Financial Management

•Financial Management •An Introduction

Basic Forms of Business Organization

An Overview of the Financial System

Financial System Composed of: Financial Market  Financial Institutions/Intermediaries  Financial Instruments  Financial Services 

Function of the Financial Markets

Funds

Financial Intermediaries

Funds

Funds Lender-Savers Households Business firms Governments Foreigners

Funds

Financial Markets

Borrower Spenders Funds Business Firms Governments Households Foreigners

Financial Markets and Financial Intermediaries Financial Markets and Financial intermediaries have the basic functions of getting people with surplus funds to those who have a shortage of funds.  Well functioning of the financial markets and financial intermediaries are crucial to economic health. 

Functions of the Financial Markets Person A is having a powerful idea and Person B is having surplus funds.  The Role or function of the financial markets (bonds and Stock markets) is get people like A and B together.  This requires flow of funds from savers to borrowers.  This flow can occur in two ways; Direct Finance and Indirect finance route. 

Direct and Indirect Finance Direct Finance: Borrowers borrow funds directly from the lenders in the financial markets by selling them securities (financial instruments), which are claims on the borrower’s future income or assets.  Securities are assets for the person who buys them but liabilities to the person or firms that sells or issue them. 

Direct and Indirect Finance Indirect Finance: Borrowers borrow funds through financial intermediaries(banks, insurance companies, pension funds) in the form of loans and deposits.  Banks issue a liability(saving deposits, time deposits etc) use these funds to acquire an asset by a loan to Honda motors or by buying Honda motors bonds in the financial markets. 

Function of the Financial Markets INDIRECT FINANCE Funds

Financial Intermediaries

Funds

Funds Lender-Savers Households Business firms Governments Foreigners

Funds

Financial Markets

DIRECT FINANCE

Borrower Spenders Funds Business Firms Governments Households Foreigners

Why this channeling of Funds so important for the economy? Financial markets are essential to promote economic efficiency.  Financial markets are essential to increase production  Financial markets are helpful to fulfill you dreams.  Financial markets enhance entrepreneurial development and national welfare 

Functions of Financial Intermediaries Financial intermediaries also do the function of connecting people for investments.  Financial intermediaries are important as it;  Reduces transaction costs  Enables risk sharing  Removes information costs and moral hazards. 

Structure of Financial Markets Several categorization of financial markets illustrate essential features of Financial Markets.  Debt and Equity markets.  Primary and Secondary Markets  Exchange and Over the counter Markets  Money and Capital Markets  Internationalization of the Financial Markets. 

Debt and Equity Markets A firm or individual can obtain funds in a financial markets in two ways; issue of bonds or issue of equities.  Bonds: A contractual agreement by the borrower of the fund to pay the holder of the instrument fixed amount at regular interval (int. payments and principal) until a specified time (maturity period). 

Debt and Equity Markets 

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Equity: Claims to the share in the net income (income after expenses and taxes) and the assets of a business. If you hold one share in a company who has issued 100 shares, you are entitled to get 1% of the firm’s net income and 1% of the firm’s assets. You are also entitled for periodic payments of dividends. You have right to vote in electing the board members.

Debt and Equity Markets The equity holders are the residual claimants; the corporation must pay the bond holders first before paying to the equity holders.  The equity holders directly get advantages from any increase in the corporation’s profitability or asset values. 

Primary and Secondary Markets A primary market is a financial market in which new issues of a security such as bond or stocks are sold to initial buyers by the corporations or Government.  Secondary markets deals with securities that previously issued. These securities are resold in these markets. 

Primary and Secondary Markets The public does not know the primary markets for securities as the transactions are done behind closed doors.  The Investment Banks assist an initial sale of securities in the primary markets.  It does this by underwriting securities.  It guarantees a price for a corporation’s security and then sale them to the public. 

Primary and Secondary Markets When an individual buys securities in the secondary market, the corporation acquires no new funds.  A corporation gets new funds when its securities are first sold in the primary markets.  Nonetheless, the functioning of the secondary market is very important 

Functioning of the Secondary Markets Secondary markets make the financial instruments more liquid.  They determine the price of the securities those are issuing firms sale in the primary markets.  So, condition in the secondary market enhances the credibility of the corporations.  Hence, we will focus more on the functioning of the secondary markets. 

Structure of the Financial Markets Debt and Equity Market  Primary and Secondary Market  Exchanges and Over-the-Counter Markets Secondary markets can be organized in two ways; one is to organize exchanges, where the buyers and sellers or their agents or brokers meet at central location to conduct trades. - BSE 

Structure of the Financial Markets 

The other method of organizing a secondary market is to have an over-the-counter(OTC) market, in which dealers at different locations who have inventory of securities stand ready to buy and sale securities over the counter – local stock exchanges.

Structure of the Financial Markets Money and Capital Markets:  MM: Money market is a financial market in which only short-term debt instruments are traded. Generally, those instruments are maturity less than one year.  CM: Capital market is the market in which longer term debt and equity instruments are traded. (maturity greater than one year). 

Money and Capital Market Money market securities are usually less fluctuating. Corporations use money market instruments to earn money.  Capital market instruments are generally held by financial intermediaries, insurance companies and pension funds.  Money market is a market for very short term 

Money Market  

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Crowther defines, money market is the market that deals in various grades of near monies. WR Wegess defines, what a bank balance is to an individual the money market is to the country’s credit system. Segments of Money Market: Call Money Market Acceptance Market Bill discount Market Collateral loan market.

Call Money Market      

Call money market deals in loans at call and short notices. Deals with extreme form of short term loans; 24 hours, 7-15 days maturity. They can be recalled on demand or shortest possible notice. Normally, collaterals are not insisted upon. In India, CMM provides facilities for inter-bank tending. Surplus suppliers of funds: UTI, SBI, LIC

Call Money Market  

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Call Money Rate is the interest rate at which money is lended in the market. The market experiences some regular seasonal changes; it is normally tighter during the busy season (October – April) than during the slack season (May – September). It is much tighter in April. By its nature, the call money rate is highly volatile, in 1990-91was 70 and 85 in 1991-92, 1995-96

Internationalization of Financial Markets With the ongoing financial liberalization, each country now have a wider source of funds.  The traditional instruments in the international bond market are known as Foreign bonds.  Foreign bonds are sold in the foreign countries and are denominated in that country’s currency. 

Internationalization of Financial Markets Foreign bonds: German auto maker sales a foreign bond in US denominated in US dollar.  Euro Bond: Bonds denominated in in a currency other than that of the country in which it is sold.  Euro bond: A bond denominated in US dollar and sold in London. 

Internationalization of Financial Markets However, A bond denominated in euro is called Euro Bond if it is sold outside the countries that adopted Euro as their currencies.  Euro Currencies: A variant of euro bond is euro currencies. Foreign currencies deposited in banks outside the home country. US dollar deposited in Banks outside US. 

Financial Intermediaries: Risk sharing and reducing information costs. Financial intermediaries do help the investors reducing risks they are exposed to  They do this through the process called risk sharing.  They create and sale assets with risk characteristics that people are comfortable with. 

Risk Sharing 

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However, the intermediaries do use these funds acquired by selling to purchase other assets that may have far more risk. The process of risk sharing is also called asset transformation process. The asset transformation process turned the risky assets into safer assets for investors. Te risk sharing process also calls for diversification. Diversification: investing in the collection of assets (portfolio)

Asymmetric Information: Adverse Selection and Moral Hazard 

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In financial markets one party does not know enough about the other party to make accurate decisions. This inequality is called Asymmetric Information. A borrower has better information about the potential return and risk associated with the project for which the fund borrowed that the lender.

Asymmetric Information 

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Lack of information creates problems in the financial systems on two grounds: before transaction is entered and after. Adverse Selection: is the problem created by asymmetric information before the transaction occurs. Adverse selection in the financial markets occurs when the potential borrowers who are the most likely to produce an adverse outcome – bad credit risk.

Asymmetric Information Because adverse selection makes it more likely that loans might be made to bad credit risks, lender may decide not to make any loans even though there are good credit risk in the marketplace.  Example: Person X conservative: only when he is sure of returning back, he come for borrowing. Person Y aggressive investor with an idea of investment of get-rich-quick scheme. 

Asymmetric Information If you know both the persons, you will lend only person X.  If you do not know, you may not lend anybody because of the possibilities of adverse selection.  Though person X has excellent credit risk might need loan for worthwhile investment. 

Moral Hazard 

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Moral hazard is the problem created by asymmetric information after the transaction occurs. Moral hazard in the financial markets is the risk(hazard) that the borrower might engage in activities that are undesirable (immoral) from the lender’s point of view. The existence of moral hazard lowers the probability that loans will be repaid. So, Lender will decide not to make a loan.

Moral Hazard 

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Suppose that you have made 1 lakh loan to person A, who promised to make a cyber café and word processing job to help students process their assignments and term papers. However, he started gambling in the market with 1 lakh There is a possibility of getting back or loosing. Because of asymmetric information, you will be prevented from giving loans to him.

Financial Intermediaries can solve these problems. With financial intermediaries in the market, small saves will deposit their money in the banks and they screen out bad risk and good risk.  So, the risks due to asymmetric information and adverse selection are removed. 

•What is Finance Anyway? What is this course all about? • •

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Accounting is the language of business. Finance uses accounting information together with other information to make decisions that affect the market value of the firm. There are Four primary decision areas that are of concern.

•Four decision areas in finance: •

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Investment decisions - What assets should the company hold? This determines the left-hand side of the balance sheet. Financing decisions - How should the company pay for the investments it makes? This determines the right-hand side of the balance sheet. Dividend decisions - What should be done with the profits of the business? Working capital management decisions

Financial Management  Acquisition of funds and their effective

utilization so as to achieve the goal of financial Management

•All management decisions should help to accomplish the goal of the firm! •What should be the goal of the firm?

Goals of Firm 

What should be the goal of a corporation? – – – –

Maximize profit? Minimize costs? Maximize market share? Maximize the current value of the company’s stock?

Goals of the Firm 

Goal of the firm cam be stated in three ways – Maximize Shareholder Wealth – Maximize the Value of the Firm – Maximize the Share Price

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Profit maximization is not the same as wealth maximization. It fails to account for: – differences in the level of cash flows – the timing of the cash flows, and – the risk of the cash flows.

•Many people think the goal is to maximize profits. •

Would this mean short-term profit, or longterm profit? Businesses are sometimes criticized for being overly concerned about short-term profits results rather than the long-term strategic positioning of the company.

•What about risk? Isn’t risk important as well as profits? •

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How would the stockholders of a small business react if they were told that their manager canceled all casualty and liability insurance policies so that the money spent on premiums could go to profit instead. Even though the expected profits increased by this action, it is likely that stockholders would be dissatisfied because of the increased risk they would bear.

•The common stockholders are the owners of the corporation! •

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Stockholders elect a board of directors who in turn hire managers to maximize the stockholders’ well being. When stockholders perceive that management is not doing this, they might attempt to remove and replace the management, but this can be very difficult in a large corporation with many stockholders.

•More likely, when stockholders are dissatisfied they will simply sell their stock shares. •This action by stockholders will

cause the market price of the company’s stock to fall.

•When stock price falls relative to the rest of the market (or relative to the rest of the industry) ... •Management is failing in their job to

increase the welfare (or wealth) of the stockholders (the owners).

•Conversely, when stock price is rising relative to the rest of the market (or industry), ... •Management is accomplishing their

goal of increasing the welfare (or wealth) of the stockholders (the owners).

•The goal of the firm should be to maximize the stock price! • •

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This is equivalent to saying the goal is to maximize owners’ wealth. Note that the stock price is affected by management’s decisions affecting both risk and profit. Stock price can be maintained or increased only when stockholders perceive that they are receiving profits that fully compensate them for bearing the risk they perceive.

•Important focal points in the study of finance: • • •

Accounting and Finance often focus on different things Finance is more focused on market values rather than book values. Finance is more focused on cash flows rather than accounting income.

•Why is market value more important than book value? •

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Book values are often based on dated values. They consist of the original cost of the asset from some past time, minus accumulated depreciation (which may not represent the actual decline in the assets’ value). Maximization of market value of the stockholders’ shares is the goal of the firm.

Why is cash flow more important than accounting income? •

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Cash flow to stockholders (in the form of dividends) is the only basis for valuation of the common stock shares. Since the goal is to maximize stock price, cash flow is more directly related than accounting income. Accounting methods recognize income at times other than when cash is actually received or spent.

•One more reason that cash flow is important: •

When cash is actually received is important, because it determines when cash can be invested to earn a return. [Also: When cash must be paid determines when we need to start paying interest on money borrowed.]

•Examples of when accounting income is different from cash flow: • •

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Credit sales are recognized as accounting income, yet cash has not been received. Depreciation expense is a legitimate accounting expense when calculating income, yet depreciation expense is not a cash outlay. A loan brings cash into a business, but is not income.

•More examples: •

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When new capital equipment is purchased, the entire cost is a cash outflow, but only the depreciation expense (a portion of the total cost) is an expense when computing accounting income. When dividends are paid, cash is paid out, though dividends are not included in the calculation of accounting income.

•Definitions: Operating income vs. operating cash flow •

Operating income = earnings before interest and taxes (EBIT). This is the total income that the company earned by operating during the period. It is income available to pay interest to creditors, taxes to the government, and dividends to stockholders.

•Operating cash flow: •

Operating cash flow = EBIT + Depreciation - Taxes. This definition recognizes that depreciation expense is subtracted in computing EBIT, though it is not a cash outlay.

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It also recognizes that taxes paid is a cash outlay.

Role of Finance in a Typical Business Organization Board of Directors President VP: Sales

VP: Finance Treasurer

VP: Operations

Controller

Credit Manager

Cost Accounting

Inventory Manager

Financial Accounting

Capital Budgeting Director

Tax Department

Corporate Finance 

Every decision that a business makes has financial implications, and any decision which affects the finances of a business is a corporate finance decision.

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Defined broadly, everything that a business does fits under the rubric of corporate finance.

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Regardless of whether you work for a corporation or are an external party with an interest in a particular corporation, understanding and being able to analyze corporate decisions is important

First Principles of Corporate Finance 

Invest in projects that yield a return greater than the minimum acceptable hurdle rate with adjustments for project riskiness.

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Choose a financing mix that minimizes the hurdle rate.

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If there are not enough investments that earn the hurdle rate, return the cash to stockholders. – These decision criteria will be consistent with the objective of the firm: Maximize the Value of the Firm

Multinational/International Financial Management

Percentage of Revenue and Net Income from Overseas Operations for 10 Well-Known Corporations, 2001 Company

% of Revenue from overseas

% of Net Income from overseas

Coca-Cola

60.8

35.9

Exxon Mobil

69.4

60.2

General Electric

32.6

25.2

General Motors

26.1

60.6

IBM

57.9

48.4

JP Morgan Chase & Co.

35.5

51.7

McDonald’s

63.1

61.7

Merck

18.3

58.1

3M

52.9

47.0

Sears, Roebuck

10.5

7.8