Overview of Financial
Management
Goal of the Firm
1) Profit Maximization?
this goal ignores:
a) TIMING of Returns
(Time Value of Money)
b) UNCERTAINTY of Returns
(Risk)
Goal of the Firm
2) Shareholder Wealth
Maximization?
this is the same as:
a) Maximizing Firm Value
b) Maximizing Stock Price
Stock Prices and Shareholder
Value
The primary financial goal of management is
shareholder wealth maximization, which
translates to maximizing stock price.
Value of any asset is present value of cash flow
stream to owners.
Most significant decisions are evaluated in terms
of their financial consequences.
Stock prices change over time as conditions
change and as investors obtain new information
about a company’s prospects.
Determinants of Stock Prices
Managerial Actions, the Economic
Environment, Taxes, and the Political Climate
“Expected” “Perceived”
Investor Returns Risk
Stock’s
Price
1-5
What determines a firm’s
fundamental, or intrinsic, value?
Intrinsic value is the sum of all the future
expected free cash flows when converted
into today’s dollars:
FCF1 FCF2 FCF∞
Value = + +…+
(1 + WACC)1 (1 + WACC)2 (1 + WACC)∞
What three aspects of cash flows
affect an investment’s value?
Amount of expected cash flows (bigger is
better)
Timing of the cash flow stream (sooner is
better)
Risk of the cash flows (less risk is better)
7
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.
8
Profit vs Cash
9
Profit vs Cash
10
Profit vs Cash
ACCOUNTING
11
Profit vs Cash
12
Profit vs Cash
ACCOUNTING
13
Profit vs Cash
14
Profit vs Cash
15
Profit vs Cash
16
What is the weighted average
cost of capital (WACC)?
WACC is the average rate of return required by
all of the company’s investors.
WACC is affected by:
Capital structure (the firm’s relative use of debt and
equity as sources of financing)
Interest rates
Risk of the firm
Investors’ overall attitude toward risk
17
Value Maximization
Investment Decisions
Risk &
Valuation
Financing Decisions Value
Return Maximization
Income Distribution
Decision
18
What is Finance
Math &
Statistics
Economics
Accounting Accounting
Economics provides
developed the financial
notion that asset information
value is based on Finance: (i.e. cash flow)
its future cash flow .
• Financial Management/
Corporate Finance
• Capital Markets
• Investments
Social
Sciences
ETHICS
Operation
Management
Important Business Trends Affecting Finance
Increased globalization Ever improving IT Corporate Governance
Finance Within the Organization
Board of Directors
Chief Executive Officer (CEO)
Chief Operating Officer (COO) Chief Financial Officer (CFO)
Marketing, Production, Human Accounting, Treasury, Credit,
Resources, and Other Operating Legal, Capital Budgeting, and
Departments Investor Relations
1-20
The Corporation Life Cycle
Proprietorship
Advantages:
Limitations:
Easy & inexpensive formation; Subjects to only few
Difficult to raise capital; Unlimited personal liability;
regulations; Not subject to corporate taxation
Corporation
Advantages: Disadvantages:
Easy transferability of ownership interest; Limited liability → Complex & time consuming formation;
Easy to raise capital Subject to double taxation
21
Becoming a Public Corporation
and Growing Afterwards
Initial Public Offering (IPO) of Stock
Raises cash
Allows founders and pre-IPO investors to
“harvest” some of their wealth
Subsequent issues of debt and equity
22
Conflicts Between Managers and
Stockholders
Managers are naturally inclined to act in their
own best interests (which are not always the
same as the interest of stockholders).
But the following factors affect managerial
behavior:
Managerial compensation packages
Direct intervention by shareholders
The threat of firing
The threat of takeover
Agency Problems and
Corporate Governance
Agency problem: managers may act in their own
interests and not on behalf of owners
(stockholders)
Corporate governance is the set of rules that
control a company’s behavior towards its
directors, managers, employees, shareholders,
creditors, customers, competitors, and
community.
Corporate governance can help control agency
problems.
24
Conflicts Between Stockholders and
Bondholders
Stockholders are more likely to prefer riskier
projects, because they receive more of the
upside if the project succeeds. By contrast,
bondholders receiving fixed payments are more
interested in limiting risk.
Bondholders are particularly concerned about
the use of additional debt.
Bondholders attempt to protect themselves by
including covenants in bond agreements that
limit the use of additional debt and constrain
managers’ actions.
Financial Institutions:
Capital Formation Process
Direct Transfer
Business (Borrowers) sell securities directly to Savers
Example: A corporation issues securities (equity/debt) to (a group) of investors.
Through Investment Banking Houses
Business (Borrowers) sell securities to Savers through investment banking houses
Example: In an IPO, seasoned equity offering, or debt placement, company sells
security to investment banking house, which then sells security to investor.
Through Financial Intermediaries
• Intermediary obtain funds from Savers in exchange for its own securities
• Intermediaries uses the fund to purchase and hold securities from Business
(Borrowers)
• Commercial Banks, Life Insurance Companies, Mutual Funds, Pension Funds
• Example: An individual deposits money in bank and gets certificate of deposit, bank
makes commercial loan to a company (bank gets note (loan agreement) from
company).
Financial Management - Reza Masri 26
Investment Banking
& Investment Management
Sell Side: Underwriting & selling
corporations securities to investors
Securities Securities
Investment
Corporations Banking Investors
Houses
Dollars Dollars
Buy Side: Advising investors &
managing investors fund in buying
securities
Financial Management - Reza Masri 27
What are some types of
markets?
A market is a method of exchanging one
asset (usually cash) for another asset.
Physical assets vs. financial assets
Spot versus future markets
Money versus capital markets
Primary versus secondary markets
Private versus public markets
28
Primary vs. Secondary
Security Sales
Primary
New issue (IPO or seasoned)
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.
29
Financial Institutions
Investment banks
Commercial banks
Pension funds
Insurance companies
Mutual funds
Hedge funds
Private equity
30
Financial Institutions
Investment banks
Commercial banks
Pension funds
Insurance companies
Mutual funds
Hedge funds
Private equity
31
Stock Market Efficiency
Highly Inefficient Highly Efficient
small companies, not large companies, followed
followed by many by many analysts, good
analysts, not much contact communications with
with investors investors
32
Capital Markets: Selected Comparison
Market Capitalization (USD billions)
800.0 603.9
600.0
380.1 336.7
400.0 280.6
140.9
200.0 32.5
0.0
Singapore Malaysia Indonesia Thailand Philippines Vietnam
Number of Issuers
984
1,000 781 735
549 415
500 256
0
Malaysia Singapore Vietnam Thailand Indonesia Philippines
as of Nov. 2010
Financial Markets
Implications of active financial markets:
FINANCING alternatives for corporations
INVESTMENT alternatives for investors
Financial Management - Reza Masri 34
Why is corporate finance
important to all managers?
Corporate finance provides the skills
managers need to:
Identify and select the corporate strategies and
individual projects that add value to their firm.
Forecast the funding requirements of their
company, and devise strategies for acquiring
those funds.
35
Career Alternatives in Finance
Commercial Credit Analyst Investment Corporate Finance
Banking Banking
Loan Officer Capital Market
Corporate Treasurer Project Finance
Finance
Financial Analyst Advisory
Credit Manager Trading
Investor Relation Research
Controller Sales/Brokerage
Financial Wealth Management Rating Analyst
Planning
Portfolio Portfolio Manager
Insurance Actuary Management
Portfolio Management
Agent/Broker Marketing
Underwriter Investment Advisory
Risk Manager Mutual Fund Analyst
