FINANCIAL MANAGEMENT:

A REVISIT

IMI, Kolkata
2018
OXYGEN & HUMAN BODY
 On an average, an adult, at rest, requires 16
litres of Oxygen per Hour!

 What if the Oxygen is stopped for more than 3

minutes?
 What if a person decides to take on Usain Bolt on
track?
 What if the person wants to dive to reach
Mariana Trench?
 What if a person’s lung fails?
THE BUTTERFLY EFFECT
 When a butterfly flutters its wings in the wilds of
Brazil, there is a Tornado in Tokyo (Edward
Lorenz, 1961)

 A principle of Meteorology
 Dispersion models
 Long distance transportation of gases

 True for the current financial world

 Cascades
 Spillover
THE STORY OF BOEING & A SMALL BOOK
STORE
CFO @ Boeing
 Invest billions of Dollars
in the Super Jumbo Jet
Project carrying 500+
passengers?
 Will the investment
outcompete Airbus?
 Debt or Equity?
Combination?
 How much return to the
equity and debt holders?
At what frequency?
 What is the ROI?
Owner @ A Local Book
Store
 Invest an amount to add
a Café
 Will this investment
outcompete Crossword?
 Investment his own
saving? A Bank Loan?
 Can he take out some
money for himself?
When?
 What is the ROI?
BUSINESS IS ABOUT FUNDS!
Firms Raise Funds
Firms Invest Financial
in Assets Markets

•Fixed Assets
Reinvest
• Long Term
•Current Debts
Assets Dividends/
•Short Term
Assets Generate Cash Repayment
s/ Interest Debts
•Equity

Govt. & Other

Stakeholders
LESSONS
 Some fundamental decision on managing funds
 Choices/Decisions: Fundamental
 Leads to inflow/outflow of funds
 Timing of inflow/outflow may not be well-coordinated
 Delayed Inflow is disastrous
 Delayed outflow is welcome!
 Assets – Use of Funds
 Liabilities – Sources of Funds
 Scales: Different
 Value of a Firm
 Value of investments already made
 Value of investments forthcoming
 Maximize value of the firm
5 PILLARS OF CORPORATE FINANCE

Investment Financing Dividend Liquidity Hedging

Principle Principle Principle Principle Principle

Finance Mix: What is

How to manage
Investment in What proportions anticipated
short term Assets Managing Risks
Assets of Debt and returns < Hurdle
and Liabilities
Equity? Rate?

Rate of return ≥
Finance Type: Return the money
Hurdle Rate What type of to investors
(Minimum Debt & Equity? (Equity holders)
acceptable Return)

Hurdle Rate = Value of the Firm

OCC is Maximized

Hurdle Rate is
minimized!
FINANCING DECISIONS
• Raising funds from the Financial Markets
• Funds are require to meet the Investment requirements
• Decision regarding Capital Structure is Important
• Financial Manager’s goal is to attain an Optimal Capital structure
• Is Debt Non Optimal? – Presence of Debt affects the returns to
shareholders
• Leverage is Important – Returns to shareholders can change in the
presence of debt
• Control, Flexibility, Loan Covenants, Legal Matters are important in
arriving at a decision regarding capital structure
INVESTMENT DECISIONS
• Investment decisions lead to creation of Assets
• Capital Budgeting Decision – Related to investment in long term
assets
• Long term assets generate cash flows in future and over a period
time! There may be a GESTATION Period!
• Is the rate of return from the long term assets sufficient?
• What is the Required Rate of Return – Hurdle Rate?
• What is the expected rate of return?
• What are the risks?
DIVIDEND DECISIONS
• What should be the Plough-back Ratio?
• Is the Dividend Pay-out Ratio adequate?
• Is the dividend policy optimum – Does it maximize shareholders
value?
• Are shareholders satisfied with the Returns – Dividend Yield &
Capital Gains?
• Is the Dividend payable in Cash or in the form of Bonus Shares?
LIQUIDITY DECISIONS
• Liquidity is important
• But liquidity can affect profitability – what is the degree of tradeoff
between liquidity and profitability
• To what extent can Current Liabilities finance the Current Assets?
• What should be the source of short term borrowings?
• What is the optimal level of short term borrowings?
HEDGING DECISIONS
• Risk has to be managed – Credit Risk, Market Risk, FOREX Risk,
etc.
• Can risk be made ZERO?
• How can Risks be hedged?
• Risk sharing?
• Risk shifting?
• How to chose between various risk management mechanisms?
• What is the optimal risk management mechanism?
MACROECONOMIC FLOW: A SIMPLE MODEL
Flow of Expenditure: Consumption and Taxes

Flow of Goods and Services

Business & Households

Government

Flow of Factors of Production

Flow of Income
ACTORS IN A FINANCIAL SYSTEM

Firms

Intermediaries
Financial Government
System

Individuals
FINANCIAL INTERMEDIATION
• One of the most important INVENTIONS of the Modern World

• Primary Task: Channel SCARCE LOANABLE/INVESTIBLE funds

from those who SAVE to those who BORROW/USE

• Financial Markets INTERMEDIATES between Savers and Users

of Funds

• Use of Funds: Buy goods and services and to make investments in

new equipment and facilities

• Investments: Increase Capacity of Production and Remove Supply

Side Constraints

• Financial System: Help to create a BETTER ECONOMY –

Employment, Production & Demand
FUNCTIONS: FINANCIAL SYSTEM
• Savings Function: Conduit for transforming Savings to Investments.
Stocks, Bonds, etc. - a profitable, relatively low risk, outlet for the public’s savings

• Wealth Function: Financial instruments provide an excellent way to

store wealth (i.e. preserve the value of the assets we hold) until funds
are needed for spending. Although, one might choose to store his
wealth in things, such items are subject to depreciation and often carry
great risk of loss.
Financial Instruments have a power to appreciate and generate
RETURNS and CAPITAL GAINS

• Liquidity Function: For wealth stored in the financial instruments, the

financial market provides avenues for converting the instruments into
CASH with little risk of loss.
Financial Markets provide Liquidity to the savers
FUNCTIONS: FINANCIAL SYSTEM
• Credit Function: The financial markets furnish credit to finance
consumption and investment spending.

Credit = Loan of funds in return for a promise of future payments

• Payment Function: Provides a mechanism for making payments for goods

and services.

Checking Accounts, Negotiable Instruments, Plastic Cards are widely accepted

instruments for making payments

• Risk Function: Offers business, consumers and governments protection

against life, health, property and income risks.
General & Life Insurance, Options, Forwards and Futures

• Policy Function: Principal channel through which government

implements its stabilizing the economy, avoid inflation and promote
growth.
DIRECT FINANCE
Flow of Funds

Borrower Lender
[Deficit [Surplus
Budget Budget
Unit] Unit]

Primary Security

• Borrower & Lender meet each other and exchange funds for financial
security
• Cost of SEARCH is high – Transaction Costs are High
• Problem of Double Coincidence of Wants
• Lender must have faith in the security issued by the Borrower
•EXAMPLE: Money Lender providing Credit to Farmers in Rural India
SEMI-DIRECT FINANCE
Flow of Funds Flow of Funds

Security
Brokers,
Borrowers Dealers & Lenders
Investment
Bankers

Primary Security Primary Security

• Intermediaries bring Surplus Budget and Deficit Budget Units together

• Cost of Information is Low
• Problem of EXACT AMOUNT is reduced – Intermediaries can split up
securities and distribute in smaller lots
• Lender must have faith in the security issued by the Borrower
INDIRECT FINANCE
Flow of Funds Flow of Funds

Banks,
Borrowers Financial Lenders
Institutions

Primary Security Secondary Security

• FI takes Deposits and issues Secondary Securities

• FI guided by Regulations – Lenders have faith in the Secondary Securities
• FI searches for borrowers and invest
• Problem of EXACT AMOUNT is absent
• Transaction costs are minimum
REAL & FINANCIAL ASSETS
• Tangible Real Assets: Physical Assets that are required to carry out the
business. E.g. Plant & Machinery, Land & Building, etc.

• Intangible Real Assets: Technical know-how, technological collaborations,

patents & copyrights

• Financial Assets: Financial Instruments that are resultant to the

investment activities by the firm
THANK YOU!