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Session 1Financial Management
Foundation and FinancialBackground
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Outline of Chapter
1. Business and Its Forms
2. Finance
3. The role of the financial manager today is so important.
4. Financial management
5. Three major Financial decision.6. The goals of the firm
7. Why shareholders' wealth maximization is preferred over other goals.
8. Agency Theory
9. Corporate governance.
10. Social responsibility of the firm.11. The basic responsibilities of financial managers and the differencesbetween a "treasurer" and a "controller."
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Business
Any legal activity which is undertaken to
earn profit is called business
Forms of Business
Sole Proprietorship
Partnership
Corporation
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The Business Environment
Oldest form of business organization.Business income is accounted for on the
owner’s personal income tax form.
Sole Proprietorship -- A business
form for which there is one owner.
This single owner has unlimitedliability for all debts of the firm.
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Summary for
Sole Proprietorship
Advantages
Simplicity
Low setup cost
Quick setup
Single tax filing on
individual form
Disadvantages
Unlimited liability
Hard to raise additionalcapital
Transfer of ownership
difficulties
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The Business Environment
Business income is accounted for on
each partner’s personal income taxform.
Partnership -- A business form in
which two or more individuals
act as owners.
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Types of Partnerships
Limited Partnership -- Limited partners have
liability limited to their capital contribution
(investors only). At least one general partner isrequired and all general partners have unlimited
liability.
General Partnersh ip -- All partners have
un l imi ted l iabi l i ty and are liable for all
obligations of the partnership.
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Summary for Partnership
Advantages
Can be simple
Low setup cost, higher thansole proprietorship
Relatively quick setup
Limited liability for limited
partners
Disadvantages
Unlimited liability for the
general partner
Difficult to raise additional
capital, but easier than sole
proprietorship
Transfer of ownership
difficulties
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The Business Environment
An artificial entity that can own assets
and incur liabilities.
Business income is accounted for on theincome tax form of the corporation.
Corporation -- A business form
legally separate from its owners.
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Summary for Corporation
Advantages
Limited liability
Easy transfer ofownership
Unlimited life
Easier to raise largequantities of capital
Disadvantages
Double taxation
More difficult toestablish
More expensive to set
up and maintain
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Forms of Business
In Terms of Number
80% = Sole Proprietorship
20% = Partnership / Corporation
In terms of Dollar Value
80% = Corporation
13% = Sole Proprietorship
07% = Partnership
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Depreciation
Generally, profitable firms prefer to use an
accelerated method for tax reporting purposes.
Depreciation represents the
systematic allocation of the cost of
a capital asset over a period of timefor financial reporting purposes, tax
purposes, or both.
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Common Types of
Depreciation
Straight-line (SL)
Accelerated Types Double-Declining-Balance (DDB)
Modified Accelerated Cost Recovery System
(MACRS)
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MACRS Schedule
Recovery Property Class
Year 3-Year 5-Year 7-Year
1 33.33% 20.00% 14.29%2 44.45 32.00 24.49
3 14.81 19.20 17.49
4 7.41 11.52 12.49
5 11.52 8.936 5.76 8.92
7 8.93
8 4.46
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Financial Decision Making
Three major Decisions that a Financial
Manager has to take
The Investment Decision
The Financing DecisionThe Assets Management Decision
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Investment Decisions
What is the optimal firm size?
What specific assets should be
acquired?
What assets (if any) should be reduced
or eliminated?
Most important of the three
decisions.
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Financing Decisions
What is the best type of financing?
What is the best financing mix?
What is the best dividend policy (e.g., dividend-
payout ratio)?How will the funds be physically acquired?
Determine how the assets (LHS of
balance sheet) will be financed (RHS
of balance sheet).
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Asset Management
Decisions
How do we manage existing assets efficiently ?
Financial Manager has varying degrees of
operating responsibility over assets.Greater emphasis on current asset management
than fixed asset management.
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What is Financial
Management?
Concerns the acquisition,
financing, and management of
assets with some overall goal in
mind.
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Finance Function Involves
Preparation of Cash Budget
Monitoring Performance
Evaluating Prospective InvestmentsRaising Funds
Forecasting and Planning
Coordination and ControlInteraction with Capital Market
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Goals of Firm
Profit Maximization
Wealth Maximization
Preserve the Stakeholders Wealth
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Profit Maximization
Issue common stock for profit maximization Example).
Ignores changes in the risk level of the firm.
Calls for a zero payout dividend policy.
A financial Manager should take those decision
which increase profits for the firms
Maximizing a firm’s earnings after taxes or Maximize
Earning Per Share (EPS).
Problems
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Maximization of
Shareholder Wealth
Value creation occurs when we maximizethe share price for current shareholders.
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Stock Prices are Dependant on
following factors
Projected Earning Per Share
Timing of Earning Stream
Risk Involved
Use of Debt
Dividend Policy
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Strengths of Shareholder
Wealth Maximization
Takes account of: current and future profits
and EPS; the timing, duration, and risk of
profits and EPS; dividend policy; and allother relevant factors.
Thus, share price serves as a barometer for
business performance.
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What companies say about
their corporate goal*
Cadbury: “governing objective is growth in shareownervalue”
Credit Suisse Group: “achieve high customer satisfaction,
maximize shareholder value and be an employer of choice” Dow Chemical Company: “maximize long-term shareholdervalue”
ExxonMobil: “long-term, sustainable shareholder value”
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The Modern Corporation
There exists a SEPARATION between
owners and managers.
Modern Corporation
Shareholders Management
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Role of Management
An agent is an individual authorized by
another person, called the principal, to
act in the latter’s behalf.
Management acts as an agent
for the owners (shareholders)
of the firm.
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Agency Theory
Agency Theory is a branch of
economics relating to the behavior ofprincipals and their agents.
Jensen and Meckling developed
a theory of the firm based onagency theory .
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Agency Theory
Incentives include, stock options, perquisites, and bonuses.
Principals must provide incent ives
so that management acts in the
principals’ best interests and then
moni tor results.
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Social Responsibility
Wealth maximization does not preclude the firm
from being socially responsible.
Assume we view the firm as producing both private and social goods.
Then shareholder wealth maximization remains
the appropriate goal in governing the firm.
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Corporate Governance
Corporate governance: represents the system
by which corporations are managed and
controlled .
Includes shareholders, board of directors, and senior
management.
Then shareholder wealth maximization remains
the appropriate goal in governing the firm.
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Board of Directors
Typical responsibilities: Set company-wide policy;
Advise the CEO and other senior executives; Hire, fire, and set the compensation of the CEO;
Review and approve strategy, significant
investments, and acquisitions; and
Oversee operating plans, capital budgets, andfinancial reports to common shareholders.
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Organization of the Financial
Management Function
Board of Directors
President
(Chief Executive Officer)
Vice President
Operations
Vice President
Marketing
VP of
Finance
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TreasurerCapital Budgeting
Cash Management
Credit Management
Dividend DisbursementFin Analysis/Planning
Pension Management
Insurance/Risk Mngmt
Tax Analysis/Planning
Organization of the Financial
Management Function
VP of Finance
ControllerCost Accounting
Cost Management
Data Processing
General LedgerGovernment Reporting
Internal Control
Preparing Fin Stmts
Preparing Budgets
Preparing Forecasts
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Financial Environment
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Interest
No one lends money for free as manyfactors involved to get back the money
So, lenders want some compensation
called interest.Interest rate is expressed in percentage
Prevailing rate of Interest in any situation
is called nominal Interest rate.Real Rate of Interest
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Interest Deductibility
Interest Expense is the interest paid onoutstanding debt and is tax deductible.
Cash Dividend is the cash distribution of
earnings to shareholders and is not a taxdeductible expense.
The after-tax cost of debt is:
(Interest Expense) X ( 1 - Tax Rate)Thus, debt financing has a tax advantage!
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Financial Environment
Businesses interact continually with the financial
markets.
Financial Markets are composed of allinstitutions and procedures for bringing buyers
and sellers of financial instruments together.
The purpose of financial markets is to efficiently
allocate savings to ultimate users.
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Financial Markets
Moving of funds from saving sector toinvestment sector.
A forum where financial securities aresold.
May or may not have fixed location.
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Types of Financial Markets
Money Market: ST Securities, maturity up to one year.Player: State Bank, Commercial banks, Investmentbanks. (e.g. TB, Commercial papers). Issued by private& govt.
Funds used to meet temporary cash requirements.
Capital Market: LT Securities, maturity more than one year.(e.g. Bonds & Stocks). Funds used for LT investment.
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Primary Market: When new security is sold first timeto general public & institutions. Deficit economic unitsdirectly sell new security to surplus economic units.
e.g. SB sold TB to banks (money market).e.g. first time selling of CS, PS, TFC, Bonds (capital
market)
Secondary Market: When issued securities are
traded. Thousands transaction occur.e.g. When TBs are traded among institution (money
market).
e.g. Trading of CS,TFC, Bonds in stock exchanges.
(capital market)
Types of Financial Markets
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Stock Exchange: Just like KSE, ISE. The organizationthat facilitate trading of stocks & bonds amongst investors.Supervised, monitored and regulated by SECP.
OTC Market: have no fixed locations. Network of dealerswho maintain inventory of securities for resale purpose.
e.g. if you required some securities, you ask your broker whowill shop from those dealers having best price for you.
NASDAQ (National association of security dealersautomated quote system).
Dealers in OTC market are connected through computernetworks.
Types of Financial Markets
Fl f F d
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Flow of Funds
in the Economy
INVESTMENT SECTOR
F I N A N C I A L
I N
T E R M E D I A R I E S
SAVINGS SECTOR
FINANCIAL BROKERS
SECONDARY MARKET
Fl f F d
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Flow of Funds
in the Economy
F I N A N C I A L
I N
T E R M E D I A R I E S
SAVINGS SECTOR
FINANCIAL BROKERS
SECONDARY MARKET
INVESTMENT
SECTOR
Businesses
Government
Households
INVESTMENT SECTOR
Fl f F d
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Flow of Funds
in the Economy
F I N A N C I A L
I N
T E R M E D I A R I E S
SAVINGS SECTOR
FINANCIAL BROKERS
SECONDARY MARKET
SAVINGS
SECTOR
Households
Businesses
Government
INVESTMENT SECTOR
Fl f F d
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Flow of Funds
in the Economy
F I N A N C I A L
I N
T E R M E D I A R I E S
SAVINGS SECTOR
FINANCIAL BROKERS
SECONDARY MARKET
FINANCIAL
BROKERS
Investment
Bankers
Mortgage
Bankers
INVESTMENT SECTOR
Fl f F d
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Flow of Funds
in the Economy
F I N A N C I A L
I N
T E R M E D I A R I E S
SAVINGS SECTOR
FINANCIAL BROKERS
SECONDARY MARKET
FINANCIAL
INTERMEDIARIES
Commercial Banks
Savings Institutions
Insurance Cos.
Pension Funds
Finance Companies
Mutual Funds
INVESTMENT SECTOR
Fl f F d
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Flow of Funds
in the Economy
F I N A N C I A L
I N
T E R M E D I A R I E S
SAVINGS SECTOR
FINANCIAL BROKERS
SECONDARY MARKET
SECONDARY
MARKET
Security
Exchanges
OTC
Market
INVESTMENT SECTOR
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Allocation of Funds
In a rational world, the highest expected returns will
be offered only by those economic units with the
most promising investment opportunities.
Result: Savings tend to be allocated to the mostefficient uses.
Funds will flow to economic units that are
willing to provide the greatest expected
return (holding risk constant).