Introduction to Financial

Management

1
 Why Financial Management?
• Know the basic types of financial management decisions
• Know the goal of financial management
• Understand the conflicts of interest that can arise between owners
and managers

2
What is a Corporation?

3
• A legal entity/person
• Can make contracts, carry on a business, borrow or lend money, etc.
• One corporation can make a takeover bid for another and then merge the
two businesses
• Pay taxes- As a corporation is a separate legal entity, it is taxed separately.
Corporations pay tax on their profits, and shareholders are taxed again when
they sell their shares at a profit or receive dividends from the company.
• Owned by its shareholders but legally distinct from them
• Shareholders have limited liability- they cannot be held personally
responsible for the corporation’s debts
• Shareholders can lose their entire investment in a corporation, but no more

4
Corporations make several financial decisions.

What these decisions are?

What they are intended to accomplish?

5
 Balance Sheet of a Firm

Current Liabilities
Current Assets

Long-term Debt

Fixed Assets

-Tangible Shareholders’ Equity

-Intangible

6
Investment Decisions / Capital Budgeting
Decisions / Capital Expenditure Decisions

Current Liabilities
Current Assets

Long-term Debt

Fixed Assets What long-term

investments should
-Tangible the corporation Shareholders’ Equity
-Intangible make?

7
 Investment Decisions
• Most large corporations prepare an annual capital budget for major
investments.
• Some of these investments involve purchase of tangible assets, e.g.: airlines
purchasing airplanes.
• Corporations also need to invest in intangible assets, e.g.:
Pharmaceutical companies invest billions every year on R&D
for new drugs.
Consumer goods companies such as P&G invest huge sums in
advertising and marketing their products.
• These outlays are investments because they build know-how, brand
recognition, and reputation for the long run.
• Today’s capital investments generate future cash returns.
• The cash inflows may even last for decades. For example, Power plants. 8
 Investment Decisions
• The financial manager also has to pay attention to the timing of cash
inflows, not just to their cumulative amount. Example: nuclear power plant
• An investment could be a smashing success or a dismal failure.
• The Iridium communications satellite system, which offered instant
telephone connections worldwide, soaked up $5 billion of investment
before it started operations in 1998.
• It needed 400,000 subscribers to break even, but attracted only a small
fraction of that number.
• Iridium defaulted on its debt and filed for bankruptcy in 1999.

9
 Financing Decisions

Current Liabilities
Current Assets

How should the Long-term Debt

firm raise funds for
Fixed Assets the selected
investments?
-Tangible Shareholders’ Equity
-Intangible

10
 Financing Decisions

Lenders contribute the cash,

Lenders (e.g.: Banks) corporation pays back the
debt plus interest

A corporation can
raise money from
Shareholders hold shares of Shareholders are equity
Shareholders firm and get a fraction of investors who contribute equity
future profits and cash flow financing

11
Capital Structure Decision

Debt
Equity

Choice between debt financing and equity financing.

12
 Equity Financing

• Investors who buy

Issue new these shares will put
shares up cash.

• Reinvest the cash flow

Reinvest generated by existing
the cash assets in new assets.

13
What happens when a corporation does not reinvest all of
the cash flow generated by its existing assets?

It may hold the cash in

It may pay the cash back
reserve for future
to its shareholders.
investments.

Pay Repurchase
dividends shares

Payout Decisions
14
 Financing Decisions

• Financing decisions are less important than investment decisions.

• Financial managers say that value comes from the assets (R&D, profitable
future investments, etc.) and not from financing.
• Financing decisions may not add much value, compared with good investment
decisions, but they can destroy value if they are stupid.
• The financing decision includes not just raising cash today but also meeting its
obligations to banks and shareholders that have contributed financing in the
past.
• If it cannot do so, it ends up bankrupt.

15
 Working Capital Management

Current Liabilities
Current Assets
Net Working Capital Long-term Debt

Fixed Assets

-Tangible Shareholders’ Equity

-Intangible

Working capital management or short-term asset management ensures the best utilization of a business's current
assets and liabilities for the company's effective operation. The aim is to maintain adequate cash flow so that
corporation can meet its short-term business obligations (e.g.: salaries, bills, installments, etc.).
16
 Broad financial decisions
taken by Financial
manager

Investment decisions- Working capital

Spending the money management

Financing decisions-
Payout decisions
Raising the money

17
 The Role of the Financial Manager
The financial manager stands between the
firm and investors.

On the one hand, the financial manager helps

manage the firm’s operations, particularly by
helping to make good investment decisions.

On the other hand, the financial manager

deals with investors (banks, shareholders)

Flow of Cash Between Financial Markets and the Firm’s Operations-

1. Cash raised by selling financial assets to investors.
2. Cash invested in the firm’s operations and used to purchase assets.
3. Cash generated by the firm’s operations.
4. (a) Cash reinvested (b) Cash returned to investors. 18
 The Financial Goal of the Corporation
What shareholders want from financial managers?
• Maximize profit?
• Maximize market value of shares?

19
 Profit Maximization

• It is vague
• Which year’s profit?
• A corporation may be able to increase current profits by cutting back
on outlays for maintenance or staff-training, but those outlays may
have added long-term value.
• Shareholders will not welcome higher short-term profits if long-term
profits are damaged.
• A company may be able to increase future profits by cutting this
year’s dividend which again is not in the shareholders’ best interest.

20
 The Financial Goal of the Corporation
• Shareholders Want Managers to Maximize Market Value of Shares.
• A smart and effective manager makes decisions that increase the
current value of the company’s shares.

21
 Investment Trade-off

Shareholders can invest in Benchmark or min acceptable rate

Cancel the investment
financial markets on their of return = 10%
and pay the cash to Hurdle rate / Opportunity cost of
its shareholders own and earn 10% return
capital
Reliance Retail has
cash to open 100 new Expected rate of return Expected rate of return > 10%
Smart Bazar stores of the investment is Shareholders would support
20% the investment
Take the investment
and open new stores
Expected rate of return Expected rate of return < 10%
of the investment is 5% Shareholders would vote against
the investment and take their cash

22
 Agency Problem
• Managers are agents for stockholders but may get tempted to act in their
own interests rather than maximizing value.
• Managers may not think much before spending money which is not their
own, for instance-
• They may schedule business meetings at unnecessarily expensive resorts.
• They may shy away from good but risky projects because they are more
worried about their job safety than about maximizing shareholder value.
• This conflict between managers’ and shareholders’ objectives is called
Agency problem.
• Agency cost is the value lost from agency problems (managers do not
attempt to maximize value) or the cost of mitigating agency problems
(monitoring the managers and constraining their actions). 23
 Corporate Governance

• Good system of governance ensures that shareholders’ pockets are close to

managers hearts.
• Well-designed incentives for managers, i.e., linking their incentives to
corporations’ performance indicators
• Standard for accounting and disclosure to investors
• Requirements for Board of Directors

24
 Financial Markets

Issuance of a security Transactions take place

Primary Market by a firm for the first between firm and
time investors

Financial Markets

Buying and selling of Transactions take place

Secondary Market previously issued among investors (e.g.:
securities trading on BSE/NSE)

25