EBA 6013 (Intro to Finance)

8/12/2019 EBA 6013 (Intro to Finance)

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EBA 6013

Principle of Finance)

Introduction to Finance


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Outline

Finance as a resources

Financial Decisions

The Challenge of Financial Managers

Financial Objectives

Basic concepts in Finance

Agency Relationship


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Introduction to Finance

Finance is the financial resources available tobusiness entity

The management of this resources is delegated by

the owners of the business to their employedmanagers.

The managers then are concerned with acquiring,managing and financing the business entitysresources or assets (tangible or intangible)

To pay for this business entity, managers mayraise funds by selling shares to the public, issuingdebt securities, borrowing from banks, leasingassets or using retained cash from business

operations.


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Financial Decisions

The objective of financial decisions is to

maximize the shareholders wealth

The higher the value of the business, thehigher will be the shareholders wealth


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Financial Decisions

Investment decisions, Financing decisions,Dividend decisions and Working CapitalManagement Investment decisions involve in choosing from a

long list of available projects to be undertaken andassets to be purchased

Financing decisions involve in generating fundsinternally or externally to finance the investment

Dividend decisions involve in returning some ofthe internal available fund to the owners(shareholders)

Working Capital Management involve in ensuringthe availability of fund in supporting day to daybusiness operations


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The Challenge. Investment Decision (Capital budgeting)process of

planning and managing a firms investments in fixedassets. The key concerns are the size, timing andriskiness of future cash flows.

Financing Decision (Capital structure)mix of debt

(borrowing) and equity (ownership interest) used by afirm. What are the least expensive sources of funds?Is there an optimal mix of debt and equity? When andwhere should the firm raise funds?

Dividend DecisionHigh or Low Dividend Policy?

Working capital managementmanaging short-termassets and liabilities. How much inventory should the

firm carry? What credit policy is best? Where will weget our short-term loans?


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The Financial Division

The Chief Financial Officer (CFO) orVice-President of Finance coordinates

the activities of the treasurer and thecontroller.

The controller handles cost and financialaccounting, taxes and information systems.

The treasurer handles cash management,financial planning and capital expenditures.


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The Companys Overall Objective

Managers seek to maximize economic profit(ignoring the contribution by & distribution toowners)

NOW, maximize the shareholders wealth. Apolicy of maximizing shareholders wealth willmaximize shareholders utility

Will there ever be a conflict of objectivesthen? -------- Agency Relationship (measuredin term of agency costs)


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Do Managers Always Act in the Share (stake)holders Interests?

Shareholders technically have control of thefirm, and dissatisfied shareholders can oustmanagement via proxy fights, takeovers, etc.However, this is easier said than done.

Staggered elections for board members oftenmake it difficult to remove the board thatappoints management. Poison pills and otheranti-takeover mechanisms make hostiletakeovers difficult to accomplish.

Stakeholders are other groups, besidesstockholders, that have a vested interest inthe firm and potentially have claims on the

firms cash flows. Stakeholders can includecreditors, employees and customers.


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Agency RelationshipThe Agency Problem and Control of the Corporation

Agency RelationshipsThe relationship betweenshare (stake)holders and management is called theagency relationship.

This occurs when one party (principal) hiresanother (agent) to act on their behalf. Thepossibility of conflicts of interest between theparties is termed as the agency problem.

Agency costs

direct costscompensation and perquisites formanagement

indirect costscost of monitoring and sub optimaldecisions


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Some Basic Concepts of Finance

Shareholders Value

The companys financial objective is to

maximize shareholders wealth The financial manager has to make financial

decisions which add value to shareholdersequity

To finance companys investment, financialmanagers will need to issue securities suchas shares and debt securities in financialmarkets. Therefore understanding how the

financial markets work is a must


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The actions of buyers and sellers of

these securities in the financial markets

will determine the price of thesesecurities and also the value of the

company


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As an investor you may either consume orinvest your wealth

A risk averse may choose to invest in a debt

securities for which they receive interest andrepayment of the amount invested in thefuture date

A risk seeker may prefer to consume

companys share for which they may receivepart of companys profits (in the form ofdividend) in proportion to their ownershipinterest


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The success of the companys investment willbe judged by its ability to generate more cashthan its original cash outlay on the investment,

where it should be sufficient enough for thecompany to make the fixed interest payment todebtholders and repay the principal, and to paydividends to its shareholders.

Risk and Return from the investment must alsobe carefully analyze and weighted against thebenefit of issuing shares and debt securities asmeans of financing.


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Time, Uncertainty & Risk

The value of an investment depends on the

amount and timing of the cash flowsgenerated by the investments.

And this amount and timing of cash flows arenot usually known with certainty.

The timing of the cash flows receivedsometimes in the future is referred to as aconcerned to the concept of time value ofmoney

The return received sometimes in the futurewill also be exposed to risk

The relationship between risk and returnneed to be discussed in depth.


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Market Efficiency and Capital Asset Pricing

To finance an investment, a financialmanager will issue securities in financialmarkets

Their initial assumption is that these markets

are efficient, i.e., composed of well-informedindividuals

Their trading activities cause prices to adjustinstantaneously and without bias in response

to new information

Price changes are caused by the availabilityof new information and are not supposed tobe caused by past price changes or otherspeculative factors


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The concept of market efficiency means thatwe should expect securities and other assetsto be fairly priced, given their expected risks

and returns. E.g., higher risk, higher return(vice-versa)

Share securities is more risky than Debtsecurities, the return for share investors are

dividend and increase share prices while fordebt investors are interest and increase indebt amount

To get the best trade-off between risk and

expected return, financial manager uses amodel called CAPM (Capital Asset PricingModel) and APT (Arbitrage Pricing Theory)

Systematic (non-diversifiable) Risk vs

Unsystematic (Diversifiable) Risk


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Issues to be discussed further:

Capital Budgeting

Risk & Return Analysis


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Tutorial Questions1. Distinguish between investment and financing

decisions2. What are the main functions of financial

managers

3. What is the relationship between diversifiable

and non-diversifiable risk? How does thisdistinction affect the reward that investorsdemand for bearing risk?

4. What is meant by the terms agency

relationship and agency costs?

Documents

EBA 6013 (Intro to Finance)