FHBM 1224 Financial Management

Foundation in Arts

Subject Information
3 hours lecture + 1 hour tutorial Text book: Ross, S. A., Westerfield, R. W., and Jordan, B. D. (2010). Fundamentals of corporate finance. (9th ed.). New York: McGraw-Hill. Lecturer: Ms. Liu / Ms. Leong Tutor: Pn. Liu / Ms. Leong Email: Liusy@utar.edu.my / leongxy@utar.edu.my

Methods of Evaluation
1. Assignment 2. Mid-term Test 3. Final exam Total 25% 15% 60% 100%

Teaching Materials
Students are expected to download own lecture notes or any other materials via the website provided by Web Based Learning Environment: http://wble.utar.edu.my It is essential that each student has access to this website. Active subject-related discussion among students in WBLE forum is strongly encouraged.

Expectation on students
- Be punctual!! -Dress appropriately. -Switch your phone to silent mode. - Dont talk while the lecturer is explaining the concept. - Dont disturb others - Do all exercises given - Be independent

- Utilize your brain wisely

UTAR Student Dress Code

Proper Attire

UTAR Student Dress Code

Unacceptable Attire

Third week of the trimester onwards Full implementation as follow:

1st time offenders: details of students taken down and submitted to the academic advisor for further action 2nd time offenders: details of students submitted to the Dean/Deputy Dean for further action.
3rd time offenders: Warning letter issued to the student 4th time offenders: Student to be sent for counseling

5th time offenders: Barred from entering the campus

FHBM 1224 Financial Management

~ Chapter 1 ~ Foundations

Learning Objectives
Know the goal of financial management Understand the conflicts of interest that can arise between owners and managers Know the basic types of financial management decisions and the role of the financial manager Know the financial implications of the different forms of business organization Understand the various types of financial markets

What is
Finance studies and addresses the ways in which individuals, businesses and organizations raise, allocate and use monetary resources over time, taking into account the risks entailed in their projects.

Example
Lets say you earn RM3,000 per month, how do you allocate the income?

5% for insurance 30% for installment

Car loan House loan

RM 3,000

20% for retirement plan

45% for monthly expenditure

Back

Possible Goals of Financial Management

Survival Avoid financial distress and bankruptcy Beat the competition Maximize sales or market share Minimize costs Maximize profits Maintain steady earnings growth

Problems with these Goals

Each of these goals presents problems. These goals are either associated with increasing profitability or reducing risk. They are not consistent with the long-term interests of shareholders. It is necessary to find a goal that can encompass both profitability and risk.

The Firms Objective

The goal of financial management is to maximize shareholders wealth.

Shareholders wealth can be measured as the current value per share of existing shares.
This goal overcomes the problems encountered with the goals outlined above.

The Agency Problem

Agency relationship
Principal hires an agent to represent his/her interest Stockholders (principals) hire managers (agents) to run the company

Agency problem - A situation in which agents of an organization use

their authority for their own benefit rather than that of the principals.

Principals hire agents

Principals (shareholders) Principals delegate authority to agents to manage firms

Agents (managers)

Agency problem: Conflict of interest between

principal and agent

Example: Agency Problem

You hire someone to sell your house and agree to pay that person a flat fee when he sells the house. The agents incentive is to make the sale, not necessarily to get you the best price. Hence, the agent may not be acting in your best interest.

Agency Relationships/Problems
Ownership (shareholders)

Problem created by separation of

Control (Management & Employees)

Management may maximize own welfare (job securities) instead of owners wealth (higher profit)

Do Managers Act in Shareholders Interests? The answer to this will depend on two factors:

how closely management goals are aligned with shareholder goals the ease with which management can be replaced if it does not act in shareholders best interests.

Example: Aligning goals

From the previous example, if, you offer a commission of, say, 10% of the sales price instead of a flat fee, you are aligning your agents interest with yours, since you want your house to be sold at the highest possible price, so does your agent.

Ways to Overcome Agency Problem

management compensation schemes (ESOS)
monitoring of management (Board of Directors) the threat of takeover

Employee Stock Option Scheme

a plan through which a company awards Stock Options to the employees based on their performance
employees have the right to buy the shares of the company on a predetermined date at a predetermined price.

Example: ESOS
An employee is granted the option to purchase 1,000 shares of the companys stock at a price of RM5 per share (the "grant" price). The employee can exercise the option at RM5 per share. Plans allow employees to exercise their options after a certain number of years or when the companys stock reaches a certain price. If the price of the stock increases to RM20 per share, for example, the employee may exercise his or her option to buy 1,000 shares at RM5 and then sell the stock at the current market price of RM20.

Board of Directors
Board of Directors (BoD) should have a majority of independent directors. Independent directors are individuals who are not current or former employees of the company and must not have any business dealings with the company. The BoD has the ultimate authority to hire and fire top management so a strong board would deter management from engaging in actions that are detrimental to shareholders.

Threat of Takeover
Poorly-managed firms are more attractive as acquisitions than well-managed firms because of greater profit potential. A hostile takeover is usually associated with jobloss. Hence, it gives management another incentive to act in the shareholders interests.

Responsibility of Financial Managers

To acquire funds (cash) needed by a firm To direct those funds into profitable activities To maximize value of a firm

Financial Management Decisions

1. Investment Decisions (Capital Budgeting) What long-term investments or projects should the business take on? 2. LT Financing Decisions (Capital Structure) Should we use debt or equity? 3. ST Financial Decisions (Working Capital Management) How do we manage the day-to-day finances of the firm? 4. Dividend Decisions (Dividend Distribution Policy) How much dividends should we pay to our shareholders? How much earnings should we retain for reinvestment?

1. The Investment Decision

Capital budgeting is the planning and control of cash outflows in the expectation of deriving future cash inflows from investments in non-current assets. Involves evaluating the:
size of future cash flows timing of future cash flows risk of future cash flows.

Cash Flow Size

Accounting income does not mean cash flow. For example, a sale is recorded at the time of sale and a cost is recorded when it is incurred, not when the cash is exchanged.

Vs.

Cash Flow Timing

A dollar today is worth more than a dollar at some future date.
There is a trade-off between the size of an investments cash flow and when the cash flow is received.

Cash Flow Timing

Which is the better project?
Future Cash Flows Year 1
2 3 Total

Project A $0
$10 000 $20 000 $30 000

Project B $20 000

$10 000 $0 $30 000

Cash Flow Risk

The role of the financial manager is to deal with the uncertainty associated with investment decisions.
Assessing the risk associated with the size and timing of expected future cash flows is critical to investment decisions.

2. Long Term Financing Decisions

A firms capital structure is the specific mix of debt and equity used to finance the firms operations.
Decisions need to be made on both the financing mix and how and where to raise the money.

3. Short Term Financial Decisions

- working capital management
How much cash and inventory should be kept on hand? Should credit terms be extended? If so, what are the conditions? How is short-term financing acquired?

4. Dividend Decision
Involves the decision of whether to pay a dividend to shareholders or maintain the funds within the firm for internal growth.
Factors important to this decision include growth opportunities, taxation and shareholders preferences.

Forms of Business Organization

Three major forms in Malaysia 1. Sole proprietorship 2. Partnership
General Limited

3. Corporation
Private Limited Company ( Sdn Bhd ) Public Limited Company ( Bhd )

Sole Proprietorship
The business is owned by one person. The least regulated form of organization. Owner keeps all the profits but assumes unlimited liability for the businesss debts. Amount of equity raised is limited to owners personal wealth.

Partnership
The business is formed by two or more owners. All partners share in profits and losses of the business and have unlimited liability for debts. Partnership dissolves if one partner sells out or dies. More capital available but amount is limited to the combined personal wealth of the partners. Income is taxed as personal income to partners.

Liability of Partners
General Partner - Has unlimited liability for all obligations of the business disadvantage Limited Partner -Liability limited to the partnership agreement advantage - Limited partnership involves at least one general partner and one or more limited partners

Corporation
A business created as a distinct legal entity composed of one or more individuals or entities. Easy to raise capital. Shareholders and management are usually separated. Ownership can be readily transferred. Owners (shareholders) have limited liability.

Private vs. Public Companies

Private Limited Company (Sdn Bhd) - cannot offer its shares for sale to the public - shares normally held by one shareholder or a small group of shareholders Public Limited Company (Bhd) - offers its shares for sale to the public through a stock exchange (e.g. Bursa Malaysia)

A financial market is
a mechanism to facilitate the transfer of savings from those economic units that have a savings surplus to those that have a savings deficit.

It brings together the buyers and sellers of debt and equity securities.

Structure of Financial Markets

Financial Markets

Money Market

Capital Market

Primary Market

Secondary Market

Primary Market

Secondary Market

Financial Market Components

Money markets Market for short-term securities ( 1 year) Less risk, low return (Fixed Deposits, Commercial Paper) Capital markets Market for long-term securities (> 1 year) High risk, higher return (Shares and Bonds )

Primary vs. Secondary Markets

1. Primary - new securities or primary claims are issued, resulting in cash inflow to the issuer. - firms issuing common shares to public for the 1st time is known as Initial Public Offering (IPO). 2. Secondary - already existing financial claims such as stocks and bonds are bought and sold, no resulting cash inflow to the issuer.

The Corporation and Financial Markets

Corporation Investors

Government

The Corporation and Financial Markets

Corporation Primary Market
Capital Securities

Investors

Government

The Corporation and Financial Markets

Corporation
Capital Securities

Investors

Secondary market

Government

The Corporation and Financial Markets

Corporation
Capital Securities

Investors

Secondary market

Cash Flow

Government

The Corporation and Financial Markets

Corporation
Capital Securities

Investors

Secondary market

Cash Flow tax

Government

The Corporation and Financial Markets

Corporation
Capital Securities Reinvest

Investors

Secondary market

Cash Flow tax

Government

The Corporation and Financial Markets

Corporation
Capital Securities Reinvest

Investors

Secondary market

Cash Flow (dividends) tax

Government

Movement of Savings: 1.The direct transfer of funds

cash firm

saver

securities

Movement of Savings: 2. Indirect transfer with investment banker

funds saver investment banker

funds

firm

securities

securities

Movement of Savings: 3. Indirect transfer with financial intermediary

funds funds

saver

financial intermediary firm securities

firm

intermediary securities

Lecture Exercise
Match the following with the questions below: (a.) restructuring (b.) capital market (c.) money market (d.) inflation (e.) primary market (f.) secondary market (g.) financial capital

1.______This form of capital is found on the Statement of Financial Position under long-term liabilities and equity. 2.______The purchasing power of the dollar shrinks over time. 3.______A market where the securities being traded are new public offerings. 4.______Securities with a maturity of less than 1 year. 5.______Redeploying the asset and liability structure of the firm. 6.______Market composed of common stock, preferred stock, commercial and government bonds and other long-term securities. 7.______This market trades previously issued securities. Answer: (1.) g (2.) d (3.) e (4.) c (5.) a (6.) b (7.) f

"I hear and I forget.

I see and I remember.

I do and I understand."
-- Confucius