INTRODUCTION TO FINANCIAL MANAGEMENT

Chapter 1
• WHAT IS FINANCE?
Finance can be defined as science and art of managing money.
 
• KEYWORDS
 
FINANCIAL MANAGEMENT – Corporate Finance/Financial Management is the
study of the following three concepts:
– What line of business will the organization be in, and what will be needed for that
business.
– How the business will be paid for.
– How everyday financial activities will be managed.
• For example: when to introduce a new product, when to invest in new
asset,when to replace existing assets, when to borrow from banks, how much
cash to maintain,when to issue stocks or bonds etc.
• FINANCIAL MANAGER – is the person who is in charge of
answering ALL questions raised by these 3 issues/ideas. A Financial
Manager represents the business organization.
– CAPITAL BUDGETING – is the process of managing a firm’s long term
investments. The financial manager tries to identify investment
opportunities that are word pursuing for the firm. Condition - VALUE OF
CASH FLOW for an asset should be greater that the COST of the asset.
– CAPITAL STRUCTURE/FINANCIAL STRUCTURE – is the specific mixture of
long term debt and equity the firm uses to finance its operations.
Financial manager decides what mixture of debt and equity is best.
– WORKING CAPITAL MANAGEMENT – is the management of the firm’s
short term assets, and liabilities. E.g. inventory and debt to suppliers.
 
 Managerial Finance Function:
Relationship to Economics
• The field of finance is closely related to economics.
• Financial managers must understand the economic
framework and be alert to the consequences of
varying levels of economic activity and changes in
economic policy.
• They must also be able to use economic theories as
guidelines for efficient business operation.

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 Managerial Finance Function:
Relationship to Accounting
• The firm’s finance and accounting activities are
closely-related and generally overlap.

• In small firms accountants often carry out the finance

function, and in large firms financial analysts often
help compile accounting information.

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 Managerial Finance Function:
Relationship to Accounting (cont.)

• Whether a firm earns a profit or experiences a loss, it

must have a sufficient flow of cash to meet its
obligations as they come due.

• The significance of this difference can be illustrated

using the following simple example.

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 Managerial Finance Function:
Relationship to Accounting (cont.)

The Nassau Corporation experienced the following

activity last year:

Sales $100,000 (1 yacht sold, 100% still uncollected)

Costs $ 80,000 (all paid in full under supplier terms)

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 Managerial Finance Function:
Relationship to Accounting (cont.)

Now contrast the differences in performance under the

accounting method (accrual basis) versus the financial
view (cash basis):
Income Statement Summary
Accrual basis Cash basis
Sales $100,000 $ 0
Less: Costs (80,000) (80,000)
Net Profit/(Loss) $ 20,000 $(80,000)

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 Managerial Finance Function:
Relationship to Accounting (cont.)

Finance and accounting also differ with respect to

decision-making:
– Accountants devote most of their attention to the collection
and presentation of financial data.

– Financial managers evaluate the accounting statements,

develop additional data, and make decisions on the basis of
their assessment of the associated returns and risks.

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 Goal of the Firm:
Maximize Profit?
Which Investment is Preferred?

Profit maximization may not lead to the highest possible share price for at least three reasons:
1. Timing is important—the receipt of funds sooner rather than later is preferred
2. Profits do not necessarily result in cash flows available to stockholders
3. Profit maximization fails to account for risk

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• Is profit maximization the goal of a financial
manager?
– Timing: the receipt of funds sooner rather than
later is preferred
– Cash Flow: profit do not necessarily result in cash
flows available to the stockholders.
– Risk: the chance that actual outcomes may differ
from expected.
– Example
• What is the goal of a financial manager?
• Maximize shareholder wealth – to maximize the
wealth of the owners for whom the company is
being operated. The wealth of corporate owners
is measured by the share price of the stock,
which is based on the timing of returns (CASH
FLOW), their magnitude and their risk. FINANCIAL
MANAGERS SHOULD ONLY ACCEPT ACTIONS
THAT ARE EXPECTED TO INCREASE SHARE PRICE
 Governance and Agency:
Corporate Governance
• Corporate governance refers to the rules, processes,
and laws by which companies are operated,
controlled, and regulated.
• It defines the rights and responsibilities of the
corporate participants such as the shareholders, board
of directors, officers and managers, and other
stakeholders, as well as the rules and procedures for
making corporate decisions.

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 Governance and Agency:
The Agency Issue
• A principal-agent relationship is an arrangement in
which an agent acts on the behalf of a principal. For
example, shareholders of a company (principals) elect
management (agents) to act on their behalf.
• Agency problems arise when managers place
personal goals ahead of the goals of shareholders.
• Agency costs arise from agency problems that are
borne by shareholders and represent a loss of
shareholder wealth.

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 The Agency Issue:
Management Compensation Plans

• Incentive plans are management compensation plans

that tie management compensation to share price; one
example involves the granting of stock options.

• Performance plans tie management compensation to

measures such as EPS or growth in EPS. Performance
shares and/or cash bonuses are used as compensation
under these plans.

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 The Agency Issue: The Threat of
Takeover
• When a firm’s internal corporate governance structure
is unable to keep agency problems in check, it is
likely that rival managers will try to gain control of
the firm.

• The threat of takeover by another firm, which

believes it can enhance the troubled firm’s value by
restructuring its management, operations, and
financing, can provide a strong source of external
corporate governance.
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 FIN 254

Lecture 2
Firms and financial markets
Every firm has an ongoing need for funds. They
can obtain funds from external sources in 2
ways.
• FINANCIAL INSTITUTIONS
• FINANCIAL MARKETS
FINANCIAL INSTITUTIONS
• A financial institution accepts savings and transfers them to those
that need funds. They serve as intermediaries by channeling the
savings of individuals, businesses, and governments into loans or
investments. Additionally, they pay savers interest on deposited
funds, and provide services (with/without fees).
• FINANCIAL INSTITUTIONS ARE REQUIRED BY THE GOVERNMENT TO
OPERATE WITHIN ESTABLISHED REGULATORY GUIDELINES.
• Financial institutions take funds from individuals, businesses and
governments, combine them and make loans available to
individuals and businesses.
• What is the most common financial institution?
• What are some of the other types of financial
institutions?
• Commercial banks
• Credit unions
• Insurance companies
• Pension funds
• Etc.
 Commercial
banks
• Commercial banks collect the savings of individuals as well as
businesses and then lend those pooled savings to other
individuals and businesses.

• They make money by charging a rate of interest to borrowers

that exceeds the rate they pay to savers.

• Commercial banks are subject to strict government regulations

to protect individual depositors and avoid bank runs.

• Potential asset liability mismatch

 Non-bank financial
intermediaries

• Investment banks (e.g. Investment Corporation of Bangladesh)

• Investment companies (e.g. mutual funds)

 Investment
banks
• Investment banks are specialized financial intermediaries that:
– help companies and governments raise money
– provide advisory services to client firms on major
transactions such as mergers

• As a result of the 2008 financial crisis, many stand alone

investment banks failed
 Investment
companies
• Investment companies are financial institutions that pool the
savings of individual savers and invest the money in the
securities issued by other companies purely for investment
purposes.

• Examples include mutual funds.

 Mutual
funds
• Mutual funds are professionally managed according to a
stated investment objective.

• Individuals can invest in mutual funds by buying shares in the

mutual fund.

• The origin of mutual fund is based on a key idea of modern

finance
– the benefits of diversification.
KEY CUSTOMERS OF FINANCIAL INSTITUTIONS
• Key Supplier – those who save more money than
they borrow from financial institutions.
• WHO are the net/key suppliers of financial institutions?
• Key Demanders – those who borrow more money
than they save
• WHO are the net/key demanders of financial institutions?
• Loans and investments of FINANCIAL INSTITUTIONS
are made without the knowledge of the
suppliers/savers
FINANCIAL MARKET
• Is where the net suppliers of funds and the net
demanders can transact business DIRECTLY.
• Suppliers in the financial market know where
their money is being invested.
• To raise funds in the financial market, firms
can use either private placements or public
offerings.
 – PRIVATE PLACEMENTS – sale of NEW company stock
directly to a select group of investors.
– PUBLIC OFFERINGS – sale of securities/stocks/bonds to
the general public.
• PRIMARY MARKET – is the ONLY place where YOU
are directly involved in the transaction and receive
direct benefit from the issue. The market in which
securities/stocks are initially issued.
• SECONDARY MARKET – Is where pre-owned shares
are sold/bought.
• Q. Is there a relationship between financial
institutions and financial markets?
• A. Financial institutions actively participate in
the financial market and both suppliers and
demanders of funds. Financial institutions are
an integral part of financial markets.
• MONEY MARKET
• CAPITAL MARKET
MONEY MARKET
• -The money market deals with SHORT TERM funds.
• - It creates a relationship between the suppliers and demanders of short term funds.
• - It exists because some individuals, businesses, governments and financial institutions have
temporarily idle funds that they wish to put to some interest-earning use. At the same time,
other individuals, businesses, governments and financial institutions find themselves in need of
short term funds (cash flow). The money market brings these two groups together
• Money market transactions are done through MARKETABLE SECURITIES

• Treasury bills:. T-bills are sold in denominations of $1,000 up to a maximum purchase of $5

million and commonly have maturities of one month (four weeks), three months (13
weeks) or six months (26 weeks).
• Certificates of deposit A certificate of deposit (CD) is a savings certificate with a fixed
maturity date , specified fixed interest .A CD restricts access to the funds until the maturity
date of the investment. CDs are generally issued by commercial banks.
• CAPITAL MARKET – is the market that enables
suppliers and demanders of LONG TERM FUNDS
to make transactions. The capital market is
formed by the various SECURITIES EXCHANGES
that provide a forum for bond and stock
transactions.
• KEY SECURITIES TRADED IN THE CAPITAL MARKET
– BONDS
– STOCK
• BONDS – are LONG TERM debt instruments
used by business and governments to raise
large sums of money, from a diverse group of
lenders.
• STOCKS – units of ownership or EQUITY in a
corporation.
• COMMON STOCK – common stockholders earn a
return by receiving dividends – periodic distribution
of earnings – or by realizing increases in share price.
• PREFERRED STOCK – preferred stockholders are
PROMISED a FIXED PERIOD DIVIDEND that MUST be
paid prior to payment of any dividends to common
stockholders
 Types of securities: Equity
securities
• Equity securities represent ownership of the corporation.
• Common stock is a security that represents equity ownership in a
corporation, provides voting rights, and entitles the holder to a share
of the company’s success in the form of dividends and any capital
appreciation in the value of the security.
– Common stockholders are residual owners of the firm. They earn a
return only after all other security holder claims (debt and
preferred equity) have been satisfied in full.
– Dividends on common stocks are neither fixed nor guaranteed. A
company can choose to reinvest all profits and pay no dividends.
• Preferred stock is an equity security that has preference with regard
to:
– Dividends: They are paid before the common stockholders.
– Claim on assets: They are paid before common stockholders if the
firm
goes bankrupt and sells or liquidates its assets.
 Preferred stock
• Preferred stock is also referred to as a hybrid security as it
has features of both common stock and bonds.

• Preferred stock is similar to common stocks in that:

– It has no fixed maturity date.
– The nonpayment of dividends does not result in
bankruptcy of
the firm.
– The dividends are not deductible for tax purposes.

• Preferred stock is similar to corporate bonds in that:

– The dividends are typically a fixed amount.
– There are no voting rights.
• SECURITIES EXCHANGES
Q. WHAT ARE SECURITIES EXCHANGES ?
A. The marketplace in which firms/corporations can raise funds through the
sale of new securities and the purchasers of securities can resell them when
necessary
- ORGANIZED SECURITIES EXCHANGE
- OVER THE COUNTER SECURITIES EXCHANGE
 
ORGANIZED SECURITIES EXCHANGES
Are tangible organizations that act as secondary markets where securities are
sold and resold. The two best known stock exchanges are –NYSE
New York Stock Exchange – MOST EXCHANGES ARE MODELED AFTER THE
NYSE;AMEX – American Stock Exchange
• OVER THE COUNTER SECURITIES EXCHANGE
Intangible trading system that consists of network of
brokers and dealers around the country.
The facilities consists under OTC
 The dealers who hold the inventories of stock
 The brokers who act as an agent bringing dealers
with investors
 The electronic networks that provide a
communication link between dealers and brokers