Financial Management
oguzhansaglik
Week_1.pptxIntroduction to Financial Management
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What is Finance?
The study of fund management and asset allocation over time
This can apply to:
Companies (corporate finance)
People (personal finance)
Governments (public finance)
Regardless of the subject, the goal is to understand how the decisions made today will have financial implications in the future
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Two Most Important Elements
Time
Every decision made
Risk
Uncertainty = Risk
The future is uncertain and Since finance is a forward-looking practice,
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How Does Finance Differ from Other Fields of Study?
Finance
How to optimally allocate assets
Forward looking
Economics
Analyzes the production, distribution, and consumption of goods and services
Cause and effect relationships in an economic ecosystem
Accounting
Communicates a historical financial information
“The language of business”
Backward looking record of the financial condition of an entity (business, person, government)
Overlap
Finance, economics, and accounting overlap in a lot of areas. For example, an investor will use accounting to see whether a company has shown past financial success and to predict what the company will look like in the future. Part of that prediction incorporates economics. The investor wants to know what the overall economy will look like in the future and wants to know how the company will interact with its competitors. The investor can use finance to figure out what his or her investment will be worth in the future.
There are few strong delineators between finance, economics and accounting. All three fields intermingle and influence one another. It is almost impossible to have a strong grasp of one without at least a basic understanding of the other two.
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Role of Financial Management in an Organization
Ultimate goal = Maximize value
Value can mean several things (discussed later)
Financial decision maker must determine the best course of action to take to maximize value and consider:
Short-term versus long-term goals (pay a dividend or invest in R&D of new project)
Different opportunities with competing resources (use $100 for either Project A or Project B)
Wil the way funds are allocated create benefits that justify their use? (Internal rate of return)
If an attractive opportunity exists, but the organization does not have available resources to pursue it, can the necessary funds be borrowed?
Maximizing value boils down to a series of investing and financing decisions (discussed later)
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Investing vs Financing
Investing
Spending capital that will create the most value for a firm over a specific period of time
Need to establish the proper mix of short-term versus long-term allocation of funds
Hold cash to pay bills in the short-term versus maximizing value over the long-term
Three criteria for investment:
Maximize the value of the organization
Must be financed appropriately
If an investment opportunity does not exist that meets the first two criteria, the funds should be returned to the shareholders in order to maximize value (dividends or stock repurchase)
Financing
How to pay for different functions in a firm
Two ways to finance an investment:
Using a company’s own money
Raise money from an external provider
Take on debt
Sell equity
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Financing from External Sources
Taking on Debt
Receive a loan from an external provider
Bank
Bond holders
The original amount of the loan has to be paid back plus interest
The rate of interest is agreed upon at issuance of the debt
Selling Equity
Selling an ownership stake in the firm in exchange for capital
Shareholders invest in an ownership stake with the expectation the firm will create value in the future
Stock issuance can be done via:
Private placement (venture capital)
A public exchange (New York Stock Exchange)
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Goal of Financial Management: Maximize Value
Sound financial management creates value through the allocation of scarce resources among competing business opportunities
How do we decide what to allocate these resources to?
Valuation: Determination of what something is worth
Relies on fundamental analysis of the subject (business, project, asset) via financial statements
Note: This is a key crossover of finance and accounting
Financial statements are a function of accounting (“language of business”) that inform the financial decision maker’s outlook
Accuracy of financial statements is critical for fundamental analysis and valuation
Applications include:
Sale/purchase of a business
Appraisal to resolve disputes
How to allocate business resources
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Goal of Financial Management: Maximize Value (cont.)
Maximizing Shareholder Value
In firms where there is a separation of ownership and management, the management has a fiduciary responsibility to maximize value
The relationship between management and the shareholders is known as the principle-agent relationship
An arrangement in which one entity (the principle) legally appoints another to act on its behalf (agent)
Principle-agent problems can arise (discussed later)
How does the agent pursue maximizing shareholder (principle) value?
Dividends
Increasing market value
Maximizing Market Value
Market value: Price at which an asset would trade in a competitive auction setting (e.g., public stock exchange)
Market value is determined by the auction setting an asset is trading on
A more active exchange will have a more efficiently priced market value
A less frequently
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Principle-Agent Problem
Occurs when agents (management) do not appropriately represent the best interests of principles (shareholders)
Agents are typically hired to conduct business on behalf of the principles because they possess the skills the principle lacks (Apple hiring a Chief Marketing Officer with 25 years of experience in marketing)
Agents may decide to act in their own best interest instead of principles
Example: Enron
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Financial Markets
An aggregate of possible buyers and sellers of financial securities, commodities and other fungible items
Can be classified by asset:
Capital markets (stocks and bonds)
Derivatives markets (options and futures)
Money markets
Currency markets
Or can be classified by seller:
Primary market: Where newly issued securities are bought and sold (IPO)
Secondary market: Where buying and selling of securities occurs on a continuous basis (NYSE)
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Financial Markets (cont.)
Role of Financial Markets a Financial Manager
Financial markets function through the interaction of buyers and sellers that determine the price of traded assets
Provide a sign for the allocation of funds in the economy based on the demand and supply through the mechanism called the price discovery process
Provides feedback to management on how their organization is viewed by the public
Investors assign a value to a company’s financial value when buying/selling stock
Not all feedback is useful (fundamental versus sentiment-driven analysis)
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