Overview of Financial Management

Lecture -1-
Overview of Financial Management
Abir M. El Anwar
DBA, AAGSB
Lecture 1s Plan
Financial management
Forms of business organization
Objective of the firm: Maximize
wealth
Determinants of stock pricing
The financial environment
Financial instruments, markets and
institutions
Interest rates and yield curves
Managerial Finance Lecture 1
What is Financial Management?

Financial management is concerned with the
efficient use of an important economic resource,
namely, capital funds, Solomon.
Financial management is the operational
activity of a business that is responsible for
obtaining and effectively utilizing the funds
necessary for efficient operation , Massie.
Financial management is an area of financial
decision making harmonizing individual motives
& enterprise goals, Weston & Brigham.
Financial management is concerned with the
maintenance and creation of economic value or
wealth.
Why is corporate finance

important to all managers?
Corporate finance provides the
skills managers need to:
Identify and select the corporate
strategies and individual projects that
add value to their firm.
Forecast the funding requirements of
their company, and devise strategies
for acquiring those funds.
Financial decisions
Financing decision where is money going to
come from
Investment decision how much to invest and in
what assets
Operations
Financial
markets
Financing
Investments
Financial
Manager
Function of Financial Manager

1a.Raising
funds
2.Investments
Financial
Operations
Manager
(plant,
equipment
3.Cash from
, projects) operational
Financial
1b. Obligations
Markets
(stocks, debt
(investors)
securities)
activities
4.Reinvesting
5.Dividends or
interest
payments
Finance function managing the cash flow

Financial decisions
Capital structure and cost
of capital
Operations
Financial
markets
Financing
Investments
Financial
Manager
Forms of business organization
Sole proprietorship
Partnership
Corporation
Starting as a Sole Proprietorship
Advantages:
Easiest to start
Least regulated
Single owner keeps all the profits
Taxed once as personal income
Disadvantages:
Limited to life of owner
Unlimited liability
Difficult to raise capital to support growth
Starting as or Growing into

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

Two or more owners

More capital available
Relatively easy to start
Income taxed once as
personal income
Disadvantages
Unlimited liability
General partnership
Limited partnership
Partnership dissolves when one

partner dies or wishes to sell
Difficult to transfer ownership
10
Becoming a Corporation
A corporation is a legal entity separate
from its owners and managers.
Advantages
Limited liability
Unlimited life
Separation of ownership
and management
Transfer of ownership is
easy
Easier to raise capital
Disadvantages
Separation of ownership
and management
Double taxation
(income taxed at the
corporate rate and then
dividends taxed at
personal rate)
Cost of set-up and
report filing
11
Becoming a Public Corporation

and Growing Afterwards
Initial Public Offering (IPO) of Stock
Raises cash
Allows founders and pre-IPO investors to
harvest some of their wealth
Subsequent issues of debt and equity
Agency problem: managers may act in their
own interests and not on behalf of owners
(stockholders)
12
What should managements

primary objective be?
The primary objective should be
shareholder wealth maximization,
which translates to maximizing stock
price.
Should firms behave ethically? YES!
Do firms have any responsibilities to society
at large? YES! Shareholders are also
members of society.
13
Is maximizing stock price good for

society, employees, and customers?
Employment growth is higher in

firms that try to maximize stock
price. On average, employment goes
up in:
firms that make managers into owners (such
as LBO firms)
firms that were owned by the government
but that have been sold to private investors
14
Is maximizing stock price good for

society, employees, and customers?
Consumer welfare is higher in

capitalist free market economies than
in communist or socialist economies.
Fortune lists the most admired firms.
In addition to high stock returns,
these firms have:
high quality from customers view
employees who like working there
15
What three aspects of cash flows

affect an investments value?
Amount of expected cash flows

(bigger is better)
Timing of the cash flow stream
(sooner is better)
Risk of the cash flows (less risk
is better)
16
What are free cash flows

(FCF)
Free cash flows are the cash flows
that are:
Available (or free) for distribution
To all investors (stockholders and
creditors)
After paying current expenses, taxes, and
making the investments necessary for
growth.
17
Determinants of Free
Cash Flows
FCF= Sales Revenue Operating costs
operating taxes required investment in
operating capital
Sales revenues
Current level
Short-term growth rate in sales
Long-term sustainable growth rate in sales
Operating costs (raw materials, labor,
etc.) and taxes
Required investments in operations
(buildings, machines, inventory, etc.)
18
What is the weighted average

cost of capital (WACC)?
Financing Decisions: Mix of debt and
equity, retained earnings level, dividends to be
paid, interest rate and market conditions, and
risk levels.
The weighted average cost of capital
(WACC) is the average rate of return required
by all of the companys investors (stockholders
and creditors)
19
What factors affect the weighted

average cost of capital?
Capital structure (the firms relative

amounts of debt and equity)
Interest rates
Risk of the firm
Stock market investors overall
attitude toward risk
20
What determines a firms

value?
A firms value is the sum of all the
future expected free cash flows when
converted into todays dollars:
FCF1
FCF2
FCF
Value =
+
+ ....
1
2
(1 + WACC) (1 + WACC)
(1 + WACC)
21
What are financial assets?

A financial asset is a contract that
entitles the owner to some type of
payoff.
Debt
Equity
Derivatives
In general, each financial asset
involves two parties, a provider of
cash (i.e., capital) and a user of
cash.
22
What are some financial

instruments?
Instruments
U.S. T-bills
Rate (April 2003)
Rate (April 2006)
1.14%
4.79%
Bankers
acceptances
1.22
5.11
Commercial paper
1.21
4.97
Negotiable CDs
1.24
5.07
Eurodollar
deposits
1.23
5.10
Commercial loans
Tied to prime
Tied to prime
(4.25%) or LIBOR (7.75%) or LIBOR
(1.29%)
(5.13%)
(More . .)
23
Financial Instruments
(Continued)
Instruments
U.S. T-notes and

T-bonds
Rate (April 2003)
Rate (April 2006)
5.04%
5.04%
Mortgages
5.57
6.15
Municipal bonds
4.84
4.66
Corporate (AAA)
bonds
5.91
5.93
Preferred stocks
6 to 9%
6 to 9%
Common stocks
(expected)
9 to 15%
9 to 15%
24
Financial markets and

Financial System
25
Financing decisions
Financing
decisions
Internal corporate
financing
Retained earnings
External sources
of funds
Direct financing
(financial markets
Instruments)
Indirect financing
(financial
Intermediaries)
Stocks
Loans
Debt instruments
(bonds, CPs etc.)
26
Who are the providers (savers) and

users (borrowers) of capital?
Households: Net savers

Non-financial corporations: Net
users (borrowers)
Governments: Net borrowers
Financial corporations: Slightly net
borrowers, but almost breakeven
27
What are three ways that capital is

transferred between savers and borrowers?
28
What are some financial

intermediaries?
Investment Banks
Commercial banks
Savings & Loans, mutual savings
banks, and credit unions
Life insurance companies
Mutual funds
Pension funds
Financial Service corporations
29
The Top 5 Banking Companies

in the World
2001
Bank Name
Country
Citigroup
U.S.
Deutsche Bank AG
Germany
Credit Suisse
Switzerland
BNP Paribas
France
Bank of America
U.S.
2009
Bank Name
Country
JPMorgan Chase
U.S.
Credit Suisse
Switzerland
Goldman Scatchs
U.S.
Banco Syantender
Spain
Industrial and
Commercial Bank of
China
China
30
What are some types of markets?

A market is a method of exchanging
one asset (usually cash) for another
asset.
Physical assets vs. financial assets
Spot versus future markets
Money versus capital markets
Primary versus secondary markets
31
Financial markets
Financial markets
Primary markets
Money market
Organized
exchanges
Secondary markets
Capital market
Over-the-counter
32
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 allows investors to
trade financial instruments between
themselves. Secondary transactions take
place without involving the corporation.
33
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
34
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-thecounter (OTC) market. Facilitates secondary
market transactions. Unlike the organized
exchanges, the OTC market doesnt have a
trading floor. The buy and sell orders are
completed through a telecommunications
network.
35
Organized exchanges mechanism
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.
36
Types of financial instruments
Type of issuer
Government, government
agencies
Corporations
Financial
institutions
Others
37
Maturity
Short-term instruments
Long-term instruments
38
Type of yield
Dividend bearing
(stocks)
Discount debt
Instruments
(treasury bills)
Interest income instruments (bonds)
39
By level of risk
Risk-free instruments (treasury bills)
Low-risky
Low
risky securities (treasury notes and bonds),
investment grade corporate bonds,
blue-chip stocks)
High-risky securities (junk bonds,

stocks), derivatives
40
Cost of Capital & Interest Rates

What do we call the price, or
cost, of debt capital?
The interest rate
What do we call the price, or
cost, of equity capital?
Required Dividend
Capital
=
+
.
return
yield
gain
41
What four factors affect the

cost of money?
Production opportunities
Time preferences for consumption
Risk
Expected inflation
42
Real versus Nominal Rates
r*
= Real risk-free rate.

T-bond rate if no inflation;
1% to 4%.
= Any nominal rate.
rRF
= Rate on Treasury securities.
43
r = r* + IP + DRP + LP + MRP
Here:
r = Required rate of return on
a debt security.
r* = Real risk-free rate.
IP = Inflation premium.
DRP = Default risk premium.
LP = Liquidity premium.
MRP = Maturity risk premium.
44
Premiums Added to r* for

Different Types of Debt
Premiums
ST
Treasury
LT
Treasury
ST
LT
corporate corporate
ST
LT
inflation
inflation
DRP
LP
IP
ST
inflation
MRP
LT
inflation
45
DRP added to r* for Different

Types of Debt (contd)
Long-term
Bonds
Rate
DRP
2001
2003
2001
2003
5.5%
4.9%
--
--
AAA
6.5
5.5
1.0
0.6
AA
6.8
5.6
1.3
0.7
7.3
6.2
1.8
1.3
BBB
7.9
6.8
2.4
1.9
BB+
10.5
8.4
5.0
3.5
Treasury
46
What is the term structure of interest

rates? What is a yield curve?
Term structure: the relationship

between interest rates (or yields)
and maturities.
A graph of the term structure is
called the yield curve.
47
How can you construct a

hypothetical Treasury yield curve?
Step 1: Estimate the inflation

premium (IP) for each future year.
This is the estimated average inflation
over that time period.
Step 2: Estimate the maturity risk
premium (MRP) for each future year.
48
Assume investors expect inflation to be 5% next

year, 6% the following year, and 8% per year
thereafter.
Step 1: Find the average expected

inflation rate over years 1 to n:
n
INFLt
IPn =
t=1
49
IP1 = 5%/1 = 5.00%.

IP10= [5 + 6 + 8(8)]/10 = 7.5%.
IP20= [5 + 6 + 8(18)]/20 = 7.75%.
Must earn these IPs to break even

versus inflation; that is, these IPs
would permit you to earn r* (before
taxes).
50
Assume the MRP is zero for Year 1 and increases by

0.1% each year.
Step 2: Find MRP based on this

equation:
MRPt = 0.1%(t - 1)
MRP1 = 0.1% x 0 = 0.0%.
MRP10 = 0.1% x 9 = 0.9%.
MRP20 = 0.1% x 19 = 1.9%.
51
Step 3: Add the IPs and MRPs to r*:

rRFt = r* + IPt + MRPt .
rRF = Quoted market interest
rate on treasury securities.
Assume r* = 3%:
rRF1 = 3% + 5% + 0.0%
= 8.0%.
rRF10 = 3% + 7.5% + 0.9% = 11.4%.
rRF20 = 3% + 7.75% + 1.9% = 12.65%.
52
Hypothetical Treasury Yield Curve
Interest
Rate (%)
15
Maturity risk premium
10
Inflation premium
1 yr
10 yr
20 yr
8.0%
11.4%
12.65%
5
Real risk-free rate
Years to Maturity
0
1
10
20
53
What factors can explain the

shape of this yield curve?
This constructed yield curve is

upward sloping.
This is due to increasing expected
inflation and an increasing
maturity risk premium.
54
What kind of relationship exists between the

Treasury yield curve and the yield curves for
corporate issues?
Corporate yield curves are higher than

that of the Treasury bond. However,
corporate yield curves are not
necessarily parallel to the Treasury
curve.
The spread between a corporate yield
curve and the Treasury curve widens as
the corporate bond rating decreases.
55
Hypothetical Treasury and

Corporate Yield Curves
Interest
Rate (%)
15
BB-Rated
10
AAA-Rated
Treasury
6.0%
yield curve
5.9%
5.2%
Years to
maturity
0
0
10
15
20
56
Problems #1 5 - Chapter (1) p. 42

(To be distributed)

Overview of Financial Management

Uploaded by

Document Information

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Overview of Financial Management

Uploaded by

Copyright:

Available Formats

Lecture -1-

Overview of Financial Management

Managerial Finance Lecture 1

What is Financial Management?

Why is corporate finance

Managerial Finance Lecture 1

Function of Financial Manager

Finance function managing the cash flow

Forms of business organization

Managerial Finance Lecture 1

Starting as a Sole Proprietorship

Managerial Finance Lecture 1

Starting as or Growing into

Two or more owners

Managerial Finance Lecture 1

Partnership dissolves when one

Managerial Finance Lecture 1

Becoming a Public Corporation

Managerial Finance Lecture 1

What should managements

Managerial Finance Lecture 1

Is maximizing stock price good for

Employment growth is higher in

Managerial Finance Lecture 1

Is maximizing stock price good for

Consumer welfare is higher in

Managerial Finance Lecture 1

What three aspects of cash flows

Amount of expected cash flows

Managerial Finance Lecture 1

What are free cash flows

Managerial Finance Lecture 1

What is the weighted average

Managerial Finance Lecture 1

What factors affect the weighted

Capital structure (the firms relative

Managerial Finance Lecture 1

What determines a firms

Managerial Finance Lecture 1

What are financial assets?

What are some financial

Rate (April 2003)

Rate (April 2006)

Managerial Finance Lecture 1

U.S. T-notes and

Rate (April 2003)

Rate (April 2006)

Managerial Finance Lecture 1

Financial markets and

Managerial Finance Lecture 1

Managerial Finance Lecture 1

Who are the providers (savers) and

Households: Net savers

Managerial Finance Lecture 1

What are three ways that capital is

Managerial Finance Lecture 1

What are some financial

The Top 5 Banking Companies

Managerial Finance Lecture 1

What are some types of markets?

Managerial Finance Lecture 1

Managerial Finance Lecture 1

Primary and secondary

Managerial Finance Lecture 1