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FUNCTIONS OF THE FINANCIAL MANAGER

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Presentation on theme: "FUNCTIONS OF THE FINANCIAL MANAGER"— Presentation transcript:

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 markets
B 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.


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