INTRODUCTION TO FINANCIAL MANAGEMENT How to balance shareholder value/maximization of

profit and the interest of society?

Finance - The art and science of managing money.
To maximize value, firms must develop products
- It is concerned with the process, institutions, markets,
that consumers want, produce the products efficiently,
and instruments involved in the transfer of money
sell them at competitive prices, and observe laws
among individuals, businesses, and governments.
relating to corporate behavior.
FINANCIAL MANAGEMENT - planning, organizing,
FINANCIAL MARKETS AND INSTITUTIONS
directing, and controlling the financial activities such as
procurement and utilization of funds of the enterprise Diagram of the Capital Formation Process of Business

- focuses on decisions relating to how much and what

type of assets to acquire, how to raise the capital
needed to purchase assets and how to run the firm to
maximize its value

LEGAL FORMS OF BUSINESS ORGANIZATIONS

1. SOLE PROPRIETORSHIP
2. PARTNERSHIP
3. CORPORATIONS
TYPES OF MARKETS
SCOPE
1. Physical Asset Markets versus Financial Asset
1. Investment Decisions-includes decisions for Markets
investment in fixed assets (capital budgeting) and
Physical Assets Markets-for tangible products such as
investment in current assets (working capital)
computers, food, etc.
2. Financial decisions- relates to raising of finance from
Financial Asset Markets-deals with stocks, bonds, notes
various resources which will depend upon decisions on
and mortgages
type of source, period of financing, cost of financing and
returns 2. Money Markets versus Capital Markets
3. Dividend decisions-decisions with regards to net Money Markets- market or short-term, highly liquid
profit distribution debt securities
OBJECTIVES Capital Markets-markets for intermediate or long-term
debt securities and corporate stocks
1. To ensure regular and adequate supply of funds.
3. Primary Market versus Secondary Markets
2. To ensure adequate returns to the shareholders.
Primary Market-markets in which corporation raise the
3. To ensure optimum fund utilization.
capital
4. To ensure safety of investment.
Secondary Market- markets in which existing, already
5. To plan a sound capital structure. outstanding securities are traded among investors

FUNCTIONS OF FINANCIAL MANAGEMENT FINANCIAL INSTITUTIONS

1. Estimation of capital requirements Investment Banks

2. Determination of capital composition Commercial Banks

3. Choice of surplus of funds Financial Services Corporations

4. Investment of funds Credit Unions/Cooperative Associations

5. Disposal of surplus Pension Funds

6.Management of cash Life Insurance Companies

7. Financial controls Mutual Funds

Exchange Traded Funds

Hedge Funds

Private Equity Companies

FUNDAMENTAL CONCEPTS IN FINANCIAL Liquidity Ratios
MANAGEMENT
1. Current Ratio = Current Assets ÷ Current Liabilities
FINANCIAL STATEMENTS, CASH FLOWS AND TAXES
Evaluates the ability of a company to pay short-term
Financial Statements and Reports obligations using current assets (cash, marketable
securities, current receivables, inventory, and
Annual Reports
prepayments).
1. Verbal Section - describes the firms operating
2. Acid Test Ratio = Quick Assets ÷ Current Liabilities
results during the past year and discusses new
developments that will affect future operation Also known as "quick ratio", it measures the ability of a
2. Four Basic Financial Statements company to pay short-term obligations using the more
a. Balance Sheet/Statement of Financial liquid types of current assets or "quick assets" (cash,
Position marketable securities, and current receivables).
b. Income Statement/Statement of Financial
3. Cash Ratio = (Cash + Marketable Securities) ÷ Current
Performance
Liabilities
c. Statement of Cash Flows
d. Statement of Stockholders’ Equity Measures the ability of a company to pay its current
liabilities using cash and marketable securities.
Balance Sheet/Statement of Financial Position - shows Marketable securities are short-term debt instruments
what the company owns and who has claims on that are as good as cash.
those assets as of a given date
4. Net Working Capital = Current Assets - Current
Income Statement/Statement of Financial Liabilities
Performance - shows the firms sales and costs and
profit as of a given date Determines if a company can meet its current
obligations with its current assets; and how much
Statement of Cash Flows - shows how much cash the excess or deficiency there is.
firm began with, how much cash it ended up with, and
what it did to increase or decrease its cash MANAGEMENT EFFICIENCY RATIOS

Statement of Stockholders’ Equity - shows the amount -measures how effectively a firm is managing its assets
of equity the stockholders had at the start of the year, -set of ratios that answer the question: Does the
the items that increased or decreased equity and the amount of each type of asset seem reasonable, too
equity at the end of the year high, or too low in view of current and projected sales?
INCOME TAXES Management Efficiency Ratios
1. Individual Taxes
2. Corporate Taxes

ANALYSIS OF FINANCIAL STATEMENTS

RATIO ANALYSIS

LIQUIDITY RATIOS

-measures the firm’s ability to pay off debts that are

maturing within the year

-answers the question: will the firm be able to pay off

debts as they come due and thus remain a viable
organization

Liquid asset-an asset that can be converted to cash

quickly without having to reduce the asset’s price very
much
 PROFITABILITY RATIOS

-assess a company's ability to earn profits from its sales

or operations, balance sheet assets, or shareholders'
equity

-indicate how efficiently a company generates profit

and value for shareholders

-it also shows the combined effects of liquidity, asset

management and debt on operating results

Profitability Ratios

LEVERAGE (DEBT MANAGEMENT RATIOS)

-measures how firm manages its debt

Valuation and Growth Ratios
-The use of debt will increase or “leverage up” a firm
ROE if the firm earns more on its assets than the
interest rate it pays on debt.

Leverage (Debt Management) Ratios

TYING THE RATIOS TOGETHER: The DuPont Equation

Using Financial Ratios to Assess Performance

1. Comparison to Industry Average

2. Benchmarking -process of comparing a
particular company with as set
of benchmark companies
3. Trend Analysis -an analysis of firm’s financial
ratios over time, used to estimate the likelihood
of improvement or deterioration in its financial
condition

TIME VALUE OF MONEY

INTEREST RATES, RISK AND RETURN, BONDS & STOCKS BONDS AND THEIR VALUATION

Cost Of Money BOND

4 factors affecting the cost of money • A long-term contract under which a borrower
agrees to make payments of interest and
a) production opportunities - the investment
principal on specific dates to the holders of the
opportunities in productive (cash generating)
bond
asset
b) time preferences for consumption - the • Are issued by corporations and government
preference of consumers for current agencies that are looking for long-term debt
consumption as opposed to saving for future
TYPES OF BONDS
consumption
c) risk - in a financial market, the chance that an 1. Treasury Bonds - bonds issued by the
investment will provide a low or negative return government
d) inflation - the amount by which prices increase
over time 2. Corporate Bonds -issued by business firms

3. Municipal Bonds - issued by local

governments

4. Foreign Bonds - issued by a foreign

government

KEY CHARACTERISTICS OF BONDS

1. PAR VALUE - stated face value of the bond

2. COUPON INTEREST RATE - payments set at

the time the bond is issued and remains in force
during the bond’s life

3. MATURITY DATE - date on which the par

value must be paid
MACROECONOMIC FACTORS THAT INFLUENCE
4. CALL PROVISION - right of the issuer to call
INTEREST RATE LEVELS
the bonds for redemption
1. GOVERNMENT RESERVE POLICY - if the government
5. SINKING FUNDS - sinking fund provision
wants to stimulate the economy, it increases the money
facilitates the orderly retirement of the bond
supply
- it requires the issuer to buy back a specified
2. GOVERNMENT BUDGET DEFICITS OR SURPLUSES -
percentage of the issue each year
deficits should be covered with borrowings which will
increase the demands for funds thus pushing the 6. Other Features
interest rates upward
convertible bonds- bonds that are convertible
3. INTERNATIONAL FACTORS into stock

4.BUSINESS ACTIVITY putable bonds –bonds that has provision to

allow investors to require the company to pay
RISK AND RETURN
in advance
KEY IDEAS
• BOND VALUATION
1. There is trade-off between risk and return.
- The value of the bond is the present
2. Diversification is crucial. value of the cash flows the asset is
expected to produce
3. Real Returns are what matter.
Bond’s Value= interest rate payments +
4. The risk of an investment often depends on par/maturity value of the bond
how long you plan to hold the investment.

5. While the past gives us insights into the risk and

returns on various investments, there is no
guarantee that the future will repeat the past.
STOCK AND THEIR VALUATION

Legal Rights and Privileges of Common Stockholders

1. Control of the Firm

2. Preemptive Right

STOCK VALUE

The value of a share of common stock depends

on the cash flows it is expected to provide

-dividends + price of stock when it is sold

PREFERRED STOCK - entitles its owner to regular, fixed

dividend payments

Value of the Preferred Stock = Dividend of the preferred

stock/rate of preferred stock

INVESTING IN LONG-TERM ASSETS: CAPITAL

BUDGETING

THE COST OF CAPITAL

CAPITAL BUDGETING
Firm’s Capital Components

1. Debt
2. Preferred Stock
3. Equity

Weighted Average Cost of Capital (WACC)

WACC is the weighted average of the component costs

of debt, preferred and common equity.

WACC= (% of debt) (After tax cost of debt) + (% of

preferred stock)(cost of preferred stock) + (% of
common equity)(cost of common equity)
CASH FLOW ESTIMATION AND RISK ANALYSIS

CAPITAL STRUCTURE AND DIVIDEND POLICY

DISTRIBUTION TO SHAREHOLDERS: DIVIDENDS AND

SHARE REPURCHASES
CAPITAL STRUCTURE AND LEVERAGE