An Overview of Financial Management

The Balance-Sheet Model of the Firm

Total Value of Assets: Current Assets Total Firm Value to Investors: Current Liabilities Long-Term Debt

Fixed Assets 1 Tangible 2 Intangible

Shareholders Equity

The Balance-Sheet Model of the Firm

The Capital Budgeting Decision
Current Assets

Current Liabilities
Long-Term Debt

Fixed Assets 1 Tangible 2 Intangible

What longterm investments should the firm engage in?

Shareholders Equity

The Balance-Sheet Model of the Firm

The Capital Structure Decision
Current Assets

Current Liabilities
Long-Term Debt

How can the firm raise the money for the Fixed Assets required 1 Tangible investments?
2 Intangible

Shareholders Equity

The Balance-Sheet Model of the Firm

The Net Working Capital Investment Decision
Current Assets Current Liabilities
Net Working Capital

Long-Term Debt

Fixed Assets 1 Tangible 2 Intangible

How much short-term cash flow does a company need to pay its bills?

Shareholders Equity

Corporate Finance Functions

Capital-Raising (Financing)

Capital Budgeting

Financial Management

Risk Management

Corporate Governance

Relationship with Accounting

The firms finance (treasurer) and accounting (controller) functions are closely-related and overlapping. In smaller firms, the financial manager generally performs both functions One major difference in perspective and emphasis between finance and accounting is that accountants generally use the accrual method while in finance, the focus is on cash flows. Finance and accounting also differ with respect to decisionmaking. While accounting is primarily concerned with the presentation of financial data, the financial manager is primarily concerned with analyzing and interpreting this information for decision-making purposes

TEN PRINCIPLES OF FM
1. 2. 3. 4. 5. 6. Risk Return Trade off: We wont take any additional risk unless we expect to be compensated with additional return. Time Value of Money: A dollar received today is worth more than a dollar received in the future Cash-Not Profits-Is King Incremental Cash Flows-Its only what changes that counts The curse of competitive markets- Why its hard to find exceptionally profitable projects Efficient Capital Markets- The markets are quick and the prices are right; there fore wealth maximization is a good objective of FM

7.

The Agency Problem- Managers wont work for owners unless its in their best interest. 8. Taxes bias business decisions 9. All risks are not equal, some risks can be diversified away, and some cannot 10. Ethical behavior is doing the right thing, and ethical dilemmas are everywhere in Finance

DECISIONS, RETURN, RISK, AND MARKET VALUE

Capital Budgeting Decisions Return Market Value of the Firm Dividend Decisions Risk Working Capital Decisions

Capital Structure Decisions

THE OBJECTIVE OF CORPORATE FINANCE

Characteristics of a Good Objective Function

It is clear and unambiguous It comes with a clear and timely measure that can be used to evaluate the success or failure of decisions. It does not create costs for other entities or groups that erase firmspecific benefits and leave society worse off overall. As an example, assume that a tobacco company defines its objective to be revenue growth.

First Principles
Invest in projects that yield a return greater than the minimum acceptable hurdle rate. The hurdle rate should be higher for riskier projects and reflect the financing mix used - owners funds (equity) or borrowed money (debt) Returns on projects should be measured based on cash flows generated and the timing of these cash flows; they should also consider both positive and negative side effects of these projects. Choose a financing mix that minimizes the hurdle rate and matches the assets being financed. If there are not enough investments that earn the hurdle rate, return the cash to stockholders.

The form of returns - dividends and stock buybacks - will depend upon the stockholders characteristics. Objective: Maximize the Value of the Firm

The Classical Objective Function

STOCKHOLDERS Hire & fire managers - Board - Annual Meeting Lend Money Maximize stockholder wealth No Social Costs

BONDHOLDERS

Protect bondholder Interests Reveal information honestly and on time

Managers

SOCIETY
Costs can be traced to firm

Markets are efficient and assess effect on value

FINANCIAL MARKETS

Another Way of Presenting this is...

Why Stock Price Maximization Works

Stockholders hire managers to run their firms for them Because stockholders have absolute power to hire and fire managers Managers set aside their interests and maximize stock prices Because markets are efficient Stockholder wealth is maximized Because lenders are fully protected from stockholder actions Firm Value is maximized Because there are no costs created for society Societal wealth is maximized

Maximizing stock prices as opposed to firm value

Stock price is easily observable and constantly updated (unlike other measures of performance, which may not be as easily observable, and certainly not updated as frequently). If investors are rational (are they?), stock prices reflect the wisdom of decisions, short term and long term, instantaneously. The stock price is a real measure of stockholder wealth, since stockholders can sell their stock and receive the price now.

What can go wrong?

STOCKHOLDERS Have little control over managers Managers put their interests above stockholders Significant Social Costs

Lend Money

BONDHOLDERS

Bondholders can get ripped off Delay bad Markets make news or mistakes and provide misleading can over react information FINANCIAL MARKETS

Managers

SOCIETY Some costs cannot be traced to firm

The Counter Reaction

STOCKHOLDERS 1. More activist investors 2. Hostile takeovers Protect themselves Managers of poorly run firms are put on notice. Corporate Good Citizen Constraints

BONDHOLDERS
1. Covenants 2. New Types

Managers

SOCIETY
1. More laws 2. Investor/Customer Backlash

Firms are punished for misleading markets

Investors and analysts become more skeptical

FINANCIAL MARKETS