Lecture 1

Introduction to Financial Management:

Overview of Сorporate Financial Decisions

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What is Financial Management?

2
What is Financial Management?

Financial Management Concerns the

acquisition, financing, and management
of assets with some overall goal of the
firm in mind.

The Investment, Financing and Asset Management

Decisions

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 Acquisition – The Investment
Decisions
• Determine the assets that should be acquired or
disposed (RHS of balance sheet)
– Most important of the three decisions.
• Financial managers are concerned with:
– What is the optimal firm size?
– What specific assets should be acquired?
– What assets (if any) should be reduced or eliminated?

4
 Financing Decisions
• Determine how the assets (LHS of balance sheet)
will be financed (RHS of balance sheet).
• Financial managers are concerned with:
– What is the best type of financing?
– What is the best financing mix?
– What is the best dividend policy (e.g. dividend-payout
ratio)?
– How will the funds be physically acquired?

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 Asset Management Decisions
• How does a firm manage existing assets
efficiently?
• Financial Manager has varying degrees of
operating responsibility over assets.
– Greater emphasis on current asset management
than fixed asset management (Thus: WCM).

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 What is the Goal of the
Firm?
Value creation occurs when we maximize the share
price for current shareholders.

Thus:
– The goal of the firm is maximization of shareholder
wealth
or
– Maximization of the price of the existing common stock

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The Modern Corporation

Modern Corporation

Shareholders Management

There exists a SEPARATION between

owners and managers.
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 The Role of Management

Management acts as an agent for

the owners (shareholders) of the
firm.
• An agent is an individual authorized
by another person, called the
principal, to act in the latter’s behalf.

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 Financial decisions
Capital structure and cost of capital

Investment decision – how Financing decision – where is

much to invest and in what money going to come from
assets

Financial
Operations Manager
Financial
Investments

Financing
REAL SYSTEM Corporate Finance markets
FINANCIAL SYSTEM

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r (r>k) k
 Functions of the Financial
Manager
2. Investments 1a. Raising funds

Operations Financial 1b. Obligations Financial

(plant, Manager (stocks, debt Markets
securities) (investors)
equipment, 3. Cash
projects) from
operational
activities
4. Reinvesting 5. Dividends or
interest
payments

Finance function – managing the cash flow 11

 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
(saving deficit units)

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 The Financial Intermediation Process
Households

Savings Loans Return on

financial
Repayments
assets held

Net Financial
government markets Direct
borrowing purchase
of shares, etc
Borrowing Return on
or the sale bonds and
Government of shares for shares, etc
investment

Retained
Taxes Business earnings

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Financing decisions
Financing
decisions

Internal corporate External sources

financing of funds

Direct financing Indirect financing

Retained
(financial markets (financial
earnings
Instruments) Intermediaries)

Stocks Loans

Debt instruments
(bonds, CPs, CDs etc.)

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 Financial markets

Financial markets

Organized exchanges
Primary markets Money market
Over-the-counter
Secondary markets Capital market

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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 – Secondary
transactions take place.
– allows investors to trade financial instruments
between themselves.

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 Money and capital markets
Money markets – short-term assets (maturity less
than 1 year) are traded:
Certificates of deposits (CDs)
Commercial papers (CPs)
Treasury bills
Capital markets – long-term assets (maturity longer
than 1 year) are traded:
Stocks
Corporate bonds
Long-term government bonds

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 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.
• Stocks not listed on the organized exchanges are
traded in the 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 telecommunications network.

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 Prices of Financial Instruments
• Prices of financial instruments are
determined in equilibrium by demand and
supply forces
• They reflect market expectations regarding
the future as inferred from currently
available information

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 Types of Financial Instruments
• Financial Instruments can be classified
into 4 different types according to:
– Type of Issuer
– Maturity
– Type of Yield
– Risk Level

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Types of financial instruments
Type of issuer

Government, government
agencies

Regions, Municipalities

Corporations

Financial institutions

Others

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Types of financial instruments

Maturity

Short-term instruments

Long-term instruments
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Types of financial instruments
Type of yield

Dividend bearing
(stocks)

Discount debt
Instruments
(treasury bills)

Interest income instruments (bonds)

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Types of financial instruments
By level of risk

Risk-free instruments (treasury bills)

Low-risky securities (treasury notes and bonds),

investment grade corporate bonds,
blue-chip stocks)

High-risky securities (junk bonds,

stocks), derivatives

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 The Ten Principles That Form The
Foundations of Financial Management
• “…although it is not necessary to
understand finance in order to understand
these principles, it is necessary to
understand these principles in order to
understand finance.”

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 Finance: Historic Evolution

2000-
M
o Behavioral finance
d Markets Efficiency
Chaos Theory,
e Non Linear Dynamics
1990- r
Paradigm years 100

n
Methods based on Fuzzy Sets Theory
Financial Innovation
(Kaufmann y Gil, 1986-87)
1980- A
p Options Valuation Models (Black y Scholes, 1973)
p
r APT Model
CAPM (widening and reformulation) (Ross, 1970)
o
1970- a Efficient
c Financial Structure Capital Assets Pricing Model Market Theory
h (Modigliani, Miller, 1958) (CAPM) (Sharpe, 1963-4, Lintner,
(Fama, 1970)
1965)
Portfolio selection Theory
(Markowitz, 1952,1959) Dividends Policy (Modigliani, Miller, 1963)
1950-

Classical Approach
1900- 26
 Principle 1: The 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 its
expected return will be.

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 Principle 2: The Time Value of Money

• A shilling received today is worth more than a

shilling received in the future.
– Because we can earn interest on money received today,
it is better to receive money earlier rather than later.

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Principle 3: Cash – Not Profits – Is the King

• Cash Flow, not accounting profit, is used

as our measurement tool.
– Cash flows, not profits, are actually received
by the firm and can be reinvested.

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Principle 4: Incremental Cash Flows

• It is only what changes that counts

– The incremental cash flow is the difference between
the projected cash flows if the project is selected,
versus what they will be, if the project is not selected.

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 Principle 5: Competitive Markets

• The curse of competitive markets

– It is hard to find exceptionally profitable projects
– If an industry is generating large profits, new entrants
are usually attracted.
• The additional competition and added capacity can
result in profits being driven down to the required rate
of return.
• Product Differentiation, Service and Quality can
insulate products from competition

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 Principle 6: Efficient Capital Markets

• The markets are quick and the prices are right.

– The values of all assets and securities at any
instant in time fully reflect all available information.

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 Principle 7: The Agency Problem
• The separation of management and the ownership of
the firm creates an agency problem – Agency costs.
• Managers may make decisions that are not in line with the
goal of maximization of shareholder wealth.
• Managers won’t work for the owners unless it is in their
best interest
• Types of agency costs:
– Direct agency costs: the purchase of something for
management that can’t be justified from a risk-return
standpoint; monitoring costs.
– Indirect agency costs; management’s tendency to forgo
risky or expensive projects that could be justified from a
risk-return standpoint.
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 Learning Activity
• Why might the threat of a takeover make
managers to work towards the goals of
stockholders.

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Principle 8: Taxes Bias Business Decisions

• The cash flows we consider are the

after-tax incremental cash flows to the
firm as a whole.

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 Principle 9: All Risk is Not Equal

• Some risk can be diversified away, and

some cannot
– The process of diversification can reduce risk,
and as a result, measuring a project’s or an
asset’s risk is very difficult.

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 Principle 10: Ethical Behavior
• Businesses are expected to behave ethically
– Ethical Behavior Is Doing the Right Thing (and Ethical
Dilemmas Are Everywhere in Finance)
• Note:
– Each person has his or her own set of values, which
forms the basis for personal judgments about what is the
right thing
• Social responsibility
• Governance

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 Basic Areas Of Finance
• Corporate finance – Business Finance
• Investments
• Financial Institutions/Financial Markets
• International Finance
• Public Finance
• Personal Finance

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 Business Finance
• “Business finance” is just another name for
“corporate finance”.
• Some important questions that are answered
when dealing with business finance
– What long-term investments should the firm take on?
– Where will we get the long-term financing to pay for the
investments?
– How will we manage the everyday financial activities of
the firm?
• Financial managers try to answer some, or
all, of these questions 39
 Investments
• Work with financial assets such as stocks
and bonds
• Value of financial assets, risk versus return,
and asset allocation
• Job opportunities
– Stockbroker or financial advisor
– Portfolio manager
– Security analyst

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 Financial Institutions
• Companies that specialize in financial
matters
– Banks – commercial and investment, credit
unions, savings and loans
– Insurance companies
– Brokerage firms
• Job opportunities
– Bank (FI) managers
– Financial advisors (analysts)
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 International Finance
• This is an area of specialization within each of
the areas discussed so far
• It may allow you to work in other countries or at
least travel on a regular basis
– Need to be familiar with exchange rates and political
risk
– Need to understand the customs of other countries
– Speaking a foreign language fluently is also helpful

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 Public Finance
• The study of the role of the government in the
economy.
• It is the branch of economics which assesses the
government revenue and government expenditure of
the public authorities and the adjustment of one or the
other to achieve desirable effects and avoid
undesirable ones.
– Collection of taxes from those who benefit from the
provision of public goods by the government, and
the use of those tax funds toward production and
distribution of the public goods.
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 Personal Finance
• The financial management which an individual or a
family unit performs to budget, save, and spend
monetary resources over time, taking into account
various financial risks and future life events.
– When planning personal finances, the individual would
consider the suitability to his or her needs of a range of
banking products (current, savings, consumer loans) or
investment private equity (stock market, bonds, mutual
funds) and insurance (life, health disability) products or
participation and monitoring of individual- or employer-
sponsored retirement plans, social security benefits, and
income tax management.
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 Why Study Finance?
• This course is generally required of all business
majors
– Everyone needs to have a basic understanding of financial
concepts so that they can communicate effectively within
an organization.
– This is the same reason that everyone is required to take
marketing courses, management courses, etc.
– It is important to speak the language of business, and that
includes finance.

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 Why Study Finance?
• Marketing
– Have to work within a budget
– Marketing research is often very important to financial
analysts; those doing the research need to understand what
information the analysts need so that they ask the right
questions
– Marketing financial products – including entire companies
through IPOs and seasoned equity offerings, as well as
insurance and other basic financial products
• Accounting
– Prepare the financial statements that financial analysts rely on
for information
– In smaller businesses, accountants often perform both the
accounting and finance functions
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 Why Study Finance? (Cont…)
• Management
– Business strategy – have to understand the
goals of the business and how cash flow works
– Understand how job performance affects
profitability

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 Quick Quiz
• What are the four basic areas of finance?
• What are the three types of financial
management decisions, and what questions are
they designed to answer?
• What are the three major forms of business
organization?
• What is the goal of financial management?
• What are agency problems, and why do they
exist within a corporation?

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 Inter-relationships between financing,
investment and dividend decisions
Investment: Company Finance: Company will Dividends: if finance is
decides to take on a need to raise finance in not available from
large number of order to take on the external sources,
attracting new projects dividends may need to
investment projects be cut in order to
increase internal
financing
Dividends: company Finance: lower level of Investment: if finance
decides to pay higher retained earnings is not available from
levels of dividends to available for investment external sources the
the shareholders means the company company may have to
may have to find postpone future
finance from external investment projects
sources
Finance: company Investment: due to a Dividends: the
finances itself using higher cost of capital company’s ability to pay
more expensive sources the number of projects dividends in the future
resulting in a higher attractive to the will be adversely 49
cost of capital company decreases affected
Financial Management - Remember

• The maintenance and creation of

economic value or wealth.
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 Learning Activity
Read about the financial System in general and relate it to the Tanzanian
financial superstructure:
• The Institutions:
– The banking sector
• Retail banks
• Wholesale banks
• International banks
• Building societies
• Finance houses
– Long-term savings institutions
• Pension funds
• Insurance funds
– The risk spreaders
• Unit trusts
• Investment trusts
• Open-ended investment companies (OEIC)
• The Markets
– Money markets
– Bond markets
– Foreign exchange markets
– Share markets
– Derivatives markets
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 Responsibilities of the Financial Manager
F
i
n
a
1. Managing the
n working capital 2. Estimating the
c seasonal fund needs
i
a
l 3. Long-term financial
planning: forecasting long-
M
a term fund requirements
n
a
g
e 4. Determining appropriate
r investment mix
6. Determining the
amount of dividends 5. Determining appropriate
to be paid financing mix
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