What Is Finance?
An Overview of Financial
Management and the Financial
Environment
Finance is the art and science of managing
money
Science? In some situations, its fundamental
concepts, principles, theories, and models can be
applied universally to make decisions
Art? In some situations, precise models cannot be
created/used, rather intuition or insight or
creativity is used to make decisions
1
Financial Management (13th edt)
By E.F. Bringham and M.C. Ehrhardt
1-1
What Is Corporate or Managerial
Finance?
What Is Finance?
At the personal level, finance is concerned
with individuals decisions about:
How much of their earnings they spend
How much they save
How they invest their savings
1-2
An important area of finance that deals with
The sources of funding,
The capital structure of firms,
The tools and analysis used to allocate financial
In a business context, finance involves:
resources, and
How firms raise money from investors
How firms invest money in to earn profits
How firms decide whether to reinvest profits in the
business or distribute them back to investors.
The actions taken to maximize the firms value
to the shareholders
Continued
1-3
What Is Corporate or Managerial
Finance?
1-4
Finance VS Economics & Accounting
Finance grew out of Economics and Accounting
Is concerned with the duties of the financial
manager working in a business
Helps financial managers administer the
financial affairs of all types of businesses
Tasks include:
Developing a financial plan
Evaluating proposed large expenditures
Raising money to finance the firms operations
Extending credit to customer
1-5
Economics
Accounting
Finance
Provides structure
for decision making
and suggests that
assets value is
based on its ability
to generate CFs
now and in the
future
Deals with collection
and presentation of
financial data and
measures firms
performance
Deals with evaluating
accounting statement,
developing additional data,
and making decisions based
on associated risk and return
and makes plans for CFs to
maintain firms solvency
May be positive or
normative
Is backward looking and
deals with historical
data
Is forward looking and makes
analysis and decisions about
future
1-6
Four Golden Rules of Finance
Finance Within the Organization
Board of Directors
Chief Executive Officer (CEO)
Chief Operating Officer (COO)
Chief Financial Officer (CFO)
Marketing, Production, Human
Resources, and Other Operating
Departments
Accounting, Treasury, Credit,
Legal, Capital Budgeting, and
Investor Relations
If it dont jingle, it dont count
Risk is the possibility that bad or good things
may happen
The greater the risk, the greater the expected
reward
A $1 today is worth more than a $1 tomorrow
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1-8
Basic Forms of Business Organization
Basic Forms of Business Organization
Sole Proprietorship
Owned by one person
Legal entity created by law
Operated for personal profit
Mandatory registration
Unlimited liability
Legally functions separate and apart from its
owners
Partnerships (general and limited)
Owners liability is limited to the amount of their
investment
Owned by two or more people
Operated for joint profit
Owners hold common stock, and ownership can be
transferred
Liable personally and collectively
Run by partnership deed
Corporations
Continued
1-9
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Corporation
Proprietorships and Partnerships
Advantages
Ease of formation
Advantages
Disadvantages
Subject to few regulations
Limited Liability
Double taxation
No corporate income taxes
Permanency
Disadvantages
Transferability of
ownership
Cost of set-up and
report filing
Difficult to raise capital
Better access to capital
markets
Unlimited liability
Separation of owners
from management
Limited life
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1-12
Separation of Ownership and
Control
Partnership Vs. Corporations
Board of Directors
Assets
Shareholders
Debt
Debtholders
Management
Equity
Corporation
Partnership
Liquidity
Shares can easily be
exchanged.
Subject to substantial
restrictions.
Voting Rights
Usually each share
gets one vote
Taxation
Double
General Partner is in
charge; limited
partners may have
some voting
Partners
payrights.
taxes
Reinvestment and
dividend payout
Broad latitude
Liability
Limited liability
Continuity
Perpetual life
on distributions.
All NCF is distributed
to partners.
General partners may
have unlimited liability.
Limited partners enjoy
limited liability.
Limited life
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1-14
Becoming a Public Corporation and
Growing Afterwards
Agency Problems, Agency Costs and
Corporate Governance
Initial public offering (IPO) of stock
Raises cash
Allows founders and pre-IPO investors to
harvest some of their wealth
Subsequent issues of debt and equity
Agency problem arises when managers act in
their own interests and not on behalf of owners
Agency costs arise from agency problems that
are borne by shareholders and represent a loss of
shareholder wealth
Corporate governance is the set of rules that
control a companys behavior towards its directors,
managers, employees, shareholders, creditors,
customers, competitors, and community
Can help control agency problems
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1-16
Types of Agency Problems
Mitigating Agency Problems
Type-I agency problem: The conflict of interests
between managers and stockholders (the classic
agency problem)
Type-II agency problem: When controlling
stockholders (families) have an incentive to extract
private benefits of control at the expense of minority
stockholders
Type-III agency problem: Stockholders through
managers could take actions to maximize stock price
that are detrimental to creditors
1-17
Factors affecting managerial behavior:
The role of board of directors*
Managerial compensation packages
Direct intervention by shareholders
The threat of firing
The threat of takeover
Audited financial statements
Corporate governance code (soft laws)
1-18
The Balance-Sheet Model of the Firm
Continued
Financial Management Decisions
Risk Management
What financial risks should we take on or hedge
out
Capital structure
How should we pay for our assets?
Should we use debt or equity or both?
From which source should we raise capital?
1-22
Capital budgeting
What LT investments should we engage in?
Where, when & how to make LT investments?
1-20
The Balance-Sheet Model of the Firm
1-21
Financial Management Decisions
Continued
1-19
The Balance-Sheet Model of the Firm
Continued
The Balance-Sheet Model of the Firm
Capital Analysis
What is something worth?
How can we create value for the firm?
Working capital management
How do we manage the day-to-day CFs?
Continued
1-23
1-24
Cash Flows Between the Firm and
Financial Markets
Capital Allocation Process
Transfers of capital between savers and users
Direct transfers--businesses issue securities like
commercial papers directly to savers
Indirect transfers--through investment banking
house (ICB, IDLC) which underwrites the issue
Indirect transfers--through a financial
intermediary where individual deposits money in
banks and banks make commercial loans to firms
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Types of Securities
1-26
Types of Financial Markets
Financial securities are simply pieces of paper with
contractual provisions that entitle their owners to
specific rights and claims on specific CFs or values
Debt instruments typically have specified payments and
a specified maturity (capital market security, money
market security)
Equity instruments are a claim upon a residual value
Derivatives are securities whose values depend on the
values of some other traded assets (e.g. options, futures,
forward, etc.)
Spot markets are the markets where assets are
bought or sold for on-the-spot delivery (literally,
within a few days)
Futures markets are the markets where assets are
bought or sold for delivery at some future date, such
as 6 months or a year into the future
1-28
Types of Financial Markets
Money markets are the markets for ST, highly liquid
debt securities (bankers acceptance, commercial
paper) with a maturity of less than 1 year
Capital markets are the markets for corporate
stocks and debt maturing more than a year in the
future
Mortgage markets deal with loans on residential,
agricultural, commercial, and industrial real estate
Consumer credit markets involve loans for autos,
appliances, education, vacations, and so on
Continued
Financial asset markets deal with stocks, bonds,
notes, mortgages, derivatives, and other financial
instruments
Continued
1-27
Types of Financial Markets
Physical asset markets (called real asset
markets) are markets for such products as wheat,
autos, real estate, computers, and machinery
1-29
Primary markets are the markets in which the
original security is directly sold to the public by the
issuer (corporation/government) with the help of
investment banking houses
IPO market is a subset of the primary market. Here
firms go public by offering shares to the public for
the first time
Secondary markets are the markets in which
existing, already outstanding securities are traded
among investors
Private markets are markets where transactions are
worked out directly between two parties
1-30
The Primary objective of the
Corporation
The Primary objective of the
Corporation
Decision rule for managers: Only take actions
that are expected to increase the share price.
Which one?
Survive?
Avoid financial distress and bankruptcy?
Beat the competition?
Maximize sales or market share?
Maintain steady earnings growth?
Minimize costs?
Maximize profit!!!
Does this mean we should do anything and
everything to maximize profit?
Fig: Financial decisions maximizing stock price
Continued
Which Investment is Preferred?
Earnings per share (EPS)
Year 1
Year 2
Year 3
Total (years 1-3)
Rotor
1.40
1.00
0.40
2.80
Valve
0.60
1.00
1.40
3.00
SHAREHOLDER WEALTH MAXIMIZATION
The same as:
Maximizing market price of stock
Maximizing intrinsic value of stock
Maximizing value of the equity
Maximizing value of the firm
Profit maximization may not lead to the highest possible
stock price for at least three reasons:
1. Timing is importantthe receipt of funds sooner is preferred
2. Profits do not necessarily result in CFs available to stockholders
3. Profit maximization fails to account for risk
Continued
Continued
1-33
The Primary objective of the
Corporation
1-32
The Primary objective of the
Corporation
The Primary objective of the
Corporation
Investment
Continued
1-31
1-34
Stock Prices and Intrinsic Value
Why best goal?
A comprehensive goal for the firm, its managers,
and employees
In equilibrium, a stocks price should equal its
true or intrinsic value
Intrinsic value is a long-run concept
This goal can be explored through EVA
To the extent that investor perceptions are incorrect, a
stocks price in the short run may deviate from its
intrinsic value
This goal avoids actions that prove to be
detrimental to stakeholders
This goal meets triple bottom line
Economic (generating monetary value)
Social (the impact of business on people inside and outside)
Ideally, managers should avoid actions that
reduce intrinsic value, even if those decisions
increase the stock price in the short run
Environmental (the total impact on natural environment)
Continued
1-35
1-36
Determinants of Intrinsic Values and
Stock Prices
Managerial Actions, the Economic
Environment, Taxes, and the Political Climate
True Investor
Returns
True
Risk
Perceived
Investor Returns
Stocks
Intrinsic Value
Is Stock Price Maximization the Same
as Profit Maximization?
No,
despite a generally high correlation
amongst stock price, EPS, and CFs
Perceived
Risk
Current stock price depends on current as well as
future earnings and CFs
Some actions may cause earnings to increase, yet
cause the stock price to decrease and vice-versa
Stocks
Market Price
Market Equilibrium:
Intrinsic Value = Stock Price
1-37
1-37
The Goal of Non-Business Firm
1-38
Three Basic Questions
To maximize the interests (benefits) of
stakeholders given a set of resources
The goal of a university:
Quality education for the students
Good management for the university
Right contribution to the society and to the country
Financially healthy condition
Do firms have any responsibilities to society
at large? YES! Shareholders are also
members of society
Should firms behave ethically? YES!
Is stock price maximization good or bad for
the society, employees, and customers?
YES, Good!
1-39
Three Aspects of CFs Affecting An
Investments Value
Stock Price Maximization Increases
Social Welfare
To a large extent, the owners of stock are society
When a manager takes actions to maximize the stock price, this
improves the quality of life for most citizens as they are shareholders
Amount of expected CFs (bigger is better)
Timing of the CF stream (sooner is better)
Risk of the CFs (less risk is better)
Consumer benefits
Stock price maximization requires efficient, low-cost businesses that
produce high-quality goods and services at the lowest possible cost.
1-40
Employees benefits
Companies that successfully increase stock prices also grow and add
more employees, thus benefiting society
Consumer welfare is higher in capitalist free market economies than
in communist economies
1-41
1-42
The Big Picture: The Determinants of
Intrinsic Value Using FCF and WACC
Sales
Revenue
Operating costs
and taxes
Free cash flow
(FCF)
Value =
Determinants of a Firms Value
Required investments
in operating capital
FCF
The cash available for distribution to all investors after
meeting all expenses and making required investment in
operations to support growth
FCF1
FCF2
FCF
+
+ +
(1 + WACC)1 (1 + WACC)2
(1+WACC)
WACC
The minimum return a company needs to earn to satisfy all
of its investors, including stockholders, bondholders, and
preferred stockholders (from investors perspective)
Weighted average
cost of capital
(WACC)
Market interest rates
Determined by the capital structure, interest rates, the firms
risk, and attitude toward risk
Firms debt/equity mix
Cost of debt
Market risk aversion
The cost of capital for the firm as a whole (from the firms
perspective)
Cost of equity
Firms business risk
1-43
Calculation of WACC
1-44
The Cost of Money or Fund
Equity capital of $50,000 and the required rate of return is
12%.
Preferred stock of $10,000 and preferred dividend is 6%.
Bank loan of $20,000 @ 15% interest and tax rate is 40%.
Bonds of $20,000 @ 10% interest and tax rate is 40%.
Funds
(1)
Amount
(2)
Weight
(3)
Rate
(4)
WACC
(5)=(3)(4) (1-t)
Equity
$50,000
0.5
0.12
0.50.12=0.060
Pref Stock
$10,000
0.1
0.06
0.2.15(1-0.4) =0.006
Bank Loan
$20,000
0.2
0.15
0.2.15(1-0.4) =0.018
Bonds
$20,000
0.2
0.10
0.2.10(1-0.4) =0.012
Total
$50,000
1.0
For debt, it is the interest rate
For equity, it is the cost of equity consisting of
the dividends and capital gains stockholders
expect
0.096
1-45
Economic Conditions and Policies
Affecting the Cost of Money
Factors Affecting the Cost of Money
1-46
Production opportunities (the ability to turn
capital into benefits)
How open market operations influence the price of Tbills, loanable fund and interest rate
Inverse relation between T-bills price and interest rate
Time preferences for consumption (as
opposed to saving for future consumption)
Risk of return
Expected inflation
The policy of central bank
A low interest rates stimulates economy by allowing firms to
borrow fund at a low cost for new projects
The national budget deficit or surplus
Government borrowing by issuing new T-bills
The same impact
Continued
1-47
1-48
Economic Conditions and Policies
Affecting the Cost of Money
Economic Conditions and Policies
Affecting the Cost of Money
The level of business activities
Interest rates and inflation rise prior to a recession and
fall afterwards
During recession:
International trade deficits or surpluses.
Trade deficit is financed by debt
Increased borrowing drives up interest rates
International investors are willing to hold country debt
Consumer demand slows, keeping companies from increasing
prices, which reduces price inflation
Companies also cut back on hiring, which reduces wage inflation
Less disposable income causes consumers to reduce their
purchases of homes and automobiles, reducing consumer
demand for loans
if and only if the risk-adjusted rate paid on this debt is
competitive
If the trade deficit is large relative to the size of the
Companies reduce investments in new operations, which reduce
their demand for funds
The cumulative effect is downward pressure on inflation and
interest rates
Continued
overall economy, it will hinder the central banks ability
to reduce interest rates and combat a recession
Continued
1-49
1-50
Economic Conditions and Policies
Affecting the Cost of Money
International country risk
A particular countrys economic, political, and social
environment can increase the cost of money that is
invested abroad
Exchange Rate Risk
The value of an investment depends on what happens
to exchange rates.
This is known as exchange rate risk.
1-51
