FINANCIAL MANAGEMENT Unit -I

Lecture 1: What is finance?

*Dr.G.V.Satya Sekhar,MBA, Ph.D

Lecture 1: What is finance?

Introduction Defining finance Corporate Finance: the financial function The financial objective: value creation Financial main principles Finance: historic evolution

Why study financial management?

To manage your organizational resources To make decisions relating to all financial issues in corporate entity To pursue interesting and rewarding career opportunities

Financial Claims
Financial claims are also called financial assets and liabilities, securities, loans, and financial investments. For every financial asset, there is an offsetting financial liability.
Total receivable equal total payable in the financial system Loans outstanding match borrowers liabilities

1.1. Introduction:Financial Claims (2)

Financial markets offer opportunity for:

Financing for corporate entities ( primary market) Financial investing option for business firms (primary and secondary) Providing liquidity via trading financial claims in secondary markets

THE FLOW OF FUNDS DIAGRAM

Funds
Surplus Spending Unit (SSU)

Funds
Deficit Spending Unit (DSU)

Financial Assets = Financial Claims

THE FLOW OF FUNDS DIAGRAM

Funds
Surplus Spending Unit (SSU)
Saver, lender buyer of financial assets financial investor supplier of loanable funds buyer of securities.

Funds
Deficit Spending Unit (DSU)
Borrower demander of loanable funds seller of securities

Financial Assets = Financial Claims

Real & Financial assets

Assets: any possession that has value in an exchange tangible: value depends on particular physical
properties (reproducible and non-reproducible)

intangible: legal claims to some future benefit. Financial assets

Main properties of financial assets

Rate of return (R): expected return Risk (r): credit risk, market risk Liquidity (L): how much sellers stand to lose if
they wish to sell immediately against engaging in a costly and time-consuming search (J.Tobin)

THE FLOW OF FUNDS DIAGRAM

DIRECT FINANCING
Brokers Dealers (Markets)

Funds
Surplus Spending Unit (SSU)

Funds
Deficit Spending Unit (DSU)

Funds

Funds
Intermediaries

INDIRECT FINANCIAL INVESTMENT OR INTERMEDIATION FINANCING

THE FLOW OF FUNDS DIAGRAM

Direct Financial Assets Purchase

DIRECT
Brokers Dealers

Direct Financial Assets Issue

Funds
Surplus Spending Unit (SSU)

Funds
Deficit Spending Unit (DSU)

Funds
Indirect Financial Assets Purchase

Funds
Intermediaries
Direct Financial Assets Issue

INDIRECT

Defining Finance Finance is the study of how organisations allocate resources over time
costs and benefits are distributed over time but the actual timing and size of future cash flows are often known only probabilistically

Understanding finance helps you evaluate these uncertain cash flows

Bodie and Merton

Defining Finance

When implementing decisions, people make use of the Financial System which can be defined as the set of markets and other institutions used for financial contracting and exchange of assets and risks
Bodie and Merton

Financial theory consists of:

the set of concepts that help to organize ones thinking about how to allocate resources over time the set of quantitative models used to help evaluate alternatives, make decisions, and implement them
These concepts and models apply at all levels and scales of decision making

Bodie and Merton

Defining Finance: a new paradigm. The Value Creation Function of Finance

The practice of finance exists for the creation of value Financial contracting brings about the substitution of real wealth (i.e. real business assets) for financial wealth (i.e. securities)

Investing in financial securities has better attributes that in

real assets. Value is created in tthe real assets held by businesses, and then transmitted into the value of financial wealth issued by businesses and held by investors.

Norton y Scott, A new Paradigm: the value creation function of finance, january 2001

The three primary areas of finance

Financial management (Corporate finance) deals with how firms raise and use funds to make short-term and long-term investments. Investment deals with how the securities markets work and how to evaluate and manage investments in stocks and bonds. Financial Markets and Institutions includes the study of the banking system and markets.
Peterson and Fabozzi

FINANCIAL SUBSYTEM

Subsistema Management de direccin Subsytem y gestin

Financial Planning Planificacin Financiera Planificacin Financiera

Subsistema Human de recursos Recourses humanos Subsystem

FINANCING FINANCIACIN Demanda de Debt crditos E N V T O I R O N N O M E N T

INVERSIN INVESTMENT

Empoloyees

Financiacin External Externa Financing

Funds Dinero

Financiacin en Fixed activo fijo Asset Operations Subsistema de operaciones Subsystem

Valores Securities
e ss r rc uso su co Re

Autofinanciacin Retained earnings

Financial Mercados Financieros Market

Inversin en activo Current circulante Assets

Resources Dividends Dividendos Impuestos Taxes Reserves Reservas Benefit Beneficio Amortizacin Depreciation Commercial Subsistema comercial Subsystem Costs Costes

In Income

Expenses

Corporate Finance: the financial function

Corporations face two broad financial questions: - What investments should the firm make? - How should it pay for those investments? Financial managers are concerned with : Investment Decisions (use of funds): The buying, holding or selling of types of assets Financing Decisions (acquisitions of funds)

Corporate Finance: the financial function

INVESTMENT / FINANCIAL SUBSYTEM

REAL SYSTEM r (r>k)

FINANCIAL SYSTEM k

INVESTMENT

FINANCING

FIRM OPERATIONS (Real goods & services

RETURN

FINANCIAL MANAGEMENT (CORPORATE FINANCE)

FINANCIAL MARKETS
REPAYMENT AND RETURN

The Financial objective: value creation

Goal of management: maximize the economic well-being, or wealth, of the owners (current shareholders) => maximize the price of the stock Share price today = Present value of all future expected dividends at required return

Max.Share. Pr ice. = max .

i =1

di i 1 + k

The Financial objective: value creation

Financial managers must create or generate value for their shareholders. Economic Value Added (EVA) is a measure of a company's financial performance based on the residual wealth calculated by deducting cost of capital from its operating profit (adjusted for taxes on a cash basis). The formula for calculating EVA is as follows: EVA = Net Operating Profit After Taxes - (Capital * Cost of Capital)

Financial main principles

Rational Financial behavior Risk aversion Budgetary diversification Existence of two parts in all financial transaction ( debit and credit) Measurement by cash flows Efficiency of financial markets Direct relation of risk and return Existence of valuable ideas The Time Value of the money

Main Issues in finance

Financial Planning Financial Forecasting Capital Structure Cost of Capital Managements of Investments Capital Budgeting. Working capital management Dividend Policy.

References:
Kidwell, Peterson, Blackwell, Whidbee: Financial Institutions, Markets, and Money, Eighth Edition, John Wiley & Sons, 2003 Fabozzi, Modigliani: Capital Markets. Institutions and Instruments. Prentice Hall, 2003 Bodie, Zvi and Merton, Robert C.: Finance. Prentice Hall, 1999 Pamela P. Peterson and Frank Fabozzi: Financial Management and Analysis, 2nd Edition, John Wiley & Sons, 2003