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FINANCIAL MANAGEMENT I AND II The Scope of Corporate Finance.

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Presentation on theme: "FINANCIAL MANAGEMENT I AND II The Scope of Corporate Finance."— Presentation transcript:

1 FINANCIAL MANAGEMENT I AND II The Scope of Corporate Finance

2 What is Finance?  Concerned with maintenance and creation of economic value or wealth.  Focuses on decision making with an eye toward creating wealth.  The activities involved in managing cash flows in a business environment.  Companies must make best use of capital, while balancing needs of corporate shareholders, managers, and other stakeholders.

3 The Financial Manager  Would be in charge of answering the three questions: What long-term investments should you take on? Where will you get the long term financing to pay for your investment? How will you manage your everyday financial activities such as collecting from customers and paying suppliers?

4 The Financial Management Function Financing (Capital-Raising) Capital Budgeting Financial Management Corporate Governance Risk Management

5 The Legal Forms of Business Organization 1. Sole Proprietorship: a business owned by a single individual and has a minimum amount of legal structure. Advantages: a. Easily established with few complications b. Minimal organizational costs c. Does not have to share profits or control with others. Disadvantages: a. Unlimited liability for the owner b. the amount of equity is limited to the amount of the owner’s personal wealth c. Business terminates immediately upon death of owner

6 The Legal Forms of Business Organization 2. Partnership: a business formed by two or more individuals or entities.  Two types of partnership:  General Partnership: all the partners share in gains or losses (agreements) and all have unlimited liability for all partnership debts.  Limited Partnership: one or more general partners will run the business and have unlimited liability, but there will be one or more limited partners who will not actively participate in the business.

7 The Legal Forms of Business Organization 1. Corporation: a business created as a distinct legal entity composed of one or more individuals or entities. Advantages: a. Ownership (represented by shares of stock) can be readily transferred b. The life of corporation is not limited c. Limited liability of owners d. Ability to raise large amounts of capital is increased Disadvantages: a. Due to corporation is a “legal” person, it must pay taxes b. Most difficult and expensive form of business to establish

8 The Goal of Financial Management  The goal of financial management – “to maximize the current value per share of existing stock”  Maximize Profit? Earnings per share are backward-looking, dependant on accounting principles Do not fully consider cash flow timing Ignores risk  Maximize Shareholder Wealth? Maximize stock price, not profits Shareholders as residual claimants, have better incentives to maximize firm value.

9 The Agency Problems  The possibility of conflict of interest between the stockholders and management of a firm.  Managers act as agents of the owners who hired them and gave them decision-making authority to manage the firm for the owners’ benefit.  In practice however, self-interests may cause managers to pursue objectives other than shareholder- wealth maximization.  This conflict of goals gives rise to managerial agency problems.

10 How Agency Costs Can Be Controlled  Ways to overcome agency problems: Takeovers Monitoring and bonding Compensation contracts  Executive compensation packages

11 C. Cash flow from firm’s assets F. Dividends and debt payments Financial Markets and The Corporation Financial Markets Short-term debt Long-term debt Equity shares A. Firm issues securities B. Firm invests in assets Current Assets Fixed Assets D. Government Other stakeholders E. Reinvested cash flows

12 Financial Markets and The Corporation A. Firm issues securities to raise cash B. Firm invests in assets C. Firm’s operations generate cash flow D. Cash is paid to government as taxes. Other stakeholders may receive cash. E. Reinvested cash flows are plowed back into firm. F. Cash is paid out to investors in the form of interest and dividends. * Refer previous page

13 Financial Markets and The Corporation  Primary versus Secondary Markets Primary Market: the original sale of securities by governments and corporations.  Two types: a. Initial Public Offering (IPO) – the first time issued in market to the public b. Private Placements – a negotiated sale involving a specific buyer Secondary Markets: these securities are bought and sold after the original sale.

14 The 5 Core Principles of Finance 1. The Time Value of Money The opportunity to earn a return on invested funds means that a dollar today is worth more than a dollar in the future. Business decisions involved a trade-off between spending money today and receiving money in the future.

15 The 5 Core Principles of Finance 2. Compensation of Risk Investors expect compensation for bearing risk. 3. Don’t Put Your Eggs in One Basket Investors can achieve a more favorable trade-off between risk and return by diversifying their portfolios (Harry Markowitz, 1990).

16 The 5 Core Principles of Finance 4. Markets are Smart Competition for information tends to make markets efficient. Prices of financial assets quickly, and accurately, reflect all information that investors have access to. Investors should just simply buy and hold a diversified portfolio than try to pick winners and losers in the stock market.

17 The 5 Core Principles of Finance 5. No Arbitrage Arbitrage refers to a trading strategy in which an investor simultaneously buys and sells the same asset in different markets at different prices to earn an instant, risk-free profit.

18 THE END


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