GORDON COLLEGE FIN 501 Handout #1

College of Business and Accountancy Mailene Claire Mapa, CPA, MICB

I. Overview of Financial Management
What is Financial Management?
Concerns the acquisition, financing, and management of assets with some overall goals in mind.
The Decision Function of Financial Management can be broken down into three major areas:
Investment decision
Financing decision
Asset management decision

Investment Decisions
Most important of the three decisions functions.
Determine the total amount of assets needed to be held by the firm.
Assets that can no longer be economically justified may need to be reduced, eliminated or replaced.
What is the optimal firm size?
What specific assets should be acquired?
What assets (if any) should be reduced or eliminated?

Financing Decisions
Determine how the assets (LHS of balance sheet) will be financed (RHS of balance sheet).
Have large amount of debt or debt free.
Dividend payout ratio:
annual cash dividends divided by annual earnings
dividend per share divided by earning per share.
What is the best type of financing?
What is the best financing mix?
What is the best dividend policy?
How will the funds be physically acquired?

Asset Management Decisions

Once assets have been acquired and appropriate financing provided, these assets must be managed
efficiently.
Financial Manager has varying degrees of operating responsibility over assets.
Greater emphasis on current asset management than fixed asset management.
o How do we manage existing assets efficiently?

What is the Goal of the Firm? Maximization of Shareholders Wealth!

What is shareholders wealth?
The total shareholders wealth is the outstanding number of shares times market value per share.
The market price per share of the firms common stock which is a reflection of a firms investment,
financing and asset management decisions.
Value creation occurs when we maximize the share price for current shareholders.

Shortcomings of Alternative Perspectives

Profit Maximization
Maximizing a firms earnings after taxes.
Problems
Could increase current profits while harming firm (e.g., defer maintenance, issue common stock to buy T-bills,
etc.).
May result in a decrease in earning per share
Ignores changes in the risk level of the firm.

Earnings per Share Maximization

Maximizing earnings after taxes divided by shares outstanding.
Problems
Does not specify timing or duration of expected returns.
Ignores changes in the risk level of the firm.
Calls for a zero payout dividend policy. A firm will want to improve EPS by retaining earning and investing them
in any positive rate of return.
Strengths of Shareholder Wealth Maximization

Takes account of: current and future profits and EPS; the timing, duration, and risk of profits and EPS; dividend
policy; and all other relevant factors.
Thus, share price serves as a barometer for business performance.

Financial Managers Responsibilities

Raise funds from investors

Invest funds in value-enhancing projects
Manage funds generated by operations
Return funds to investors - dividends
Reinvest funds in new projects

The Financial Managers Role

1 Cash raised by selling financial assets in financial markets - financing decision

2 Cash invested in firms operations and used to purchase real assets - investment decision
3 Cash generated from firms operations
4 Cash returned to investors - financing decision
5 Cash reinvested in firms operations - financing decision

The Modern Corporation

Role of Management
Agency Theory

Jensen and Meckling developed a theory of the firm based on agency arrangement known as the agency theory.
According to the Agency Theory the agents will make optimal decisions if appropriate incentives are given and
only if agents are monitored.

Principals must provide incentives so that management acts in the principals best interests and then monitor results.
Incentives include stock options, perquisites, and bonuses.
Monitoring involves auditing financial statements, reviewing management perquisites and limit management
decisions.

Social Responsibility

Wealth maximization does not preclude the firm from being socially responsible, such as protecting the
customer, paying fair wages to employees, fair hiring practices, safe working conditions, and becoming involved
in environmental issues like clean air and water.
Consider the interests of stakeholders other than shareholders.

Organizational Stakeholders

II. Financial markets and Institutions

What is Financial system?
Financial system (FS) a framework for describing set of markets, organisations, and individuals that engage in
the transaction of financial instruments (securities), as well as regulatory institutions.
- the basic role of FS is essentially channelling of funds within the different units of the economy from
surplus units to deficit units for productive purposes.

What is Financial Markets?

Financial markets perform the essential function of channeling funds from economic players that have
saved surplus funds to those that have a shortage of funds
At any point in time in an economy, there are individuals or organizations with excess amounts of funds,
and others with a lack of funds they need for example to consume or to invest.
Exchange between these two groups of agents is settled in financial markets
The first group is commonly referred to as lenders, the second group is commonly referred to as
the borrowers of funds.
There exist two different forms of exchange in financial markets. The first one is direct finance,
in which lenders and borrowers meet directly to exchange securities.
Securities are claims on the borrowers future income or assets. Common examples are stock,
bonds or foreign exchange
The second type of financial trade occurs with the help of financial intermediaries and is known
as indirect finance. In this scenario borrowers and lenders never meet directly, but lenders
provide funds to a financial intermediary such as a bank and those intermediaries
independently pass these funds on to borrowers

Debt vs Equity
Financial markets are split into debt and equity markets.
Debt titles are the most commonly traded security. In these arrangements, the issuer of the
title (borrower) earns some initial amount of money (such as the price of a bond) and the
holder (lender) subsequently receives a fixed amount of payments over a specified period of
time, known as the maturity of a debt title.
Debt titles can be issued on short term (maturity < 1 yr.), long term (maturity >10 yrs.) and
intermediate terms (1 yr. < maturity < 10 yrs.).
The holder of a debt title does not achieve ownership of the borrowers enterprise.
Common debt titles are bonds or mortgages.

Equity titles are somewhat different from bonds. The most common equity title is (common)
stock.
First and foremost, an equity instruments makes its buyer (lender) an owner of the borrowers
enterprise.
Formally this entitles the holder of an equity instrument to earn a share of the borrowers
enterprises income, but only some firms actually pay (more or less) periodic payments to
their equity holders known as dividends. Often these titles, thus, are held primarily to be sold
and resold.
Equity titles do not expire and their maturity is, thus, infinite. Hence they are considered long
term securities.

PRIMARY MARKETS Vs SECONDERY MARKETS

Markets are divided into primary and secondary markets
Primary markets are markets in which financial instruments are newly issued by borrowers.
Secondary markets are markets in which financial instruments already in existence are traded
among lenders.
Secondary markets can be organized as exchanges, in which titles are traded in a central
location, such as a stock exchange, or alternatively as over-the-counter markets in which titles
are sold in several locations.

MONEY MARKETS VS CAPITAL MARKETS

Money markets are markets in which only short term debt titles are traded.
Capital markets are markets in which longer term debt and equity instruments are
traded.

INSTRUMENTS TRADED IN THE FINANCIAL MARKETS

Corporate stocks are privately issued equity instruments, which have a maturity of infinity by
definition and, thus, are classified as capital market instruments
 Corporate bonds are private debt instruments which have a certain specified maturity. They
tend to be long-run instruments and are, hence, capital market instruments
The short-run equivalent to corporate bonds are commercial papers which are issued to
satisfy short-run cash needs of private enterprises.
On the government side, the most commonly used long-run debt instruments are Treasury
Bonds or T-Bonds. Their maturity exceeds ten years.
Short-run liquidity needs are satisfied by the issuance of Treasury Bills or T-Bills, which are
short-run debt titles with a maturity of less than one year.

Functions of Financial markets

Borrowing and Lending
Financial markets channel funds from households, firms, governments and foreigners that
have saved surplus funds to those who encounter a shortage of funds (for purposes of
consumption and investment)
Price Determination
Financial markets determine the prices of financial assets. The secondary market herein plays
an important role in determining the prices for newly issued assets
Coordination and Provision of Information
The exchange of funds is characterized by a high amount of incomplete and asymmetric
information. Financial markets collect and provide much information to facilitate this
exchange.
Risk Sharing
Trade in financial markets is partly motivated by the transfer of risk from borrowers to lenders
who use the obtained funds to invest

Liquidity
The existence of financial markets enables the owners of assets to buy and resell these assets.
Generally this leads to an increase in the liquidity of these financial instruments
Efficiency
The facilitation of financial transactions through financial markets lead to a decrease in
informational cost and transaction costs, which from an economic point of view leads to an
increase in efficiency.

What are Financial Institutions ?

Financial intermediaries are firms that collect the funds from lenders and channel those funds
to borrowers (Mishkin)
Financial intermediaries are firms whose primary business is to provide customers with
financial products and services that can not be obtained more efficiently by transacting
directly in securities markets (Z.Bodie &Merton)
Any classification of financial institutions is ultimately somewhat arbitrary, since financial
markets are subject to high dynamics and frequent innovation. Thus, we roughly use four
categories:
Brokers
Dealers
Investment banks
Financial intermediaries

Brokers are agents who match buyers with sellers for a desired transaction.
A broker does not take position in the assets she/he trades (i.e. does not maintain inventories
of those assets)
Brokers charge commissions on buyers and/or sellers using their services
Examples: Real estate brokers, stock brokers
Like brokers, dealers match sellers and buyers of financial assets.
Dealers, however, take position in their assets, their trading.
As opposed to charging commission, dealers obtain their profits from buying assets at low
prices and selling them at high prices.
 A dealers profit margin, the so-called bid-ask spread is the difference between the price at
which a dealer offers to sell an asset (the asked price) and the price at which a dealer offers to
buy an asset (the bid price)
Examples: Dealers in U.S. government bonds, Nasdaq stock dealers
Investment Banks
Investment banks assist in the initial sale of newly issued securities (e.g. IPOs)
Investment banks are involved in a variety of services for their customers, such as advice,
sales assistance and underwriting of issuances
Examples: Morgan-Stanley, Goldman Sachs, ...Lehman Brothers ..(Before Crisis 2008)
Financial Intermediaries
Financial intermediaries match sellers and buyers indirectly through the process of financial
asset transformation.
As opposed to three above mentioned institutions. they buy a specific kind of asset from
borrowers usually a long term loan contract and sell a different financial asset to savers
usually some sort of highly-liquid short-run claim.
Although securities markets receive a lot of media attention, financial intermediaries are still
the primary source of funding for businesses.
Even in the United States and Canada, enterprises tend to obtain funds through financial
intermediaries rather than through securities markets.
Other than historic reasons, this prevalence results from a variety of factors.

Function of Financial Intermediaries: Indirect Finance

Lower transaction costs
Economies of scale
Liquidity services
Since transaction costs are reduced, financial intermediaries are able to provide customers with additional liquidity
services, such as checking accounts which can be used as methods of payment or deposits which can be liquidated
any time while still bearing some interest.
Reduce Risk
Risk Sharing (Asset Transformation)
Diversification
Through the process of asset transformation not only maturities, but also the risk of an asset
can change: A financial intermediary uses funds it acquires (e.g. through deposits) and often
turns them into a more risky asset (e.g. a larger loan). The risk then is spread out between
various borrowers and the financial intermediary itself.
The process of risk sharing is further augmented through diversification of assets (portfolio-
choice), which involves spreading out funds over a portfolio of assets with different types of
risk.
Reduce Asymmetric Information
Asymmetric Information in financial markets - one party often does not know enough about the
other party to make accurate decisions.
Adverse Selection (before the transaction)more likely to select risky borrower
Moral Hazard (after the transaction)less likely borrower will repay loan
=> Financial intermediaries are important in the production of information. They help reduce informational
asymmetries about some unobservable quality of the borrower for example through screening, monitoring or rating
of borrowers, Net worth and collateral.

Finally, some financial intermediaries specialize on services such as management of payments

for their customers or insurance contracts against loss of supplied funds.
Through all of these channels financial intermediaries increase market efficiency from an
economic point of view.

TYPES OF FINANCIAL INTERMEDIARIES

Depository institutions accept deposits from savers and transform them into loans
(Commercial banks, savings and loan associations, mutual savings banks and credit
unions)
Contractual savings institutions acquire funds at periodic intervals on a contractual
basis (insurance and pension funds)
Investment intermediaries serve different forms of finance. They include finance
companies, mutual funds and money market mutual funds.
FINANCIAL REGULATION
Why regulate financial markets?
Financial markets are among the most regulated markets in modern economies.
The first reason for this extensive regulation is to increase the information available to
investors (and, thus, to protect them).
The second reason is to ensure the soundness of the financial system.

1. Increasing information available to investors
As mentioned above, asymmetric information can cause severe problems in financial markets
(Risk behavior, insider trades,....)
Certain regulations are supposed to prohibit agents with superior information from exploiting
less informed agents.
In the U.S. the stock-market crash of 1929 led to the establishment of the Securities and
Exchange Commission (SEC), which requires companies involved in the issuance of securities to
disclose certain information relevant to their stockholders. The SEC further prohibits insider
trades

2. Ensuring the soundness of financial intermediaries

Even more devastating consequences from asymmetric information manifest themselves in
collapses of the entire financial system so called financial panics.
Financial panics occur if providers of funds on a large scale withdraw their funds in a brief
period of time from the financial system leading to a collapse of the system. These panics can
produce enormous damage to an economy.
Examples of some recent panics are the crises in the Asian Tiger states, Argentina or Russia. The
United States, while spared for most of the second half of 20th century, has a long tradition of
financial crises throughout the 19th century up to the Great Depression.

3. Solutions for ensuring the soundness of financial intermediaries

Restrictions on entry
Disclosure
Restrictions on Assets and Activities
Deposit Insurance
Limits on Competition
Restrictions on Interest Rates

Limits to Competition
An argument of politics rather than economics is that overly hard competition in the
banking sector increases the risk of bank failure. This belief has (especially in the past)
led to some restrictions in the commercial banking sectors
In the U.S. private banks e.g. were prohibited to open branches in different states
The empirical evidence for the benefits of limiting competition is weak and from an
economic point of view it appears more as an obstacle to risk diversification rather than
a useful regulation

Restriction of interest rates

The experience of the Great Depression in the U.S. has led to the widespread belief that
interest rate competition paid on deposits might facilitate bank failure and to strong
regulation of interest rates on bank deposits
Unlike most other developed economies, banks in the U.S. were prohibited from paying
any interest on deposits from 1933. Under what is known as Regulation Q, the Federal
Reserve System had the power to set the maximum interest rates payable on savings
deposits until 1986.