Financial Management 1

Revision of Basic Concepts of Finance

 Revisions of Finance basics 2
Finance Definition (Basic)
Finance is the management of large amounts of money, especially by governments or
large companies (Oxford Dictionary)

Another Definition
How people and businesses evaluate investments and
raise capital to fund them
 Revisions of Finance basics 3
 In 2016, when Fitbit introduced the Fitbit Blaze, an activity-
focused smart watch, it was clearly making a long-term
investment.
 The firm had to devote considerable expense to designing,
producing, and marketing the smart watch with the hope that it
would eventually capture a sufficient amount of market share
from the Apple Watch and Android Wear smart watch to make
the investment worthwhile.
 Fitbit also makes an investment decision whenever it hires a
fresh new graduate, knowing that it will be paying a salary for
at least six months before the employee will have much to
contribute.
 Revisions of Finance basics 4
Three Basic questions addressed by Finance
 What
long-term investment should undertake? Capital
Budgeting
 Total estimated amount required by Fitbit Blaze project
 How the firm will raise money to fund these
Investment? Capital Structure
 Either the amount of the project will be collected from
debt or equity
 Howthe firm will manage its day-to-day operations?
Working capital management
 Capital required for routine matters such as salaries
 Revisions of Finance basics 5
 Why Study Finance
 Even not planning career in finance, knowledge of finance will be helpful for
personal and Professional life
 Finance is primarily about Management of money, Important to manage it to stay
in business
 5 Basic Principals of Finance 6
 Money has Time value
 1 dollar today worth more than 1 dollar of future
 We always invest to get more in future
 Risk-Return Tradeoff
 We will not take additional risk unless we get more return
 Cash flows are source of value
 Cash inflows and outflows (Sale and purchase of plant and equipment)
 Accounting profit also a source of value
 Market prices reflect information
 Investors respond to new information by buying and selling their investment
 Individuals respond to incentive
 If manager will get the incentive, he will work best for the corporation
FORMS OF BUSINESS
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(Shareholders)
 Capital Market 9

1. The term capital market refers to any part of the financial

system that raises capital from shares. New stocks are sold
to investors in the primary capital market, while investors
trade stocks on the secondary capital market.
2. Capital Market is further divided into two categories
I. Primary capital market
II. Secondary capital market
 Primary capital market 10

1. When a company publicly sells new stocks for the first time, it does so in
the primary capital market.
2. This market is also called the new issues market
3. The new issue takes the form of an initial public offering (IPO).
4. After purchasing the share in the primary market, investor/shareholders can
sell them in secondary market.
 Secondary Capital Market or Stock Market 11

1. The secondary market is where securities are traded after the company has sold
its offering on the primary market.
2. It is also referred to as the stock market.
3. Example of stock market are:
I. Pakistan Stock Exchange (PSX)
II. The New York Stock Exchange (NYSE)
III. London Stock Exchange
 INTRODUCTION OF FINANCIAL MANAGEMENT
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DEFINITION OF FINANCIAL MANAGEMENT
 Financial management is concerned with the acquisition, financing, and management of
assets with some overall goal in mind
 Thus the decision function of financial management can be broken down into three major
areas:
 Investment Decisions
 Financing Decisions
 Asset Management Decisions.
 INTRODUCTION OF FINANCIAL MANAGEMENT
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INVESTMENT DECISIONS
 The investment decision is the most important of the firm’s three major decisions when it
comes to value creation.
 It begins with a determination of the total amount of assets needed to be held by the firm.
 Picture the firm’s balance sheet in your mind for a moment. Imagine liabilities and
owners’ equity being listed on the right side of the balance sheet and its assets on the left.
 The financial manager needs to determine the dollar amount that appears on the left-hand
side of the balance sheet
INTRODUCTION OF FINANCIAL MANAGEMENT
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FINANCING DECISIONS
 The second major decision of the firm is the financing decision
 Here the financial manager is concerned with the makeup of the right-hand side
of the balance sheet
 If you look at the mix of financing for firms across industries, you will see
differences.
 Some firms have relatively large amounts of debt, whereas others use less debt.
 The use of debt or equity financing differ regarding different industries
INTRODUCTION OF FINANCIAL MANAGEMENT
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ASSET MANAGEMENT DECISIONS
 The third important decision of the firm is the asset management decision
 Once assets have been acquired and appropriate financing provided, these assets
must still be managed efficiently.
 Extra cash in hand may be deposit to bank to earn profit
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 GOALS OF THE FIRM
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 Efficient financial management requires the existence of goal
 financial decision must be made in light of the goal
 The goal of the firm is to maximize the wealth of the firm’s present owners.
 Shares of common stock is a evidence of ownership in a corporation
 Shareholder wealth is represented by the market price per share of the firm’s common
stock, which, in turn, is a reflection of the firm’s investment, financing, and asset
management decisions.
 The idea is that the success of a business decision should be judged by the effect that it
ultimately has on share price.
 GOALS OF THE FIRM
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PROFIT MAXIMIZATION
 Frequently, profit maximization is offered as the proper objective of
the firm.
 However, under this goal, manager can mislead investor by increasing
sale (Adding false/fictitious entry) or reducing cost (by not recording
the cost of goods sold of a specific item)
 It happens because financial statement are prepared by the management
In past, big finance scandal such as Enron is evident where fraudulent
activities were done by management and auditor
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 GOALS OF THE FIRM
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MAXIMIZING EARNING PER SHARE
 Earning per share (EPS) = earning available to common shareholders/Number of share
 Suppose “ABC” company earned (net profit after tax) = $100
 Number of common shareholders of “ABC” company = 100
 EPS of “ABC” Company = 100/100 = 1
 Suppose ABC company is working in Pakistan where there is less economic and political
stability so EPS of “ABC” company will be more risky
 GOALS OF THE FIRM
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MAXIMIZING EARNING PER SHARE
 Earning per share (EPS) = earning available to common shareholders/Number of
share
 Suppose “XYZ” company earned (net profit after tax) = $100
 Number of common shareholders of “ABC” company = 100
 EPS of “XYZ” Company = 100/100 = 1
 Suppose “XYZ” company is working in USA where there is more economic and
political stability so EPS of “XYZ” company will be less risky (the return will
remain the same or increase)
 GOALS OF THE FIRM
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MAXIMIZING EARNING PER SHARE
 Point to Be Noted: The EPS of “ABC” and “XYZ” company is same. So,
according to EPS both have same value. But EPS ignore risk.
 In case of share price, we calculate the return and risk also. That is why, share
price is good measure
 Shareholder normally can get or calculate EPS after one year or quarter
(After the financial statements published by the company). However, share
prices are available every day
 GOALS OF THE FIRM
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MAXIMIZATION SHAREHOLDER’S WEALTH (SHARE PRICE)
 The market price serves as an important indicator for business performance; it
indicates how well management is doing on behalf of its shareholders.
 Management is under continuous review. Shareholders who are dissatisfied with
management performance may sell their shares and invest in another company.
 This action, if taken by other dissatisfied shareholders, will put downward pressure on
market price per share.
 Thus management must focus on creating value for shareholders. This requires
management to judge alternative investment, financing, and asset management
strategies in terms of their effect on shareholder value (share price).
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 GOAL OF THE MANAGER AND AGENCY PROBLEMS
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 It has long been recognized that the separation of ownership and control in the modern
corporation results in potential conflicts between owners and managers.
 In particular, the objectives/goal of management may differ from those of the firm’s
shareholders.
 In a large corporation, stock may be so widely held that shareholders cannot even make
known their objectives, much less control or influence management
 Thus this separation of ownership from management creates a situation in which
management may act in its own best interests rather than those of the shareholders.
 GOAL OF THE MANAGER AND AGENCY PROBLEMS
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 We may think of management as the agents of the owners. Shareholders, hoping that the
agents will act in the shareholders’ best interests, delegate decision-making authority to them.
 The principals, in our case the shareholders, can assure themselves that the agents
(management) will make optimal decisions only if appropriate incentives are given and only
if the agents are monitored.
 Incentives include, bonuses, automobiles and expensive offices.
 Monitoring may be done auditing financial statements. These monitoring activities
necessarily involve costs, an inevitable result of the separation of ownership and control of a
corporation. This cost is called the “agency cost”
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Key Definitions
 Agent
 Individual(s)authorized by another person, called the principal, to act
on the latter’s behalf.

 Agency theory
 A branch of economics relating to the behavior of principals (such as
owners) and their agents (such as managers).
 Agency Cost
 Agency cost refer to economic incentives such as performance bonuses,
and stock options which would stimulate agents to execute their duties
properly.
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Key Point
What should be the goal of a manager
 By summing up previous discussion, the goal of a manager should be same as the goal of
a firm, which is, maximization of shareholder's wealth (Share price)
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