1. FUNCTIONS OF THE FINANCIAL MANAGER

2. Premise The evolutionary path of financial function
Financial manager as a salesman
Financial securities
Markets
Demand side/supply side

3. The evolutionary path of the financial function
From the classical paradigm of finance to managing financial constraints
Classical Paradigm of finance:
Perfect markets; each profitable investment opportunity can attract adequate financial sources
Measures financial performances according an optimization rule that bring together:
The rationale of financial markets
The behaviour of firm’s stakeholders, driven by a risk-return objective function
Metrics for assessing the profitability of firm’s real investments according to the same rationale for assessing financial investments
Grounded on the efficient use of capital
Grounded on the value maximization paradigm
Firm seen as a black box
Under the assumptions at the heart of the classical paradigm of finance, the separation theorem holds

4. The classical objective function
MANAGERS
SOCIETY
BONDHOLDERS
LENDERS
STOCKHOLDERS
FINANCIAL MARKETS
Max stockholder wealth
Hire/Fire managers
-Board
Annual meeting
Protect bondholders Interest
Reveal info honestly and on time
No social costs
All costs can be traced to firms
Markets are efficient and assess effect on value
Lend money

5. Separation theorem
Economic agents (households, firms) simultaneously take consumption and investment decisions. To this end, they need to know:
The subjective trade-off between current and future consumption
The feasible trade-off between current and future consumption. It depends on the available investment and production opportunities
Optimal consumption decisions help identifying a subjective IR

6. Consumption and investments in a world without capital markets
Hypothesis:
Decisions to be taken in a single-period setting
No transaction costs
No uncertainty
Agents have an income (y0,y1)…
…and are required to decide (C0,C1)

7. Consumption and investments in a world without capital markets
U(C0)
U(C0,C1) C0
Trade-off between beginning and end-of-period consumption. Points A and B return the same utility A B C1 C0

8. Consumption and investments in a world without capital markets
The slope of the tangent measures the trade-off between current and future consumption. It defines the Marginal Rate of Substitution (MRS). Besides, it measures the temporal preference rate, ri, at a given point
C1a A
C1b B C0
C0a
C0b
Choices, however, are expected to considerably change when taking production
opportunities into consideration. Those opportunities allow converting one unit of
current saving/investment into one (or more than one) unit of future consumption

9. Consumption and investments in a world without capital markets
Investments are characterized by decreasing marginal returns B ri I I0 C1
Each agent undertakes all investments for which the return
exceeds ri
The slope of the tangents to the curve ABX shows the ratio
at which forgiving 1 unit of current consumption yields, as a
result of the investment, 1 unit of future consumption
Such a ratio is the Marginal Rate of Transformation
(MRT) X B
P1=C1 U2 y1 U1 C0
P0=C0 y0
In B, MRS=MRT, allowing to identify the marginal rate of return, ri,
up to which investments are profitable A

10. Consumption and with capital markets
Assumptions
All outcomes from investment are known with certainty.
Inter-temporal exchange rate of consumption bundles, r>0 is known. No transaction costs.
No taxes.
Two-period model

11. Consumption and investment with capital marketsB A y0 y1
C0*
C1*
Slope=Market interest rate = - (1+ri)
1. CONSUMPTION
With capital markets, unlimited lending or borrowing is available at the
market interest rate, r
The line W0ABW1 represents the capital market line; it represents lending
and borrowing opportunities at the market rate, r.
Slope=Individual preference rate= - (1+ri)
Given the original consumption opportunities (y0,y1), its value, W0, will be:

12. Fisher separation theorem
2. PRODUCTION
OPPORTUNITIES
Let consider production opportunities in a world where capital markets allow
lending operations. Starting from with consumption opportunities (y0,y1), we
can move along the set of production opportunities, i.e. along the capital market line
Moving from A, we would cease to invest in D if we were not able to borrow
When borrowing is available, we improve our situation:
We can borrow to expand production and investment up to B
Why?
Starting from B and moving along the capital market line, it would, then, be optimal to
borrow to obtain higher consumption levels, up to C, where our utility is maximized. A
C0* C1 C0 W0 W1 U1 U2 B y0 y1
C1* P0
W0* P1
W1* U3 C D

13. Consumption and investment with capital markets
Initial endowment, A(y0,y1)
Invest more at t=0
(or consume less at t=0)
A→D,
u(D)>u(A)
c0 c1 w unchanged
(why?)

14. Consumption and investment with capital markets
Optimal consumption without capital markets: D
ri>r
markets offer cheaper funds
invest less at t=0
consume more at t=0
borrow more to consume
D→C,
Optimal consumption with capital markets, C(c*0 c*1)
u(C)>u(D)
c0 c1 w
(why?)

15. Implications Fisher separation theorem
“Given perfect and complete markets, the production is governed by an objective market criterion without regard to individual’s subjective preferences that enter into their consumption decision.”
A D No wealth changes
D C Wealth increases (leverage)

16. Fisher separation theorem
Given complete and perfect capital markets, production decisions are only driven by an rational market principle. Subjective preferences only drive consumption decisions
Implications for corporate finance: investment decisions can be delegated to the firm’s management
Given the same set of opportunities, each investor will undertake the same investment decisions, (P0,P1), regardless of its own indifference curves C1 C0 P0
W0* P1
W1* B Y X A
Investor 1
Investor 2

17. Imperfect markets
With transaction costs, markets and intermediaries provide valuable services
Borrowing rate>lending rate
Such a difference in rates breaches the validity of the Fisher theorem
Economic agents heaving different preferences will choose different investment levels C1
Borrowing interest rate
Subject 1
P11 B
Lending Interest rate
P12 A
Subject 2 C0
P01
P02

18. The agency problem
Goal of financial management: increase shareholders’ wealth
Sole proprietorship = easy; owners are generally also the managers of the business
Big companies = difficult; owners/shareholders not directly involved in business
The shareholders (principals) appoint managers (agents) to look after their interest
Agency relationship: the relationship between the principal and the agent
Agency problem: when the agent does not make decisions in the best interest of the principal

19. Agency costs Management and shareholders goals can differ
Agency cost: Any costs (both direct and indirect) that can arise due to the agency problem
Direct agency cost: measurable amount
Indirect agency cost: not physical, lost opportunity
Control agency cost:
Incentive plans
Performance plans

20. Corporate governance
Laws, policies, processes and organisations that influence business and the business environment
Ensures that needs of shareholders & stakeholders are served
Main role players: shareholders, board of directors, management
Other stakeholders: employees , creditors, customers, community
Accepted principles of corporate governance:
Rights & equitable treatment of shareholders
Interests of other stakeholders
Role & responsibility of the board
Integrity & ethical behaviour
Disclosure & transparency
King III Report

21. What can go wrong? MANAGERS SOCIETY BONDHOLDERS LENDERS STOCKHOLDERS
FINANCIAL MARKETS
Managers put their interests above stockholders
Have little control over managers
Bondholders can get ripped off
Delay bad news or provide misleading information
Significant social costs
Some costs cannot be traced to firms
Markets make mistakes and can over react
Lend money

22. Stockholders vs management
In theory: The stockholders have significant control over management. The two mechanisms for disciplining management are the annual meeting and the board of directors. Specifically, we assume that:
Stockholders who are dissatisfied with managers can not only express their disapproval at the annual meeting, but can use their voting power at the meeting to keep managers in check.
The board of directors plays its true role of representing stockholders and acting as a check on management.
In Practice: Neither mechanism is as effective in disciplining management as theory posits.

23. Stockholders vs bondholders
In theory: there is no conflict of interests between stockholders and bondholders.
In practice: Stockholder and bondholders have different objectives. Bondholders are concerned most about safety and ensuring that they get paid their claims. Stockholders are more likely to think about upside potential

24. Firms and financial markets
In theory: Financial markets are efficient. Managers convey information honestly and in a timely manner to financial markets, and financial markets make reasoned judgments of the effects of this information on 'true value'. As a consequence:
A company that invests in good long term projects will be rewarded.
Short term accounting gimmicks will not lead to increases in market value.
Stock price performance is a good measure of company performance.
In practice: There are some holes in the 'Efficient Markets‘ assumption.

25. The counter reaction MANAGERS SOCIETY BONDHOLDERS LENDERS STOCKHOLDERS
FINANCIAL MARKETS
Managers of poorly run firms are put on notice
More activist investors
Hostile takeovers
Covenants
New types
Firms are punished for misleading markets
Corporate good citizen constraints
More laws
Investor/customer backlash
Investors and analysts become more skeptical
Protect themselves

26. The modified objective function
For publicly traded firms in reasonably efficient markets, where bondholders (lenders) are protected:
Maximize Stock Price: This will also maximize firm value
For publicly traded firms in inefficient markets, where bondholders are protected:
Maximize stockholder wealth: This will also maximize firm value, but might not maximize the stock price
For publicly traded firms in inefficient markets, where bondholders are not fully protected
Maximize firm value, though stockholder wealth and stock prices may not be maximized at the same point
For private firms, maximize stockholder wealth (if lenders are protected) or firm value (if they are not)

27. The evolutionary path of the financial function
Stages
Evolutionary paths
Depth of financial analysis
Methods
Relations between returns costs and capital sources
60s-70s
Subordination
Profitability
Simple
Static
Deterministic
(Ratio analysis)
ROE (Relations between return on assets, accounting proxies for the cost of debt, leverage
70s-80s
Integration
Sustainable growth
Operational and financial risk
Complex
Dynamic
(Sust. Growth models; risk models)
Sustainable growth rate
(return on assets, accounting proxies for the cost of debt, leverage, dividend policies…)
From 80s
Strategic finance
Systematic risk
Value
Complex, dynamic, probabilistic
(Cost of capital models
Value models
Investment analysis)
Enterprise Value Added

28. Role of the financial manager
Firm’s Operations 2
Financial Manager 1
Financial Markets
4 a 3
4 b
Cash raised from investors
Cash invested in firm
Cash generated by operations
4a) Cash reinvested
4b) Cash returned to investors

29. The financial manager as a negotiator
Primary role of the financial manager: ensuring that his company has a sufficient supply of capital.
There are two ways of looking at the financial manager’s role:
buyer of capital who seeks to minimise its cost, i.e., the traditional view;
seller of financial securities who tries to maximise their value. We develop this view (it resembles the concept of capital market economy, as opposed to a credit-based economy)

30. The financial manager as a negotiator…
The financial manager is traditionally perceived as a buyer of capital.
He negotiates with a variety of investors – bankers, shareholders, long-term lenders
Goal: obtaining funds at the lowest possible cost.
Transactions that take place on the capital markets are made up of the following elements:
a commodity: money;
a price: the interest rate in the case of debt, dividends and/or capital gains in the case of equities.

31. …but also as a salesman
Let’s now take a look at the financial manager’s job from a different perspective:
Seller of securities;
His aim is now to maximise a selling price;
Here he operates not on the capital markets, but on the market for financial instruments, be they loans, bonds, shares, etc.
we are merely looking at the same market from another point of view:
the supply of financial securities corresponds to the demand for capital;
the demand for financial securities corresponds to the supply of capital;
Equilibrium:
Interest rate in the traditional view
The price (i.e., value of securities) according to the view of financial manager as a salesman
Approach
Financial
Traditional
Market
Securities
Capital
Supply
Issuer
Investor
Demand
Price
Value of Security
Interest rate

32. Capital supply, securities, risk
Taking the traditional view, can lead the financial managers to take wrong actions (i.e., it can make decisions short-sighted)
Suppliers of capital do not all face the same level of risk
The investor’s risk must be taken into account in evaluating the cost of a source of
financing
The cost of two sources of financing can be compared only when the suppliers of the funds incur the same level of risk
Recall the pitfalls of faulty financial reasoning
Replace the statement ‘‘It doesn’t cost anything’’ with the question:
What is the impact of this action on value?

33. Issuing financial securities
There is a great variety of financial instruments, each of which has the following characteristics:
it is a contract;
the contract is executed over time;
its value derives solely from the series of cash flows it represents.
Indeed, from a mathematical and more theoretical viewpoint, a financial instrument is defined as a schedule of future cash flows.
Time, or the term of the financial security, introduces the notion of risk

34. Primary vs Secondary markets
Primary markets: markets where users of funds rise funds through new issues of financial instruments
Public offerings
Private placements
Primary markets include:
Issues of equity by firms initially going public (Initial Public Offerings-IPOs)
Issues of additional equity or debt instruments of an already publicly traded firm
Secondary markets: markets where financial instruments, once issued, are traded
Buyers: economic agents (consumers, businesses, governments) with excess funds
Sellers: economic agents in need of funds

35. Primary vs Secondary markets
Secondary markets: exist for:
Stocks
Bonds
Asset backed Securities
Derivatives securities
Foreign Exchange
Benefits of Secondary markets:
For investors, help trading securities at their market value quickly and purchasing securities with varying risk-return characteristics
They offer buyer and sellers liquidity as well as information about the price or the value of their investments
For issuers: provide information about the current market value of financial instruments (and thus, the firm) as perceived by investors
The greater the liquidity makes it more desirable and easy for issuers to sell securities

36. Money markets vs Capital markets
Money markets (MM): markets that trade debt securities or instruments with maturities of 1 year or less
MMs allow agents with short term excess supplies (shortages) of funds to lend (borrow) funds
MMs usually show quite small fluctuations in prices
Capital markets: markets that trade equity and debt instruments (bonds) with maturities of more than 1 year
Major suppliers of capital market securities (users of funds): corporations and governments
Due to their longer maturities, they usually experience wider price fluctuations

37. Money markets vs Capital markets
Capital Market Instruments
Corporate Stock
The fundamental ownership claim in a public corporation
Mortgages
Loans to individuals or businesses to purchase a home, land or other real property
Corporate Bonds
Long-term bonds issued by corporations
Treasury bonds
Long-term bonds issued by the treasury
Local government bonds
Long-term bonds issued by a local government
Bank and consumer loans
Loans to commercial banks and individuals

38. Financial manager as a negotiator
What exactly is the financial manager selling? How can the value of the financial security be determined?
From a practical standpoint, it ‘‘sells’’ management’s reputation for integrity, the firm’s financial health, the quality of its assets
Theoretically, the financial manager sells expected future cash flows that can derive only from the company’s business operations.
The corporate financial manager transforms the company’s economic activity into cash flows that he offers to financial investors.
A money-losing company pays its creditors only at the expense of its shareholders.