIM

3

Financial Management, broadly speaking is the study of ways to answer these three questions.

The maintenance and creation of economic value or wealth.

The study of investment decisions by corporations and ways the investment is financed

Finance uses accounting information together with other information to make decisions that affect the market value of the firm.

Conducting all financial matters of the organization in a way that ensures that funds are used in a proper and efficient manner

S.B.Khatri - AIM

4

1.2 Financial Management 1.2 Financial Management DecisionsDecisions

1. Capital Budgeting/ Investment Decisions (Part IV)2. Capital Structure Decisions/ Financing Decisions

(Part V)3. Working Capital Management Decisions (Part VI)4. Dividend Decisions (Part V)

Dividend Decisions are also sometimes considered as a part of Capital Structure Decisions.

S.B.Khatri - AIM

5

1. Capital Budgeting/ Investment 1. Capital Budgeting/ Investment DecisionsDecisions The process of planning and managing a firm’s

long-term investments. The types of investment opportunities that

would typically be considered depend in part on the nature of the firm’s business.

Evaluating the size, timing, and risk of future cash flows is the essence of capital budgeting.

The financial manager tries to identify investment opportunities that are worth more to the firm than they cost to acquire.

S.B.Khatri - AIM

6

2. Capital Structure Decisions2. Capital Structure Decisions A firm’s capital structure is the specific mixture of

long-term debt and equity the firm uses to finance its operations and long-term investments.

Two concerns of financial manager:1. How much of debt and how much of equity should the

firm borrow? (the mixture chosen will affect both, the value and the risk of the firm)- optimum debt-equity ratio

2. What are the least expensive sources of funds for the firm?

How the firm as a pie is sliced among creditors and shareholders?

How and where to raise the money ?S.B.Khatri - AIM

7

3. Working Capital Management 3. Working Capital Management DecisionsDecisions

Working Capital refers to a firm’s short-term assets, such as inventory, and its short-term liabilities, such as money owed to suppliers (a/c receivables)

Day-to-day activity Ensuring that firm has sufficient resources to

continue its operations. To avoid costly interruptions. Relevant issues:

• How much cash and inventory should we keep on hand?• Should we sell in credit ? What should be credit policy?• How shall we obtain needed short-term financing?

S.B.Khatri - AIM

8

4. Dividend Decisions4. Dividend Decisions Related to the decisions regarding allocation of

profit among the shareholders/owners. What should be done with the profits of the

firm ?• Whether dividend should be distributed or not ?• How much profit shall be kept in the form of retained

earnings?• How much shall be ploughed back to the business?• Does the distribution of dividend increase the value of

the firm ?S.B.Khatri - AIM

9

Some Fundamental PrinciplesSome Fundamental Principles

Before we begin to study financial management in detail, there are two fundamental concepts that must be understood:• The right goal of the firm/financial mgt/manager• The risk/return tradeoff

These two concepts underlie every major technique that we will study

S.B.Khatri - AIM

10

•All management decisions All management decisions should help to accomplish the should help to accomplish the

goal of the firm!goal of the firm!

•What should be the goal of the firm and hence the goal of FM ?

S.B.Khatri - AIM

11

1.3 Goal of Financial 1.3 Goal of Financial ManagementManagement

Possible Goals1. Survive2. Avoid financial distress3. Beat the competition4. Maximize sales of market share5. Minimize costs6. Maintain steady earnings growth

Controlling Risk

Profitability

S.B.Khatri - AIM

12

Problems with such goalsProblems with such goals Maximize sales or market share

By lowering price or relaxing credit terms ? Minimize cost

Doing away with things like R & D ? Avoid distress and bankruptcy

By never borrowing any money or never taking risk ? Survive

What about growth ? Beat the competition

Placing dependence of your activities on competitor’s actions ?

S.B.Khatri - AIM

Profit Maximization? Probably most commonly cited

goal But even this is not precise

objective

Is it ?Is it ?

WHY ?

13S.B.Khatri - AIM

14

Issues regarding this goalIssues regarding this goal Do we mean profits this year ( current profit )? If yes, then why not maximize profit by:

• Deferring maintenance• Letting inventories run down• Canceling all casualty and liability insurance policies so that the

money spent on premiums could go to profit instead.• Taking other short-run cost cutting measures

• Shall we be overly concerned about short-term profits results rather than the long-term strategic positioning of the company ?

Ok fine ! Lets us refer to some sort of “long run” or “average” profits.

Does it give clear definition of what are we trying to maximize ?

What about risk from the perspective

of shareholders

S.B.Khatri - AIM

15

Issues regarding this goal Issues regarding this goal (contd…)(contd…)

Do we mean something like accounting net income (NI) or earnings per share (EPS) ?• If yes, then these accounting numbers may be easily

manipulated. What do we mean by long run ?

• This goal doesn’t tell us what the appropriate trade-off is between current and future profits.

In the long run, we’re all DEAD !S.B.Khatri - AIM

16

Incorrectness of this goal….Incorrectness of this goal….

This goal is inadequate for at least three reasons:• It ignores the time value of money• It ignores risk• It can lead to a preoccupation with short-term

results which, in turn, can lead to sub-optimal long-term results

We need goal that encompasses both factors: safety and profit

S.B.Khatri - AIM

17

Correct Goal of the Firm/ FMCorrect Goal of the Firm/ FM

Shareholder’s Wealth Maximization

Eureka !!!!!

this is the same as:

a) Maximizing Firm Valueb) Maximizing Stock Price

S.B.Khatri - AIM

18

The Correct Goal of the FirmThe Correct Goal of the Firm

The correct goal of the firm is to maximize shareholder wealth (i.e., shareholder’s equity) or, equivalently, to maximize the firm’s stock price.

By this we mean to imply that the managers of the firm work for the shareholders

For this reason, they have a duty to make investments that are expected to increase shareholder wealth

Further, they have a duty to take all investments that are expected to increase shareholder wealth

S.B.Khatri - AIM

19

The Goal of U.S. West Inc.The Goal of U.S. West Inc.

From the U.S. West Annual Report to Shareowners 1988:Our mission is to provide quality products and services to customers in responsive and innovative ways in order to create the highest possible value for our investors through long-term growth and profitability

S.B.Khatri - AIM

20

•The goal of the firm should be The goal of the firm should be to maximize the to maximize the stock pricestock price!!

• This is equivalent to saying the goal is to maximize owners’ wealth.

• Note that the stock price is affected by management’s decisions affecting both risk and profit.

• Stock price can be maintained or increased only when stockholders perceive that they are receiving profits that fully compensate them for bearing the risk they perceive.

S.B.Khatri - AIM

21

Shareholders’ Wealth Shareholders’ Wealth MaximizationMaximization

Good decisions increase the value of the stock, and poor decisions decrease the value of the stock.

Financial manager should act in the shareholder’s best interest by making decisions that increase the value of the stock.

The goal of FM is thus, to maximize the current value per share of the existing stock.

There is no ambiguity in the criterion, and there is no short-run vs long-run issue.

We explicitly mean that our goal is to maximize the current stock value (firm’s present value)

S.B.Khatri - AIM

22

Does it seem little strong and one-Does it seem little strong and one-dimensional ?dimensional ? But, remember, shareholders are residual owners. They get what’s left after employees, suppliers and

creditors are paid their due. If the stockholders are winning in the sense that

the leftover, residual portion is growing, it must be true that everyone else is winning also.

How to identify those investments and financing arrangements that favorably impact the value of the stock ?

That’s precisely what we will be studying in FMS.B.Khatri - AIM

23

Is stock price maximization the Is stock price maximization the same as profit maximization?same as profit maximization?

No, despite a generally high correlation amongst stock price, EPS, and cash flow.

Current stock price relies upon current earnings, as well as future earnings and cash flow.

Some actions may cause an increase in earnings, yet cause the stock price to decrease (and vice versa).

S.B.Khatri - AIM

24

The Goal of Financial ManagementThe Goal of Financial Management

The primary financial goal is shareholder wealth maximization, which translates to maximizing stock price.

Do firms have any responsibilities to society at large?

Is stock price maximization good or bad for society?

Should firms behave ethically?

S.B.Khatri - AIM

25

A more General GoalA more General Goal

What is the appropriate goal with firm without traded stock ?

It is difficult to say what the value per share is at any given time.

More generally it can be said that the goal is to maximize the market value of the existing owner’s equity.

S.B.Khatri - AIM

Goal Objective Advantages Disadvantages

Profit maximization

Large amount of profits

(i) Easy to calculate profits

(ii)Easy to determine the link between financial decisions and profits.

(i) Emphasizes the short term

(ii)Ignores risk or uncertainty

(iii)Ignores the timing of returns

(iv)Requires immediate resources.

Shareholders Wealth Maximization

Highest market value of shares

(i) Emphasizes the long term

(ii)Recognises risk of uncertainty

(iii)Recognises the timing of returns

(iv)Consider shareholders’ return.

(i) Offer no clear relationship between financial decisions and share price.

(ii)Can lead management anxiety and frustration.26S.B.Khatri - AIM

27

1.4 The Risk/Return Tradeoff1.4 The Risk/Return Tradeoff

Throughout financial theory, we assume that individuals are risk averse

This means that individuals prefer less risk to more risk

However, a risk averse individual will accept almost any level of risk as long as they are properly compensated

We assume that the risk-return tradeoff is a linear function (there is no good evidence that it isn’t)

S.B.Khatri - AIM

28

The Risk/Return Tradeoff The Risk/Return Tradeoff GraphicallyGraphically Assume that there are

two projects: A and B Project B is riskier than

project A Therefore, we expect

that B will, on average over time, earn a higher return than A

Otherwise, nobody would ever invest in B Risk

Retu

rnBA

AB

S.B.Khatri - AIM

29

Risk-Return Tradeoff in Financial Risk-Return Tradeoff in Financial DecisionsDecisions

Financial decisions often involve alternative courses of action.• Should the firm set up a plant which has a capacity of

1 Mln tons or 2 Mln tons ?• Should the debt-equity ratio of the firm be 2:1 or 1:1 ?• Should the firm pursue a generous credit policy or

niggardly credit policy ?• Should the firm carry a large inventory or a small

inventory ? Each of alternative actions has different risk-

return implications. S.B.Khatri - AIM

30

Risk-Return Tradeoff (contd….)Risk-Return Tradeoff (contd….) In general, making financial decisions involves

answering following questions:• What is the expected return ?• What is the risk exposure ?• Given the risk-return characteristics of the decision, how would

it influence value ?Capital Budgeting Decisions

Capital Structure Decisions

Dividend Decisions

Working Capital Decisions

RETURN

RISK

Market Value of the Firm

S.B.Khatri - AIM

31

1.5 Organization for the finance 1.5 Organization for the finance functionfunction

The responsibilities for financial management are dispersed throughout the organization.• The engineer, proposing a new plant, shapes the investment

policy of the firm.• Marketing analyst provides inputs in the process for forecasting

and planning.• Departmental managers, in general, are important links in the

financial control system of the firm. However, many of the specialized jobs of the FM are

attended by specialist. These tasks can be distributed between two key financial

functions viz Treasurership and ControllershipS.B.Khatri - AIM

32

Finance function in a Typical Finance function in a Typical Business OrganizationBusiness Organization

Board of Directors

President

VP: Sales VP: Finance VP: Operations

Treasurer Controller

Credit Manager

Inventory Manager

Capital Budgeting Director

Cost Accounting

Financial Accounting

Tax Department

S.B.Khatri - AIM

33

Hyperthetical Organization Chart for a Corporation

C a sh m a n a g er C re d it m a n a g er

C a p ita l e xp e nd itu res F in a nc ia l p la n n ing

T re su re r

T a x m an a g er C o s t acc o u ntin g m an a g er

F in a n c ia l a cc o un tin g m a n a g er D a ta p ro ce ssin g m an a g er

C o n tro lle r

V ice P re sid e n t a n d C h ie f F in an c ia l O ffic e r (C F O )

P re s id en t a n d C h ie f O pe ra tio ns O ffice r (C O O )

C h a irm a n o f the B o a rd a n d Ch ie f E xe cu tive O ff ic e r (C E O )

B o a rd o f D ire c to rs

S.B.Khatri - AIM

34

Functions of the Treasurer and Functions of the Treasurer and ControllerController

Treasurer ControllerObtaining Finance Financial Accounting

Banking Relationship Internal Auditing

Cash Management Taxation

Credit Administration Management Accounting

Capital Budgeting

S.B.Khatri - AIM

35

Role of The Financial ManagerRole of The Financial Manager

Financialmanager

Firm'soperations

Financialmarkets

(1) Cash raised from investors

(1)

(2) Cash invested in firm

(2)

(3) Cash generated by operations

(3)

(4a) Cash reinvested

(4a)

(4b) Cash returned to investors

(4b)

S.B.Khatri - AIM

36

Other functions of financial Other functions of financial officersofficers

Involvement in injecting financial discipline in corporate management processes.

Monitoring the operations of the firm to achieve desired financial results.

Guide and participate in tasks of planning, funds allocation, and control so that the financial point of view is sufficiently emphasized in the process of corporate management.

S.B.Khatri - AIM

37

1.6 Agency Problem and the Control of the 1.6 Agency Problem and the Control of the CorporationCorporation

Because managers work for the shareholders, they are considered to be agents for the shareholders.

Occasionally, managers may act in their own best interest, rather than in the interest of their shareholders

This is known as an agency problem

S.B.Khatri - AIM

38

Agency ProblemAgency Problem

Shareholders desire wealth maximization (at all cost?)

Do managers maximize shareholder wealth?

Mangers have many constituencies “stakeholders”

“Agency Problems” represent the conflict of interest between management and owners (within the agency relationship)

S.B.Khatri - AIM

39

Agency relationshipsAgency relationships

An agency relationship exists whenever a principal hires an agent to act on their behalf and represent his/her interest.

Within a corporation, agency relationships exist between:• Shareholders and managers• Shareholders and creditors

S.B.Khatri - AIM

40

Ownership vs. ManagementOwnership vs. Management

Difference in Information

Stock prices and returns

Issues of shares and other securities

Dividends Financing

Different Objectives

Managers vs. stockholders

Top mgmt vs. operating mgmt

Stockholders vs. banks and lenders

S.B.Khatri - AIM

41

Shareholders versus ManagersShareholders versus Managers

Managers are naturally inclined to act in their own best interests.

But the following factors affect managerial behavior:• Managerial compensation plans• Direct intervention by shareholders• The threat of firing• The threat of takeover

S.B.Khatri - AIM

42

Shareholders versus CreditorsShareholders versus Creditors

Shareholders (through managers) could take actions to maximize stock price that are detrimental to creditors.

In the long run, such actions will raise the cost of debt and ultimately lower stock price.

S.B.Khatri - AIM

43

Managers and Shareholder Managers and Shareholder InterestsInterests

Tools to Ensure Management Pays Attention to the Value of the Firm• Manger’s actions are subject to the scrutiny of the

board of directors.• Shirkers are likely to find they are ousted by more

energetic managers.• Financial incentives such as stock options

S.B.Khatri - AIM

44

SolutionsSolutions

Agency Problem Solutions1 - Compensation plans – tied to financial performance in

general and oftentimes to share value in particular.2 - Board of Directors- elected by shareholders, who, in

trun hire and fire management. 3 - Takeovers4 - Specialist Monitoring5 - Auditors

S.B.Khatri - AIM

45

Conflict between shareholders and ManagersConflict between shareholders and ManagersOwners delegate operational control to agents.Agents, the managers, have their own goals which may not be

consistent with those of shareholders.

Managers are monitored and selected by directors, who are elected by shareholders

Shareholders attempt to control managers by

Using incentives in employment contracts or pay with shares, stock options or profit sharing : Agency cost

Agency costs are sum of monitoring costs of the shareholderscosts of implementing the control devices

Exploiting a competitive labor marketMounting a takeover offer and casting out the current managers

S.B.Khatri - AIM

46

Agency CostsAgency Costs There are two types of costs associated with the

agency problem:• Direct agency costs are the loss in shareholder

wealth due to managerial misconduct• Direct agency cost come in two forms:

Corporate expenditure that benefits management but costs the stockholders. Eg. Purchase of a luxurious and unneeded corporate jet.

An expense that arises from the need to monitor management actions. Eg. Paying external auditors.

• Indirect agency costs are the costs of avoiding the agency problem

S.B.Khatri - AIM

47

Whose Company Is It?Whose Company Is It?

24

29

78

83

97

76

71

22

17

3

0 20 40 60 80 100 120

% of responsesThe Shareholders

All Stakeholders

** Survey of 378 managers from 5 countries

S.B.Khatri - AIM

48

Dividends vs. JobsDividends vs. Jobs

11

11

59

60

97

89

89

41

40

3

0 20 40 60 80 100 120

% of responsesDividends

Job Security

** Survey of 399 managers from 5 countries. Which is more important...jobs or paying dividends?

S.B.Khatri - AIM

49

Control of Corporation

Board of Directors

Management

AssetsDebt

Equity

Shareholders

elections

selections

operations

S.B.Khatri - AIM

50

1.7 Relationship of Finance to 1.7 Relationship of Finance to EconomicsEconomics

Two important linkages:• Macro-economic environment defines the settings

within which a firm operates• Micro-economic theory provides the conceptual

underpinning for the tolls of financial decision making Understanding of the macro-economic

developments sensitizes the financial manager to the opportunities and threats in the environment.

Firm grounding in micro-economic principles sharpens his analysis of decision alternatives.

In fact, finance is applied micro-economics.S.B.Khatri - AIM

51

Relationship of Finance to Relationship of Finance to AccountingAccounting

In popular perception finance and accounting are often considered indistinguishable or at least substantially overlapping.

Differences and Relationship between the two:• Score Keeping Vs Value Maximizing• Accrual Method Vs Cash Flow Method• Certainty Vs Uncertainty

“The accountant’s role is to provide consistently developed and easily interpreted data about the firm’s past, present and future operations. The financial manager uses these data either in raw form or after certain adjustments and analyzes, as an important input to the decision-making process” S.B.Khatri - AIM

52S.B.Khatri - AIM

53

Something You Should Know Something You Should Know Before You Enter Into the subject Before You Enter Into the subject

ofof

FINANCIAL MANAGEMENT FINANCIAL MANAGEMENT

S.B.Khatri - AIM

54

The Fundamental Principal of The Fundamental Principal of FinanceFinance

“A business proposal – regardless of whether it is a new investment or acquisition of another company or a restructuring initiative- raises the value of the firm only if the present value of the future stream of net cash benefits expected from the proposal is greater than the initial cash outlay required to implement the proposal”

Investors• Shareholders• Lenders

The Business Proposal

Investors provide the initial cash required to finance the business proposal

The proposal generates cash returns to investors

S.B.Khatri - AIM

55

Functional Areas Needed to Accomplish the Strategic Plan

Communication Marketingand Sales Recruiting People

Team Support

Examples…

What “results” must we accomplish in these areas? GOALS

By what “means” ($$$$$) are we going to accomplish these “results” OBJECTIVES/STRATEGY

S.B.Khatri - AIM

56

•Important focal points in the Important focal points in the study of finance:study of finance:

• Accounting and Finance often focus on different things

• Finance is more focused on market values rather than book values.

• Finance is more focused on cash flows rather than accounting income.

S.B.Khatri - AIM

57

•Why is market value more Why is market value more important than book value?important than book value?

• Book values are often based on dated values (historical costs)

• For current assets, MV and BV might be somewhat similar.• For fixed assets, they’re different by far.• The MV of financial assets depends on things like its riskiness

and cash flows, neither of which have anything to do with accounting.

• They consist of the original cost of the asset from some past time, minus accumulated depreciation (which may not represent the actual decline in the assets’ value).

• Maximization of market value of the stockholders’ shares is the goal of the firm.

• Financial manager must be more interested on MV than BV.S.B.Khatri - AIM

58

Why is cash flow more Why is cash flow more important than accounting important than accounting income?income?

• Cash flow to stockholders (in the form of dividends) is the only basis for valuation of the common stock shares. Since the goal is to maximize stock price, cash flow is more directly related than accounting income.

• Accounting methods recognize income at times other than when cash is actually received or spent. (Accrual and Matching Principle)

S.B.Khatri - AIM

59

•One more reason that cash One more reason that cash flow is important:flow is important:

• When cash is actually received is important, because it determines when cash can be invested to earn a return.

[Also: When cash must be paid determines when we need to start paying interest on money borrowed.]

S.B.Khatri - AIM

60

•Examples of when accounting Examples of when accounting income is different from cash income is different from cash flow:flow:• Credit sales are recognized as accounting

income, yet cash has not been received.

• Depreciation expense is a legitimate accounting expense when calculating income, yet depreciation expense is not a cash outlay.

• A loan brings cash into a business, but is not income.

S.B.Khatri - AIM

61

•More examples:More examples:

• When new capital equipment is purchased, the entire cost is a cash outflow, but only the depreciation expense (a portion of the total cost) is an expense when computing accounting income.

• When dividends are paid, cash is paid out, though dividends are not included in the calculation of accounting income.

S.B.Khatri - AIM

62

•Definitions: Operating income Definitions: Operating income vs. operating cash flowvs. operating cash flow

• Operating income = earnings before interest and taxes (EBIT).

• This is the total income that the company earned by operating during the period. It is income available to pay interest to creditors, taxes to the government, and dividends to stockholders.

S.B.Khatri - AIM

63

•Operating cash flow:Operating cash flow:

• Operating cash flow = EBIT + Depreciation - Taxes.

• This definition recognizes that depreciation

expense is subtracted in computing EBIT, though it is not a cash outlay.

• It also recognizes that taxes paid is a cash outlay.

S.B.Khatri - AIM

64

Fund Flows via Market

Markets

Intermediaries

Surplus Units Deficit Units

S.B.Khatri - AIM

65

Fund Flows via Intermediary

Markets

Intermediaries

Surplus Units Deficit Units

S.B.Khatri - AIM

66

Fund Flows via Intermediary and Market

Markets

Intermediaries

Surplus Units Deficit Units

S.B.Khatri - AIM

67

Funds Flow via Markets and Intermediaries

Markets

Intermediaries

Surplus Units Deficit Units

S.B.Khatri - AIM

68

Funds Flow: Disintermediation

Markets

Intermediaries

Surplus Units Deficit Units

Markets

Intermediaries

Surplus Units Deficit Units

S.B.Khatri - AIM

THE ENDTHE ENDThank you

69S.B.Khatri - AIM