•Financial Management

•An Introduction
Basic Forms of Business Organization
An Overview of the Financial
System
 Financial System Composed of:

 Financial Market
 Financial Institutions/Intermediaries
 Financial Instruments
 Financial Services
 Function of the Financial Markets

Financial
Funds Intermediaries Funds

Funds

Lender-Savers
Households Financial Borrower Spenders
Business firms Markets Funds Business Firms
Governments Funds Governments
Foreigners Households
Foreigners
 Financial Markets and Financial
Intermediaries
 Financial Markets and Financial
intermediaries have the basic functions of
getting people with surplus funds to those
who have a shortage of funds.
 Well functioning of the financial markets
and financial intermediaries are crucial to
economic health.
 Functions of the Financial
Markets
 Person A is having a powerful idea and
Person B is having surplus funds.
 The Role or function of the financial
markets (bonds and Stock markets) is get
people like A and B together.
 This requires flow of funds from savers to
borrowers.
 This flow can occur in two ways; Direct
Finance and Indirect finance route.
 Direct and Indirect Finance
 Direct Finance: Borrowers borrow funds
directly from the lenders in the financial
markets by selling them securities (financial
instruments), which are claims on the
borrower’s future income or assets.
 Securities are assets for the person who
buys them but liabilities to the person or
firms that sells or issue them.
 Direct and Indirect Finance

 Indirect Finance: Borrowers borrow funds

through financial intermediaries(banks,
insurance companies, pension funds) in the
form of loans and deposits.
 Banks issue a liability(saving deposits, time
deposits etc) use these funds to acquire an
asset by a loan to Honda motors or by
buying Honda motors bonds in the financial
markets.
 Function of the Financial Markets
INDIRECT FINANCE

Financial
Funds Intermediaries Funds

Funds

Lender-Savers
Households Financial Borrower Spenders
Business firms Markets Funds Business Firms
Governments Funds Governments
Foreigners Households
DIRECT FINANCE Foreigners
Why this channeling of Funds so
important for the economy?
 Financial markets are essential to promote
economic efficiency.
 Financial markets are essential to increase
production
 Financial markets are helpful to fulfill you
dreams.
 Financial markets enhance entrepreneurial
development and national welfare
 Functions of Financial
Intermediaries
 Financial intermediaries also do the
function of connecting people for
investments.
 Financial intermediaries are important as it;
 Reduces transaction costs
 Enables risk sharing
 Removes information costs and moral
hazards.
 Structure of Financial Markets
 Several categorization of financial markets
illustrate essential features of Financial
Markets.
 Debt and Equity markets.
 Primary and Secondary Markets
 Exchange and Over the counter Markets
 Money and Capital Markets
 Internationalization of the Financial
Markets.
 Debt and Equity Markets
 A firm or individual can obtain funds in a
financial markets in two ways; issue of
bonds or issue of equities.
 Bonds: A contractual agreement by the
borrower of the fund to pay the holder of
the instrument fixed amount at regular
interval (int. payments and principal) until a
specified time (maturity period).
 Debt and Equity Markets
 Equity: Claims to the share in the net income
(income after expenses and taxes) and the assets of
a business.
 If you hold one share in a company who has
issued 100 shares, you are entitled to get 1% of the
firm’s net income and 1% of the firm’s assets.
You are also entitled for periodic payments of
dividends. You have right to vote in electing the
board members.
 Debt and Equity Markets
 The equity holders are the residual
claimants; the corporation must pay the
bond holders first before paying to the
equity holders.
 The equity holders directly get advantages
from any increase in the corporation’s
profitability or asset values.
 Primary and Secondary Markets
 A primary market is a financial market in
which new issues of a security such as bond
or stocks are sold to initial buyers by the
corporations or Government.
 Secondary markets deals with securities that
previously issued. These securities are
resold in these markets.
 Primary and Secondary Markets
 The public does not know the primary
markets for securities as the transactions are
done behind closed doors.
 The Investment Banks assist an initial sale
of securities in the primary markets.
 It does this by underwriting securities.
 It guarantees a price for a corporation’s
security and then sale them to the public.
 Primary and Secondary Markets
 When an individual buys securities in the
secondary market, the corporation acquires
no new funds.
 A corporation gets new funds when its
securities are first sold in the primary
markets.
 Nonetheless, the functioning of the
secondary market is very important
 Functioning of the Secondary
Markets
 Secondary markets make the financial
instruments more liquid.
 They determine the price of the securities
those are issuing firms sale in the primary
markets.
 So, condition in the secondary market
enhances the credibility of the corporations.
 Hence, we will focus more on the
functioning of the secondary markets.
 Structure of the Financial
Markets
 Debt and Equity Market
 Primary and Secondary Market
 Exchanges and Over-the-Counter Markets

Secondary markets can be organized in two

ways; one is to organize exchanges, where
the buyers and sellers or their agents or
brokers meet at central location to conduct
trades. - BSE
 Structure of the Financial
Markets
 The other method of organizing a secondary
market is to have an over-the-counter(OTC)
market, in which dealers at different
locations who have inventory of securities
stand ready to buy and sale securities over
the counter – local stock exchanges.
 Structure of the Financial
Markets
 Money and Capital Markets:
 MM: Money market is a financial market in
which only short-term debt instruments are
traded. Generally, those instruments are
maturity less than one year.
 CM: Capital market is the market in which
longer term debt and equity instruments are
traded. (maturity greater than one year).
 Money and Capital Market
 Money market securities are usually less
fluctuating. Corporations use money market
instruments to earn money.
 Capital market instruments are generally
held by financial intermediaries, insurance
companies and pension funds.
 Money market is a market for very short
term
 Money Market
 Crowther defines, money market is the market that
deals in various grades of near monies.
 WR Wegess defines, what a bank balance is to an
individual the money market is to the country’s
credit system.
 Segments of Money Market:
Call Money Market
Acceptance Market
Bill discount Market
Collateral loan market.
 Call Money Market
 Call money market deals in loans at call and short
notices.
 Deals with extreme form of short term loans; 24
hours, 7-15 days maturity.
 They can be recalled on demand or shortest
possible notice.
 Normally, collaterals are not insisted upon.
 In India, CMM provides facilities for inter-bank
tending.
 Surplus suppliers of funds: UTI, SBI, LIC
 Call Money Market

 Call Money Rate is the interest rate at which

money is lended in the market.
 The market experiences some regular seasonal
changes; it is normally tighter during the busy
season (October – April) than during the slack
season (May – September). It is much tighter in
April.
 By its nature, the call money rate is highly
volatile, in 1990-91was 70 and 85 in 1991-92,
1995-96
 Internationalization of Financial
Markets
 With the ongoing financial liberalization,
each country now have a wider source of
funds.
 The traditional instruments in the
international bond market are known as
Foreign bonds.
 Foreign bonds are sold in the foreign
countries and are denominated in that
country’s currency.
 Internationalization of Financial
Markets
 Foreign bonds: German auto maker sales a
foreign bond in US denominated in US
dollar.
 Euro Bond: Bonds denominated in in a
currency other than that of the country in
which it is sold.
 Euro bond: A bond denominated in US
dollar and sold in London.
 Internationalization of Financial
Markets
 However, A bond denominated in euro is
called Euro Bond if it is sold outside the
countries that adopted Euro as their
currencies.
 Euro Currencies: A variant of euro bond is
euro currencies. Foreign currencies
deposited in banks outside the home
country. US dollar deposited in Banks
outside US.
 Financial Intermediaries: Risk
sharing and reducing information
costs.
 Financial intermediaries do help the
investors reducing risks they are exposed to
 They do this through the process called risk
sharing.
 They create and sale assets with risk
characteristics that people are comfortable
with.
 Risk Sharing
 However, the intermediaries do use these funds
acquired by selling to purchase other assets that
may have far more risk.
 The process of risk sharing is also called asset
transformation process.
 The asset transformation process turned the risky
assets into safer assets for investors.
 Te risk sharing process also calls for
diversification.
 Diversification: investing in the collection of
assets (portfolio)
 Asymmetric Information:
Adverse Selection and Moral
Hazard
 In financial markets one party does not know
enough about the other party to make accurate
decisions.
 This inequality is called Asymmetric Information.
 A borrower has better information about the
potential return and risk associated with the
project for which the fund borrowed that the
lender.
 Asymmetric Information
 Lack of information creates problems in the
financial systems on two grounds: before
transaction is entered and after.
 Adverse Selection: is the problem created by
asymmetric information before the transaction
occurs.
 Adverse selection in the financial markets occurs
when the potential borrowers who are the most
likely to produce an adverse outcome – bad credit
risk.
 Asymmetric Information
 Because adverse selection makes it more likely
that loans might be made to bad credit risks,
lender may decide not to make any loans even
though there are good credit risk in the
marketplace.
 Example:

Person X conservative: only when he is sure of

returning back, he come for borrowing.
Person Y aggressive investor with an idea of
investment of get-rich-quick scheme.
 Asymmetric Information
 If you know both the persons, you will lend
only person X.
 If you do not know, you may not lend
anybody because of the possibilities of
adverse selection.
 Though person X has excellent credit risk
might need loan for worthwhile investment.
 Moral Hazard

 Moral hazard is the problem created by

asymmetric information after the transaction
occurs.
 Moral hazard in the financial markets is the
risk(hazard) that the borrower might engage in
activities that are undesirable (immoral) from the
lender’s point of view.
 The existence of moral hazard lowers the
probability that loans will be repaid.
 So, Lender will decide not to make a loan.
 Moral Hazard
 Suppose that you have made 1 lakh loan to person
A, who promised to make a cyber café and word
processing job to help students process their
assignments and term papers.
 However, he started gambling in the market with 1
lakh
 There is a possibility of getting back or loosing.
 Because of asymmetric information, you will be
prevented from giving loans to him.
 Financial Intermediaries can
solve these problems.
 With financial intermediaries in the market,
small saves will deposit their money in the
banks and they screen out bad risk and good
risk.
 So, the risks due to asymmetric information
and adverse selection are removed.
 •What is Finance Anyway?
What is this course all about?
• Accounting is the language of business.
• Finance uses accounting information
together with other information to make
decisions that affect the market value of the
firm.
• There are Four primary decision areas that
are of concern.
 •Four decision areas in finance:
• Investment decisions - What assets should
the company hold? This determines the
left-hand side of the balance sheet.
• Financing decisions - How should the
company pay for the investments it makes?
This determines the right-hand side of the
balance sheet.
• Dividend decisions - What should be done
with the profits of the business?
• Working capital management decisions
 Financial Management
 Acquisition of funds and their effective
utilization so as to achieve the goal of
financial Management
 •All management decisions
should help to accomplish the
goal of the firm!

•What should be the goal of the firm?

 Goals of Firm
 What should be the goal of a corporation?
– Maximize profit?
– Minimize costs?
– Maximize market share?
– Maximize the current value of the company’s
stock?
 Goals of the Firm
 Goal of the firm cam be stated in three ways
– Maximize Shareholder Wealth
– Maximize the Value of the Firm
– Maximize the Share Price

 Profit maximization is not the same as wealth

maximization. It fails to account for:
– differences in the level of cash flows
– the timing of the cash flows, and
– the risk of the cash flows.
 •Many people think the goal is to
maximize profits.
• Would this mean short-term profit, or long-
term profit? Businesses are sometimes
criticized for being overly concerned about
short-term profits results rather than the
long-term strategic positioning of the
company.
 •What about risk? Isn’t risk
important as well as profits?
• How would the stockholders of a small
business react if they were told that their
manager canceled all casualty and liability
insurance policies so that the money spent
on premiums could go to profit instead.
• Even though the expected profits increased
by this action, it is likely that stockholders
would be dissatisfied because of the
increased risk they would bear.
 •The common stockholders are
the owners of the corporation!
• Stockholders elect a board of directors who
in turn hire managers to maximize the
stockholders’ well being.
• When stockholders perceive that
management is not doing this, they might
attempt to remove and replace the
management, but this can be very difficult
in a large corporation with many
stockholders.
•More likely, when stockholders
are dissatisfied they will simply
sell their stock shares.

•This action by stockholders will

cause the market price of the
company’s stock to fall.
•When stock price falls relative
to the rest of the market (or
relative to the rest of the
industry) ...
•Management is failing in their job to
increase the welfare (or wealth) of the
stockholders (the owners).
•Conversely, when stock price is
rising relative to the rest of the
market (or industry), ...

•Management is accomplishing their

goal of increasing the welfare (or
wealth) of the stockholders (the
owners).
 •The goal of the firm should be to
maximize the stock price!
• This is equivalent to saying the goal is to
maximize owners’ wealth.
• Note that the stock price is affected by
management’s decisions affecting both risk
and profit.
• Stock price can be maintained or increased
only when stockholders perceive that they
are receiving profits that fully compensate
them for bearing the risk they perceive.
 •Important focal points in the
study of finance:
• Accounting and Finance often focus on
different things
• Finance is more focused on market values
rather than book values.
• Finance is more focused on cash flows
rather than accounting income.
 •Why is market value more
important than book value?
• Book values are often based on dated
values. They consist of the original cost of
the asset from some past time, minus
accumulated depreciation (which may not
represent the actual decline in the assets’
value).
• Maximization of market value of the
stockholders’ shares is the goal of the firm.
 Why is cash flow more important
than accounting income?
• Cash flow to stockholders (in the form of
dividends) is the only basis for valuation of
the common stock shares. Since the goal is
to maximize stock price, cash flow is more
directly related than accounting income.
• Accounting methods recognize income at
times other than when cash is actually
received or spent.
 •One more reason that cash flow
is important:

• When cash is actually received is important,

because it determines when cash can be
invested to earn a return.
[Also: When cash must be paid determines
when we need to start paying interest on
money borrowed.]
 •Examples of when accounting
income is different from cash
flow:
• Credit sales are recognized as accounting
income, yet cash has not been received.
• Depreciation expense is a legitimate
accounting expense when calculating
income, yet depreciation expense is not a
cash outlay.
• A loan brings cash into a business, but is
not income.
 •More examples:
• When new capital equipment is purchased,
the entire cost is a cash outflow, but only
the depreciation expense (a portion of the
total cost) is an expense when computing
accounting income.
• When dividends are paid, cash is paid out,
though dividends are not included in the
calculation of accounting income.
•Definitions: Operating income vs.
operating cash flow

• Operating income = earnings before interest

and taxes (EBIT). This is the total income
that the company earned by operating
during the period. It is income available to
pay interest to creditors, taxes to the
government, and dividends to stockholders.
 •Operating cash flow:
• Operating cash flow
= EBIT + Depreciation - Taxes.
This definition recognizes that
depreciation expense is subtracted in
computing EBIT, though it is not a cash
outlay.

• It also recognizes that taxes paid is a cash

outlay.
 Role of Finance in a Typical
Business Organization

Board of Directors

President

VP: Sales VP: Finance VP: Operations

Treasurer Controller

Credit Manager Cost Accounting

Inventory Manager Financial Accounting

Capital Budgeting Director Tax Department

 Corporate Finance
 Every decision that a business makes has financial
implications, and any decision which affects the
finances of a business is a corporate finance decision.

 Defined broadly, everything that a business does fits

under the rubric of corporate finance.

 Regardless of whether you work for a corporation or

are an external party with an interest in a particular
corporation, understanding and being able to analyze
corporate decisions is important
 First Principles of Corporate Finance
 Invest in projects that yield a return greater than the minimum
acceptable hurdle rate with adjustments for project riskiness.

 Choose a financing mix that minimizes the hurdle rate.

 If there are not enough investments that earn the hurdle rate,
return the cash to stockholders.

– These decision criteria will be consistent with the objective

of the firm: Maximize the Value of the Firm
Multinational/International
Financial Management
 Percentage of Revenue and Net Income from
Overseas Operations for 10 Well-Known
Corporations, 2001
Company % of Revenue from % of Net Income from
overseas overseas
Coca-Cola 60.8 35.9
Exxon Mobil 69.4 60.2
General Electric 32.6 25.2
General Motors 26.1 60.6
IBM 57.9 48.4
JP Morgan Chase & Co. 35.5 51.7
McDonald’s 63.1 61.7
Merck 18.3 58.1
3M 52.9 47.0
Sears, Roebuck 10.5 7.8