1. 1 Introduction to Financial Management

2. 2 What is Finance? The study of money and other assets The financial management and control of assets Profiling and managing risks The science of managing money As a verb, to “finance” is to provide funds for large purchases (car, home, equipment, etc.)

3. Accounting vs. Finance Accountants: - Collect & present financial data. Financial Managers: - Evaluate accounting statements and make decisions on an assessment of associated risks and returns. 3

4. Function of an Accountant Report data measuring the performance of the Firm Assess the Firm’s financial position Pay Taxes 4

5. Function of a Financial Manager Primary interest is cash flows Maintains the Firm’s solvency by planning cash flows necessary to achieve the goals of the Firm 5

6. Financial Management Decisions Capital Budgeting What long-term investments or projects should the Firm pursue? Capital Structure How should the Firm pay for its assets? Should the Firm use debt or equity financing? Working Capital Management How does the Firm manage its day-to-day finances? 6

7. Financial Management Decisions Dividend Decisions What should be done with the profits generated by the Firm? Risk Management Should the Firm utilize derivative securities as a risk management or speculative tool? 7

8. Investment Decisions What is the optimal size of the Firm? What specific assets should be acquired? What assets (if any) should be reduced or eliminated ? 8

9. Financing Decisions What is the best type of financing? What is the best financing mix? What is the best dividend policy (e.g., dividend-payout ratio)? How will the funds be physically acquired? 9

10. Asset Management Decisions How do we manage existing assets efficiently? Greater emphasis on current asset management than fixed asset management. 10

11. 11 Types of Business Sole Proprietorship Partnership Limited Liability Partnership Corporation

12. 12 Sole Proprietorship: Advantages (This is the most common form of business ownership) Easy to start and easy to end Since there is only one owner, business decisions can be made quickly. Tax reporting is simple; no double taxation All losses resulting from the proprietorship can be deducted from the owner’s personal tax burden

13. 13 Sole Proprietorship: Disadvantages You, the sole proprietor, are personally liable for all the debts of your sole proprietorship. The reason for this is, once again, the law makes no distinction between you, the sole proprietor, and your sole proprietorship. It’s difficult to get health insurance. Also, the owner cannot take any tax deduction for health or life insurance. It’s difficult to raise capital or borrow money since there is no distinction between you and the business. The business dies with the owner

14. 14 Partnership A partnership is a for-profit business association of two or more persons. Each partner shares directly in the organization's profits and shares control of the business operation. The consequence of this profit sharing is that partners are jointly and independently liable for the partnership's debts.

15. 15 Partnership: Advantages Partnerships are highly adaptable in form and vary in complexity since a ‘person’ include individuals, groups of individuals, companies, etc.

16. 16 Partnership: Disadvantages Each partner is legally and financially responsible for the actions of the other partners in the general course of business. If one or more of the partners becomes insolvent, the weight of that partner’s share is spread onto the remaining partners.

17. 17 Becoming a Corporation A corporation is a legal entity separate from its owners and managers. File papers of incorporation with state. Charter Bylaws

18. 18 Corporation: Advantages The law treats a corporation as a legal ‘person’ that has standing to sue and be sued, distinct from its stockholders (owners). This prevents shareholders from being personally liable for corporate debts. Ownership in the company (shares) is easily transferable. Ease of raising capital Since it is a ‘person’, corporation status gives the business perpetual life; deaths of officials or stockholders do not affect the integrity of the corporation.

19. 19 Corporation: Disadvantages Difficult and expensive to set-up Corporations have a double taxation problem. Both corporate profits and shareholder dividends are taxed (corporate profits are taxed at a lower rate than the rates for individuals). Generally speaking, the larger the corporation, the less influence the individual shareholders have.

20. Financial Markets Financial Markets - brings buyers and sellers of debt and equity securities together How do financial markets differ? Type of securities traded/how trading is conducted and who the buyers and sellers are Money markets and capital markets Money market - short term debt securities Capital market - long term debt and equity 20

21. Financial Markets and Society What is the societal benefit of financial markets? Channel savings into investment Produce and transmit information on returns and risk Provide a media and a payments system Enable the shifting of the timing of consumption over a life cycle Enable the management of risk Enable the diversification of portfolios 21

22. Capital Markets Consists of primary & secondary markets. Newly formed (issued) securities are bought or sold in primary markets. Existing securities are traded (bought & sold) in the secondary markets. 22

23. 23 Primary vs. Secondary Security Sales Primary New issue (IPO—Initial Public Offering) Key factor: issuer receives the proceeds from the sale. Secondary Existing owner sells to another party. Issuing firm doesn’t receive proceeds and is not directly involved.

24. 24 What International Conditions Affect the Cost of Money? Country risk. Depends on the country’s economic, political, and social environment. Exchange rate risk. Non-dollar denominated investment’s value depends on what happens to exchange rate. Exchange rates affected by: International trade deficits/surpluses Relative inflation and interest rates Country risk

25. 25 Federal Reserve policies Budget deficits/surpluses Level of business activity (recession or boom) International trade deficits/surpluses What International Conditions Affect the Cost of Money?

26. Shareholder Wealth Maximization Takes account of: current and future profits and EPS; the timing, duration, and risk of profits and EPS; dividend policy; and all other relevant factors. Share price serves as a barometer for business performance. 26

27. Shareholder Wealth Maximization Another measure of the wealth of a firm (or its stockholders) is called Economic Value Added (EVA) EVA=(Return on Total Capital – Cost of Capital) x Total Capital If EVA is positive then shareholder wealth is increasing. If EVA is negative, then shareholder wealth is being destroyed. 27

28. Market share Profit margin Return on investment Technological advancement Product Quality Customer satisfaction Community Service Other Objectives Which the Firm Might Pursue: 28

29. Accounting vs. Finance Finance is more focused on market values rather than book values. Finance is more focused on cash flows rather than accounting income. 29

30. Market Value vs. Book Value Book values are often based on dated values. They consist of the original cost of the asset from some past time, minus accumulated depreciation (which may not represent the actual decline in the assets’ value). Maximization of market value of the stockholders’ shares is the goal of the firm. 30

31. Cash Flow vs. Accounting Income Cash flow to stockholders (in the form of dividends) is the only basis for valuation of the common stock shares. Since the goal is to maximize stock price, cash flow is more directly related than accounting income. Accounting methods recognize income at times other than when cash is actually received or spent. 31

32. One more reason that cash flow is important : When cash is actually received is important, because it determines when cash can be invested to earn a return. When cash must be paid determines when we need to start paying interest on money borrowed. 32

33. Accounting Income vs. Cash Flow Credit sales are recognized as accounting income, yet cash has not been received. Depreciation expense is a legitimate accounting expense when calculating income, yet depreciation expense is not a cash outlay. A loan brings cash into a business, but is not income. 33

34. Accounting Income vs. Cash Flow When new capital equipment is purchased, the entire cost is a cash outflow, but only the depreciation expense (a portion of the total cost) is an expense when computing accounting income. When dividends are paid, cash is paid out, though dividends are not included in the calculation of accounting income. 34

35. 35 Free Cash Flows (FCF) Free cash flows are the cash flows that are available (or free) for distribution to all investors (stockholders and creditors). FCF = Sales revenues - Operating costs - Operating taxes - Required investments in operating capital.

36. 36 Agency Theory If management is given appropriate incentives are given and is monitored, only then will they make optimal decisions for the Firm. Monitoring includes the following: - Auditing financial statements - Explicit limitations on managerial decisions - Bonding the agent The less the ownership percentage of the managers, the less the likelihood they will behave in a manner consistent with maximizing shareholder wealth and the greater the need to monitor their activities.

37. 37 Conflicts of Interest Management vs. Shareholders Management vs. Employees Shareholders vs. Employees Shareholders vs. Creditors Corporation vs. Community

38. 10 Principles of Financial Management 38

39. Risk vs. Return Additional risk must be compensated with additional return. Investment alternatives have different amounts of risk and expected returns. Positive correlation between risk and return 39

40. Time Value of Money A dollar received today is worth more than a dollar received in the future. Because we can earn interest on money received today, it is better to receive money earlier rather than later. 40

41. Cash is More Important than Profits Cash Flow, not accounting profit, is used as our measurement tool. Cash flows, not profits, are actually received by the firm and can be reinvested. 41

42. Incremental Cash Flows The incremental cash flow is the difference between the projected cash flows if the project is selected, versus what they will be, if the project is not selected (Net Present Value). 42

43. Challenge of Competitive Markets It is hard to find exceptionally profitable projects. If an industry is generating large profits, new entrants are usually attracted. The additional competition and added capacity can result in profits being driven down to the required rate of return. Product Differentiation, Service and Quality can insulate products from competition 43

44. Efficient Markets Markets price adjustments are fast and accurate. The values of all assets and securities at any instant in time fully reflect all available information. 44

45. The Agency Problem Managers won’t work for the owners unless it is in their best interest The separation of management and the ownership of the firm creates an agency problem. Managers may make decisions that are not in line with the goal of maximization of shareholder wealth. 45

46. Taxes Bias Business Decisions The cash flows we consider are the after-tax, incremental cash flows to the firm as a whole. 46

47. All Risk is Not Equal Some risk can be diversified away, and some cannot. The process of diversification can reduce risk, and as a result, measuring a project’s or an asset’s risk is very difficult. 47

48. Ethics Ethical Behavior is doing the right thing at the right time. Ethical dilemmas are everywhere in finance Each person has his or her own set of values, which forms the basis for personal judgments about what is the right thing to do. 48