Financial Management

Session -1 Financial Management : Functions & Objectives

Corporate Finance: Objectives?

What is Corporate Finance?

Corporate Finance addresses the following three questions:
What long-term investments should the firm choose? How should the firm raise funds for the selected investments? How should short-term assets be managed and financed?
How much short-term cash flow firm need to pay its bills?

What proportion of the funds should be reinvested in the firm and what should be distributed to the shareholders?

Balance Sheet Model of the Firm

Total Value of Assets: Total Firm Value Current Liabilities Long-Term Debt

Current Assets

Fixed Assets 1 Tangible 2 Intangible Shareholders Equity

The Capital Budgeting Decision

Current Liabilities Long-Term Debt Fixed Assets 1 Tangible 2 Intangible

Current Assets

What long-term investments should the firm choose?

Shareholders Equity

The Capital Structure Decision

Current Liabilities Long-Term Debt

Current Assets

How should the firm raise funds for the selected Fixed Assets investments? 1 Tangible
2 Intangible

Shareholders Equity

Short-Term Asset Management

Current Liabilities
Net Working Capital

Current Assets

Long-Term Debt

Fixed Assets 1 Tangible 2 Intangible

How should short-term assets be managed and financed?

Shareholders Equity

Risk and Return

Financial Management involves three decisions:
Investment Decisions Financing Decisions Dividend Decisions

Whenever a financial decision involves investment and/or financing, it is also concerned with two specific factors: expected return and risk.
Expected return is the difference between potential benefits and potential costs. Risk is the degree of uncertainty associated with these expected returns.

The Firm and the Financial Markets

Firm
Invests Firm Receive in assets (B) Cash, generate Firm issues securities (A) Retained cash flows (F) Short-term debt Cash flow from firm (C) Dividends and debt payments (E) Taxes (D) Long-term debt Equity shares

Financial markets

profits through Current assets Fixed assets its operations (B)

Ultimately, the firm must be a cash generating activity.

Government

The cash flows from the firm must exceed the cash flows from the financial markets.

Corporations

Forms of Business Organization

The Sole Proprietorship The Partnership

General Partnership Limited Partnership

The Corporation

A Comparison
Corporation Liquidity Shares can be easily exchanged Usually each share gets one vote Double Broad latitude Partnership Subject to substantial restrictions General Partner is in charge; limited partners may have some voting rights Partners pay taxes on distributions All net cash flow is distributed to partners General partners may have unlimited liability; limited partners enjoy limited liability Limited life

Voting Rights

Taxation Reinvestment and dividend payout Liability

Limited liability

Continuity

Perpetual life

Role of Financial Managers

Hypothetical Organization Chart

Board of Directors Chairman of the Board and Chief Executive Officer (CEO) President and Chief Operating Officer (COO) Vice President and Chief Financial Officer (CFO)

Treasurer

Controller

Cash Manager
Capital Expenditures

Credit Manager Financial Planning

Tax Manager
Financial Accounting

Cost Accounting Data Processing

Accounting and Financial Management

The firms finance (treasurer) and accounting (controller) functions are closely related and overlapping. In smaller firms usually financial manager generally performs both functions. One major difference is that accountants generally uses accrual method while in finance, the focus is on cash flows. Finance and accounting also differ with respect to decision making. While accounting is primarily concerned with the presentation of the financial data, financial manager is primarily concerned with the analyzing and interpreting this information for the decision making purposes.

Role of Financial Managers

The financial managers are primarily concerned with investment decisions and financing decisions within business organizations. Financial Managers dilemma:
What goal(s) do managers have in mind when they choose between financial alternativessay, between distributing current income among shareholders and investing it to increase future income?

Role of Financial Managers

The Financial Managers primary goal is to increase the value of the firm by: Selecting value creating projects Making smart financing decisions
How to minimize the cost of capital

Financial Objective
There is actually one financial objective:
The maximization of the economic wellbeing, or wealth, of the owners.

Whenever a decision is to be made, management should choose the alternative that most increases the wealth of the owners of the business. The market value of shareholders equity generally measures the owners economic well being.

How to maximize shareholders wealth?

Maximize profit? Minimize costs? Maximize market share? Maximize shareholder wealth?

How to maximize shareholders wealth?

If the market for stocks is efficient, the value of a share of stock in a corporation should reflect investors expectations regarding the future prospects of the corporation. The value of a stock will change as investors expectations about the future change. For financial managers decisions to add value, the present value of the benefits resulting from decisions must outweigh the associated costs, where costs include the costs of capital.

How Stock Price Maximization Works?

Stockholders hire managers to run their firms efficiently for them
Because stockholders have absolute powers to hire and fire managers

Managers set aside their interest and maximize stock prices

Because markets are efficient

Stockholder wealth is maximized

Because lenders are fully protected from the stockholders action

Firms value is maximized

Because there are no costs created for the society

Finance Managers: Additional Issues

If there is a separation of the ownership and management of a firmthat is, the owners are not also the managers of the firmthere are additional issues to confront. What if a decision is in the best interests of the firm, but not in the best interest of the manager? How can owners ensure that managers are watching out for the owners interests? How can owners motivate managers to make decisions that are best for the owners?

The Agency Relationship

An agent is a person who acts forand exerts powers of another person or group of persons called Principal. Agency relationship
Stockholders (principals) hire managers (agents) to run the company/ to represent his/her interest

Agency problem
Conflict of interest between principal and agent

Managerial Goals
Managerial goals may be different from shareholder goals
Expensive perquisites Survival Independence

Increased growth and size are not necessarily equivalent to increased shareholder wealth

Costs of Agency Relationship

There are costs involved with any effort to minimize the potential for conflict between the principals interest and the agents interest. These are:
Monitoring Costs Lost of opportunity Hostile takeovers

How to reduce Agency Costs?

Motivating Managers:
Managerial compensation
Incentives can be used to align management and stockholder interests Job prospects Bonus, ESOP, Stock Appreciation Rights, Sweat Equity, EVA-linked Bonus

Corporate control
The threat of a takeover may result in better management

Shareholder Wealth and CSR

Discontinuing investment in an unprofitable business may mean closing down plants, laying off workers, and, perhaps destroying an entire town that depends on the business for income. So decisions to invest or disinvest may affect great numbers of people. Can a firm maximize the wealth of shareholders and stakeholders at the same time? Shareholder wealth maximization is consistent with the best interests of stakeholders and society if market forces reward firms for taking actions that are in societys interest or if the government steps in to force actions that are in societys interest.

How to Finance?

How Firms Finance Themselves

Internal financing
Retained earnings (21%) Depreciation (10%) (68%) (14%) (31%)

External financing
Issuing new equity Bank loans Issuing bonds (18%) (04%)

Foreign borrowings

(03%)

Current liabilities (25%)

How Firms Finance Themselvescontd

Excessive reliance on internal financing Large role for banks Miniscule and stagnant bond market

Source of Corporate Finance

Source: World Bank , 2005

Financial Markets, How to Finance?

Financial Markets
Call notice/Money Market:
A market to raise short-term money. usually OTC market

Money Market Securities:

Treasury bills Commercial paper Certificate of deposits Bankers acceptances Repos CBLOs

Indian Debt Market: A Broad Classification

(1) Call/notice money market
"Call Money" means deals in overnight funds "Notice Money" means deals in funds for 2 - 14 days Term Money means deals in funds for 15 days-1 year "Fortnight" shall be on a reporting Friday basis and would mean the period from Saturday to the second following Friday, both days inclusive
Products: T-bills , CDs ,Commercial Paper , CBLOs etc.

(2) Bond market

Indian Debt Market: A Broad Classification..contd

Bond market
1. Government Securities or Gilts
2. 3. Issued by the central government to fund their fiscal deficit also called direct dated securities Indirect government securities
Issued by central government in lieu of subsidies E.g., oil bonds, fertilizer bonds Do not qualify for the statutory requirements

4. State development loans (SDL)

5. Issued by the state governments

6. Corporate Bonds
7. Issued by private and public sector companies

. Examples: Zero coupon/deep discount bonds, fixed interest bonds, floating rate bonds, capital indexed bonds etc.

Regulation of Money Market

The RBI is the sole regulator of the money and debt market in India. CCIL settles all Gilts, repo and CBLO transactions in India. Oil companies are major players in CBLO market. Oil companies use the illiquid oil bonds received from the Govt. to create CBLOs and borrow funds against these collaterals at very low rate of interest.

Financial Markets: Debt Market

Bonds, notes, and medium-term notes are issued by corporations, the government, government agencies, and municipal bodies. Corporate debt securities backed by specific assets as collateral are referred to as secured notes or secured bonds. If they are not backed by specific assets, they are referred to as debentures.

Average Daily Volumes in Domestic Financial Markets

Money Market LAF 1 Mar-11 Jun-11 Sep-11 Dec-11 Jan-12 Feb-12 Mar-12 2 -809.6 -741.3 -559.2 -1166.6 -1292.3 -1405.3 -1574.3 Call Market Money Repo 3 112.8 115.6 137.8 148.8 172.6 141.6 175.1 4 151.3 166.5 138.9 99.5 89.1 121.7 111.8 CBLO 5 432.0 413.1 451.2 264.9 279.6 331.2 379.8

Forex Stock Market Certificates Market# Commercial Corporate Inter-bank G-Sec@ # Paper* Bond # (US$ bn) of Deposit* 6 803.1 1046.9 1446.2 1341.5 1498.8 1,613.94$ 7 4247.4 4237.7 3834.7 4030.0 3909.4 4028.9 8 81.4 128.4 123.2 205.7 233.4 157.9 98.6 9 22.7 23.4 22.4 30.0 24.5 35.7 26.1 10 22.2 24.1 22.4 17.8 17.7 17.7 11 148.2 128.0 137.6 108.6 131.5 198.4 151.9

Bond Market

*: Outstanding position. @: Average daily outright trading volume in Central Government dated securities. #: Average Daily Trading in Corporate Bonds. ##: Average daily Turnover in BSE and NSE. ^: As at mid-June 2011. $: Feb 15, 2012. Note: In col. 2, (-) ve sign indicates injection of liquidity while (+) ve sign indicates absorption of liquidity.

Source: rbi.org.in, Figures in INR 100 crore

Equity Market
Primary Market
Issuance of a security for the first time

Secondary Markets
Buying and selling of previously issued securities Securities may be traded in either a dealer or auction market
NYSE NASDAQ

OTC Market

Questions
Which of following actions are the result of a financing decision and which are the result of an investment decision?
1. A firm introduces a new product. 2. A firm issues new bonds. 3. A corporation issues new shares of stock. 4. A firm expands its existing manufacturing facilities. 5. A firm leases a new building to be used in its manufacturing.

Thank You!