Financial Management

Chapter 1 – Overview of
Financial Management
 Topics to be covered

• Introduction to financial management

• The goals of a firm

• 10 principles that form the foundations of financial management

• Problems of agency

• The risk-return trade off

• Time value of money

 Defining Finance
• Finance is analytical tool for money and market.

• Concerned with resources acquisition, allocation and

management

• Finance uses accounting information as an input for

decision-making.

• Finance is constantly changing.

• Finance is the study of how to invest and raise money

productively
 Introduction
• Basic Areas Of Finance

– Corporate finance

• Management of financial decisions at corporate level

– Investments

• Work with financial assets such as stocks and bonds

– Financial institutions

• Companies that specialize on financial matters

– International finance

• Oversea business operation/relation

 Financial Management Decisions
Financial management is used to help make three major
decisions:
1. Which assets should we invest in? – Investment
decision
2. How will we pay for these assets? – Financing
decisions
3. What should we do with the earnings generated by
the assets? – Dividend decisions
 Function of Financial Manager
1a.Raising
2.Investments funds

Operations Financial Financial

1b.Obligations
(plant, Manager (stocks, debt Markets
equipment, securities) (investors)
3.Cash from
projects) operational
activities
5.Dividends or
4.Reinvesting
interest
payments
 Financial markets
• The main goal of financial markets:

Take savings from those who do not wish to consume

(savings surplus units) and to channel them to those
who wish to invest more than they have presently (
deficit units)
 Financial markets

Financial markets

Organized
Primary markets Money market exchanges
Secondary markets Capital market Over-the-counter
 Primary and secondary markets
• Primary market – primary issues of securities are
sold, allows governments, banks, corporations to
raise money by directly selling financial instruments
to the public.

• Secondary market – allows investors to trade

financial instruments between themselves.
Secondary transactions take place.
 Money and capital markets
Money markets – short term assets with maturity of less than 1 year
are traded:

• Certificates of deposits (CDs)

• Treasury bills

Capital markets – long-term assets (maturity longer than 1 year) are

traded:

• Stocks

• Corporate bonds

• Long-term government bonds

Organized exchanges and over-the-counter
• Organized exchange – most of stocks, bonds and derivatives
are traded. Has a trading floor where floor traders execute
transactions in the secondary market for their clients.

• Over-the-counter (OTC) market - Facilitates secondary

market transactions. Unlike the organized exchanges, the
OTC market doesn’t have a trading floor. The buy and sell
orders are completed through a network.
 Ten Principles That Form The
Foundations of Financial Management
• Risk-Return Trade-off

– We won’t take on additional risk unless we

expect to be compensated with additional
return.
– Investment alternatives have different amounts
of risk and expected returns.
– The more risk an investment has, the higher will
be its expected return.
Principles …………………

• Time value of money

– A dollar received today is worth more than a dollar

received in the future.

– A dollar received today is worth more than a dollar

received a year from now. Because we can earn
interest on money received today, it is better to
receive money earlier rather than later.
Principles …………………
• 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
Principles …………………
• Cash—Not Profits—is King
➢ Cash Flow, not accounting profit, is used to measure
wealth.
➢ Cash flows, not profits, are actually received by the firm
and can be reinvested.

• Incremental Cash flow

➢ It is only what changes that counts;

➢ The incremental cash flow is the difference between the

projected cash flows if the project is accepted, versus what
they will be, if the project is not accepted.
Principles …………………
• Efficient capital market

– The values of all assets and securities at any instant in time

fully reflect all available information.

• The curse of competitive markets

– Why it is hard to find exceptionally profitable projects;

• Taxes affect business decisions

– The cash flows we consider are the after-tax incremental

cash flows to the firm as a whole.
Principles …………………

• All risks are not equal

– Some risk can be diversified away, and some cannot.

• Ethical Behavior Is Doing The Right Thing, and 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.
 Goal Of Financial Management
• What should be the goal of a corporation?

– Maximize profit? Minimize costs? Maximize market share?

– Maximize the current value of the company’s stock?

• And the most cited goal is Profit maximization; under the profit
maximization decision criteria, actions that increase profit of a
firm should be undertaken; and actions that decrease profit
should be rejected.
 Limitations of Profit Maximization
1. Ambiguity: The term profit or income is vague and ambiguous concept.

• Different people understand profit in different several ways. Because there

are many different economic and accounting definitions of profit. i.e

✓ Does it mean an absolute figure expressed in dollar or a rate of

profitability?

✓ Does it mean short-term or long-term profits?

✓ Does it refer to profit after tax or before tax?

✓ Net profit available to ordinary share holders?

• Then, the question or the problem would be which profit is to be

maximized?
Cont’d…
2. It could increase current profits while harming the firm future survival .

• A business might increase short term profits at the expense of long-term

competitiveness and performance of a business.

• It could be done by reducing operating expenses:

– Cutting research and development expenditure

– Defer/postpone important maintenance costs

– Cutting staff training and development

– Buying lower quality materials

– Cutting quality control mechanisms

• These policies may all have a beneficial effect on short term profits but may
undermine the long term competitiveness and performance of a business.
Cont’d….
3. Ignore time value of money concept/Timing of Benefits:

✓ The profit maximization criterion ignores the differences in

the time pattern of benefits received from investment
proposals.

▪ Profit Maximization criterion does not consider the

distinction between returns (benefits) received in different
time periods and treats all benefits as equally valuable
irrespective of the time pattern differences in benefits.
Cont’d..
• Example: ABC Company wants to choose between two
projects: project X and project Y. both projects cost the
same, are equally risky and are expected to provide the
following benefits over three years period.

BENEFITS (PROFITS)
YEAR PROJECT X PROJECT Y
1 Br. 25,000 Br. –0-
2 50,000 50,000
3 –0- 25,000
TOTAL Br. 75,000 Br. 75,000
Cont’d..
• The profit maximization criterion ranks both projects
as being equal. However, project X provides higher
benefits in earlier years and project Y provides larger
benefits in latter years.

• The higher benefits of project X in earlier years could be

reinvested to earn even higher profits for later years.
• Profit seeking organizations must consider the timing
of cash flows and profits because money received
today has a higher value than money received
tomorrow. Cash flows in early years are valued more
highly than equivalent cash flows in later years.
Cont’d..

4. Does not consider Quality of Benefits (Risk of

Benefits): Profit maximization assumes that risk or
uncertainty of future benefits is of no concern to
stockholders.
Risk is defined as the probability that actual benefit
will differ from the expected benefit.

• Financial decision making involves a risk-return trade-

off. This means that in exchange for taking greater risk,
the firm expects a higher return. The higher the risk,
the higher the expected return.
• Example: XY Company must choose between two projects. Both
projects cost the same. Project A has a 50% chance that its cash
flows would be actual over the next three years. And Project B has
a 90% probability that its cash flows for the next three years would
be realized.

Expected Benefits

YEAR PROJECT A PROJECT B

1 Br. 60,000 Br. 45,000
2 65,000 50,000
3 95,000 85,000
TOTAL Br. 220,000 Br. 180,000
Cont’d..
• Under profit maximization, project A is more attractive
because it adds more to XY than project B. But if we consider
the risk of the two projects, the situation would be reversed.

✓ Expected benefit of project A = Br. 220,000 x 50% = Br. 110,000

✓ Expected benefit of project B = Br. 180,000 x 90% = Br. 162,000

• The more certain the expected cash flow (return), the higher the
quality of benefits (i.e., low risk to investor). Conversely, the more
uncertain or fluctuating the expected benefits, the lower the
quality of benefits (i.e., high risk to investors).
Cont’d..

5. It doesn’t show cash flow available to shareholders

• Profit does not represent cash flow available to
shareholders.

✓ Owners receive returns either through cash dividends or by selling

their shares for a better price. Higher Earning per Share (EPS)
doesn’t necessarily mean dividend payments will increase.

• Above all, accounting profit is affected by the accounting

method followed and is prone to manipulation by the
management.
 Shareholders Wealth Maximization
• The contemporary view of the goal of the firm is maximizing
shareholders value.

• Wealth maximization means maximization of the value of a firm.

Or maximize the economic well-being, or wealth, of the owners
(current shareholders)

– maximize the price of the stock

• Share price today = Present value of all future expected dividends at

required rate of return:


di
Max.Share. price. = max .
i =1 (1 + k )i
Cont’d..
• There are several reasons why wealth maximization decision
criterion is superior to Profit Maximization criteria.

– First, it has an exact measurement unlike profit

maximization. It depends on cash flows (inflows and
outflows).

– Second, wealth maximization as a decision criterion

consider the quality as well as the time pattern of benefits.

– Third, it emphasizes on the long-term and sustainable

maximization of a firm’s common stock price in the
financial market.
 The Agency Problem
• Agency Problems: Goals of the parties are not
aligned:
– Agent someone who is hired to represent the
principal’s interest
• Equity: Potential conflict between shareholders
and managers (principal-agent problem)
• Debt: Potential conflict between shareholders and
debt holders.
Cont’d
• The possible objectives management may follow
apart from the goal of the firm include:
➢ Maximizing its personal returns (salaries, bonuses and
perquisites)
➢ Increasing its prestige (generously donating in
charities, maximizing the size of the firm and its
market share)
➢ Increase job security by making takeovers less likely
Cont’d
• Managers can be encouraged to act in stockholders’ best
interests through incentives that reward them for good
performance but punish them for poor performance.
• Some specific mechanisms used to motivate managers to act in
shareholders’ best interests include:
– (1) Managerial compensation,
– (2) Direct intervention by shareholders,
– (3) The threat of firing, and
– (4)The threat of takeover.
 Risk and Return
• Risk is defined as uncertainty of outcomes.

– In a financial sense, we are uncertain of the outcome of any

investment.

– Formally, uncertainty is measured by variability.

• Statistically that means variance or standard deviation.

• Return refers to the gain or loss on an investment.

– It is generally stated as a percent of the original investment,

and annualized.

• The interest rate on a savings account is a form of return.

 Risk and Return …
• Expected Return as defined in statistics is as follows
N
E (Return ) =  = kˆ =  ki pi
i =1

• Risk in statistics (and financial economics) is measured by standard

deviation, which measures the variability of the return.

( )
N
ki − kˆ
2
 =  2
= pi
i =1

• Coefficient of variation:

CV =

 Risk and Return…..
• The standard deviation can be used to measure the variability of
returns from an investment.

• As such, it gives an indication of the risk involved in the asset or

security. The larger the standard deviation, the more variable are
an investment’s returns and the riskier is the investment.

• A standard deviation of zero indicates no variability and thus no

risk.

• Because the standard deviation is an absolute measure of

variability, it is generally not suitable for comparing investments
with different expected returns. In these cases, the coefficient of
variation provides a better measure of risk.
 Defining/Measuring Risk
• If we assume that the return on two companies would be as
follows:

Rate of Return on Stock

If State Occurs
State of Probability of Auto ABC
Economy Occurrence Manufacturing Electric
Boom 0.2 110% 23%
Normal 0.5 22% 16%
Recession 0.3 -60% 8%
1.0
 Risk Aversion
• Assuming that you need to live off of your investment, and you can only
invest in one of the two companies from the previous slides, which
would it be?

– Auto Manufacturing

– ABC Electric

• If you chose ABC Electric, you are risk averse.

• Risk averse investors require higher rates of return to invest in riskier

assets.

• It is assumed that all investors are risk averse:

– If two assets offer the same return, they will opt for the less risky.
 Risk Premium
• The amount of additional return required by a riskier asset to
make that asset equally desirable by the market in general is
called a risk premium.

• When the market perceives that one asset is riskier than another,
it requires that the expected return increase to compensate
investors for the risk.

• In the real world, investors can hold more than one investment.

• But risk is still important in pricing assets given their expected

return.
 0
20
40
60

-60
-40
-20
1926
1930
1934
1938
1942
1946
1950
1954
1958
1962
1966
Returns

1970
Large -Company Stock

1974
1978
1982
1986
1990
1994
1998
 Returns
60 Long-Term Government Bonds

40

20

-20

-40

-60
192619311936194119461951195619611966197119761981198619911996
 Returns
60 Treasury Bills

40

20

-20

-40

-60
 Risk and Return
14

12
Large-Company Stocks
Average Annual Return

10

6
T-Bonds
4
T-Bills
2

0
0 5 10 15 20 25
Annual Standard Deviation
 Portfolio Risk Reduction
• Investors usually hold more than one asset.
• Collection of assets is called portfolio
• Risk can only be reduced so far.
• Almost all stocks are positively correlated.
• As the number of stocks increase, the risk approaches m.

Number of Stocks in Portfolio

Portfolios

0 5 10 15 20 25 30 35 40 45
 Portfolio Risk Reduction

Diversifiable, Unsystematic, or Company Specific Risk

Portfolios

Systematic or Nondiversifiable Risk

0 5 10 15 20 25 30 35 40 45

Number of Stocks in Portfolio

 Time Value of Money: An Introduction
• Time value of money refers to the fact that
– a dollar in hand today is worth more than a dollar promised
at some time in the future.

• Time allows one the opportunity to postpone consumption and

earn interest.

• The time value of money is used to determine whether future

benefits are sufficiently large to justify current outlays.

• Therefore, it is essential for financial managers to understand

the time value of money and its impact on financial asset
prices.
 Types of interest
Simple Interest
– Interest paid (earned) on only the original amount,
or principal, borrowed (lent).
– Interest is earned only on the original principal
amount invested.
• Compound Interest
- Interest paid (earned) on any previous interest
earned, as well as on the principal borrowed (lent).
- Interest is earned on both the initial principal and
the interest reinvested from prior periods.
 Future Value of a Single Amount
• Future value refers to the amount of money an investment
will grow to over some length of time at some given interest
rate.
• To determine the future value of a single cash flows, we need:
FVn= PV0 × (1 + r)n

• If you invested $2,000 today in an account that pays 6%

interest, with interest compounded annually, how much will
be in the account at the end of two years if there are no
withdrawals?
FV1 = PV (1+r)n
= $2,000 (1.06)2
= $2,247.20
 Present Value of a Single Amount
• Discounting is the process of translating a future value
or a set of future cash flows into a present value.
• Calculating present value is simply the inverse of
calculating future value (compounding).
FVn n
1
PV = = FVn
(1+r)n 1+r

n
• Where: 1 is the PV of $ 1 interest factor.

1+r
 Future Value and Present Value of an Annuity
• Annuity is a series of equal periodic payments (PMT)
for a specified number of periods.

• An annuity whose payments occur at the end of each

period is called an ordinary annuity.
– Payments on mortgages, car loans, and student
loans are generally made at the ends of the
periods and thus are ordinary annuities.

• If the payments are made at the beginning of each

period, it is called an annuity due.
– Rental lease payments, life insurance premiums.
 Future Value of an Ordinary Annuity
• The future value of an ordinary annuity can be computed as:

 (1 + i ) n − 1 
FV = PMT  
 i 
• If you plan to invest $1,000 each year beginning next year for three years
at an 8% compound interest rate. What will be the future value of the
investment?

FVA3 = $1,000{[(1 +0.08)3 - 1]/0.08}

= $1,000[(1.2597 - 1)/0.08]

= $1,000(3.246)

= $3,246
 Present Value of an Ordinary Annuity
• Single amount of money that should be invested
now at a given interest rate in order to provide for
an annuity for a certain number of future periods.
• PVAn = PMT{[1 - (1/(1 +r)n)]/r}

• If you will receive $1,000 each year beginning next

year for three years at an 8% compound interest
rate. What will be the present value of the
investment?
• PVAn = PMT{[1 - (1/(1 + r)n)]/r}
• PVA3 = $1,000{[1 - (1/(1.08)3)]/0.08} = $2,577
 Future Value of an Annuity Due
• An annuity due is one in which payments
are made at the beginning of each time
interval.

• FVAdue = PMT{[(1 + r)n - 1]/r} (1+ r)

 Present Value of Annuities Due
• Because each payment for an annuity due
occurs one period earlier, the payments will all
be discounted for one less period.

• The PV of an annuity due must be greater

than that of a similar ordinary annuity.

• PVAdue = PMT{[1 - (1/(1 +r)n)]/r}(1 + r)

= PVAn (1 + r)
 Perpetuities
• An important special case of an annuity arises when
the level stream of cash flows continues forever. Such
an asset is called a perpetuity because the cash flows
are perpetual.
• A perpetuity has the same cash flow every year forever.
• The present value of a perpetuity is simply:
• PV for a perpetuity = PMT/r
• For example, an investment offers a perpetual cash
flow of $500 every year. The return you require on such
an investment is 8 percent. What is the value of this
investment?
• The Perpetuity PV = $500/0.08 = $6,250
Self-Test Problems
 1.
Suppose you have predicted the following returns for stocks C and T in

three possible states of nature. What are the expected returns?

State Probability C T

– Boom 0.3 0.15 0.25

– Normal 0.5 0.10 0.20

– Recession ??? 0.02 0.01

• What is the expected return of each stock?

• If the risk-free rate is 6.15%, what is the risk premium of each stock?
• RC = .3(.15) + .5(.10) + .2(.02) = .099 = 9.99%

• RT = .3(.25) + .5(.20) + .2(.01) = .177 = 17.7%

• Stock C: 9.99 – 6.15 = 3.84%

• Stock T: 17.7 – 6.15 = 11.55%

 2.

Consider the previous given. What are the

variance and standard deviation for each stock?

• Stock C
– 2 = .3(.15-.099)2 + .5(.1-.099)2 + .2(.02-.099)2 = .002029
–  = 0.045
• Stock T
– 2 = .3(.25-.177)2 + .5(.2-.177)2 + .2(.01-.177)2 = .007441
–  = .0863
 3.

Consider the following information:

State Probability Return on ABC, Inc.

– Boom .25 .15
– Normal .50 .08
– Slowdown .15 .04
– Recession .10 -.03

• What is the expected return?

• What is the variance?
• What is the standard deviation?
• E(R) = .25(.15) + .5(.08) + .15(.04) + .1(-.03) =
.0805

• Variance = .25(.15-.0805)2 + .5(.08-.0805)2 +

.15(.04-.0805)2 + .1(-.03-.0805)2 = .00267475

• Standard Deviation = .051717985

 4.
Suppose you deposit $1,000 in an account that pays
12% interest, compounded quarterly. How much
will be in the account after eight years if there are
no withdrawals?
PV = $1,000
r = 12%/4 = 3% per quarter
n = 8 x 4 = 32 quarters
FV= PV (1 + r)n
= 1,000(1.03)32
= 2,575.10
 5.
Assume that you deposit $1,000 in an account
earning 7% simple interest for 2 years. What is
the accumulated interest at the end of the 2nd
year?

SI = P0(i)(n)
= $1,000(.07)(2)
= $140
End