INTRODUCTION TO FINANCIAL MANAGEMENT

Syed Irfan Ahmed

What is Financial Management?

Financial Management can be defined as: The management of the finances of a business / organisation in order to achieve financial objectives Or prudent use of business capital to attain objectives

Objectives
Taking a commercial business as the most common organisational structure, the key objectives of financial management would be to: Create wealth for the business Generate cash, and Provide an adequate return on investment bearing in mind the risks that the business is taking and the resources invested

Key elements
There are three key elements to the process of financial management: (1) Financial Planning Management need to ensure that enough funding is available at the right time to meet the needs of the business. In the short term, funding may be needed to invest in equipment and stocks, pay employees and fund sales made on credit. In the medium and long term, funding may be required for significant additions to the productive capacity of the business or to make acquisitions.

Key elements
(2) Financial Control Financial control is a critically important activity to help the business ensure that the business is meeting its objectives. Financial control addresses questions such as:
Are assets being used efficiently? Are the businesses assets secure? Do management act in the best interest of shareholders and in accordance with business rules?

Key elements
(3) Financial Decision-making The key aspects of financial decision-making relate to investment, financing and dividends: Investments must be financed in some way however there are always financing alternatives that can be considered. For example it is possible to raise finance from selling new shares, borrowing from banks or taking credit from suppliers A key financing decision is whether profits earned by the business should be retained rather than distributed to shareholders via dividends. If dividends are too high, the business may be starved of funding to reinvest in growing revenues and profits further.

What does a financial manager do?

Financial management is a distinct area of business management - i.e. financial manager has a key role in overall business management Prudent or rational use of capital resources -proper allocation and utilization of funds Careful selection of the source of capital Determining the debt equity ratio and designing a proper capital structure for the corporate Goal achievement - ensuring the achievement of business objectives viz. wealth or profit maximization.

What does a financial manager do?

Overall the financial manager deals with: Performing the regular finance functions including financial planning including assessing the funds requirement, identifying and sourcing funds, allocation of funds and income and controlling the use or utilization of funds towards achieving the primary goal of profit/wealth maximization. Performing the non-recurring functions including, though not exclusively, the preparation of financial plan at the time of promotion of the business enterprise, financial readjustment during liquidity crisis, valuation of enterprise at the time of merger or reorganization and such other episodic activities of great financial implications.

Goal of Financial Management

Maximization of owners wealth A. Maximize firm value B. Agency relationship 1. Principals 2. Agents a. Moral hazard: Agents surreptitiously act in own best interest b. Conflicts of interest (1) grant oneself large salary increases (2) pursue less profitable pet projects (3) unethical accounting (4) fight a merger that may be in shareholders best interest (5) excessive perquisites

Goal of Financial Management

c. Agency costs (1) monitoring costs (2) opportunity costs d. Minimization of conflicts (1) compensation plan (a) should be determined by outside directors (b) adequate salary (c) bonus plans (2) bad publicity (3) legal liability (4) hostile takeover

Goal of Financial Management

C. Social responsibility: anti-pollution
devices, fair hiring practices, product safety 1. Cost/benefit analysis 2. Society benefits a. Efficient, low cost products b. New products desired by consumers c. Good locations & times d. Efficient, courteous service

Raising Capital
I. Financial Markets A. Primary versus secondary? 1. Use Investment bankers 2. Target Organized exchanges a. Major b. Regional 3. Trade in Over-the-counter market 4. ECNs

Raising Capital
5. Financial intermediaries
a. b. c. d. Deposit types / Commercial banks Life insurance companies Pension funds Mutual funds

Money markets vs. capital markets

Other markets to think about. C Spot vs. Futures D Public vs. Private E REAL vs. Financial

INTEREST RATE = COST OF MONEY

A. Fisher equation 1. Nominal rfr = real rfr + expected inflation 2. Example 1: Assume the real risk-free rate has averaged 2% in recent years and the one-year Treasury security is yielding 8%. What does this imply expected inflation is for the year? 3. Example 2: Assume inflation is expected to be 3%, 3.2%, and 3.6% in the next three years, respectively. The real risk-free rate has averaged 2%. What rate would you expect to observe on a 3-year Treasury security?

INTEREST RATE = COST OF MONEY

4. Example 3: The expected inflation rates for the next 2 years are 1% and 1.2%, respectively. A 3-year Treasury note is yielding 5%, and the real risk-free rate has averaged 2% in recent years. What does this imply the expected rate of inflation in year three is?

INTEREST RATE = COST OF MONEY

5. TIPS: Treasury Inflation Protected Securities (1997) a. Coupon fixed; face value adjusted for inflation b. Difference in yields between nonindexed T-bond and TIPS of same maturity proxies for expected annual inflation rates over the period. B. Factors affecting cost of money 1. 2. 3. 4. Production opportunities: Time preferences for consumption Expected inflation Risk

INTEREST RATE = COST OF MONEY

C. Nominal interest rate=
real risk-free rate +expected inflation (inflation premium) +default risk premium + liquidity premium +maturity risk premium We can also add + country risk + exchange rate risk But why have we added?

INTEREST RATE = COST OF MONEY

D. Factors affecting supply and demand conditions

1. Monetary policy tools a. Discount rate b. Reserve requirement c. Open market operations 2. Fiscal policy a. Government spending b. Taxation c. Deficit management

INTEREST RATE = COST OF MONEY

E. Term structure of interest rates 1. Relationship between yield and time to maturity

2. Yield curves
* Normal yield curve/positive yield curve (short-term yields < longer term yields) * Abnormal yield curve/negative yield curve (short-term yields > longer term yields) * Flat yield curve (no difference between sortterm yields and long-term yields) What does Pure expectations theory say??

Pure Expectations Hypothesis

The PEH contends that the shape of the yield curve depends on investors expectations about future interest rates. If interest rates are expected to increase, L-T rates will be higher than S-T rates, and vice-versa. Thus, the yield curve can slope up, down, or even bow.

Alternative Forms of Business Organization

Sole proprietorship
Partnership Corporation

Sole Proprietorship
Advantages:
Ease of formation Subject to few regulations No corporate income taxes

Disadvantages:
Limited life Unlimited liability Difficult to raise capital

Partnership

A partnership has roughly the same advantages and disadvantages as a sole proprietorship.

Corporation
Advantages:
Unlimited life Easy transfer of ownership Limited liability Ease of raising capital

Disadvantages:
Double taxation Cost of set-up and report filing