Introduction to Finance PDF - BMSH2201

BMSH2201 INTRODUCTION TO FINANCE Finance and Financial Management (Cayanan, et al., 2016) Finance is always of great importance, be it in a business or one's everyday life. It is important to manage risks in business, and it is equally important to manage ris...

BMSH2201 INTRODUCTION TO FINANCE Finance and Financial Management (Cayanan, et al., 2016) Finance is always of great importance, be it in a business or one's everyday life. It is important to manage risks in business, and it is equally important to manage risks in life. Risk is nothing but an uncertain event that might damage your assets, and when it is financial risk, it creates a loss in finances. Some books define finance as the science and art of managing money. Financial Management deals with those decisions that are supposed to maximize shareholder wealth value. These decisions will ultimately affect the markets' perception of the company and influence the share price. Managers of a corporation are responsible for making the decisions for the company that would lead towards shareholder’s wealth maximization. The goal of Financial Management is to maximize the value of shares of stocks. The company's organizational structure is important, especially in the financial aspect of the business and the particular set of people. Each plays a role in the decision-making of the company. Figure 1. Organizational Structure Sample Source: Business Finance: Specialized Subject, 2016, p. 11 Each line is working for the person's interest on the line above them. Since the company managers make decisions for the interest of the board of directors and the board of directors do the same for the interest of the shareholders, it follows the goal of each individual in a corporate organization should have an objective of shareholders wealth maximization. 1. Shareholders: The shareholders elect the Board of Directors (BOD). Each share held is equal to one (1) voting right. 2. Board of Directors: The board of directors is the highest policy-making body in a corporation. The board’s primary responsibility is to ensure that the corporation is operating to serve the best interest of the stockholders. The following are among the responsibilities of the board of directors: a. Setting policies on investments, capital structure, and dividend policies. b. Approving company’s strategies, goals, and budgets. c. Appointing and removing members of the top management, including the president. d. Determining top management’s compensation. e. Approving the information and other disclosures reported in the financial statements. 3. President (Chief Executive Officer): The roles of a president in a corporation may vary from one company to another. Among the responsibilities of a president are the following: 01 Handout 1 *Property of STI  [email protected] Page 1 of 8  BMSH2201 a. Approving the information and other disclosures reported in the financial statements. Overseeing the company's operations and ensuring that the strategies as approved by the board are implemented as planned. b. Performing all areas of management: planning, organizing, staffing, directing, and controlling. c. Representing the company in professional, social, and civic activities. 4. VP for Marketing: The following are among the responsibilities: a. Formulating marketing strategies and plans. Directing and coordinating company sales. b. Performing market and competitor analysis. c. Analyzing and evaluating the effectiveness and cost of marketing methods applied. d. Conducting or directing research that will allow the company identify new marketing opportunities, e.g. variants of the existing products/services already offered in the market. e. Promoting good relationships with customers and distributors. 5. VP for Production: The following are among the responsibilities: a. Ensuring production meets customer demands. b. Identifying production technology/process that minimizes production cost and makes the company cost competitive. c. Coming up with a production plan that maximizes the utilization of the company’s production facilities. d. Identifying adequate and cheap raw material suppliers. (Cayanan, 2015) 6. VP for Administration: The following are among the responsibilities: a. Coordinating the functions of administration, finance, and marketing departments. b. Assisting other departments in hiring employees. c. Assisting in payroll preparation, payment of vendors, and collection of receivables. d. Determining the location and the maximum office space needed by the company. e. Identifying means, processes, or systems that will minimize the company's operating costs. The role of the VP for Finance/Financial Manager is to determine the appropriate capital structure of the company. Capital structure refers to how much of your total assets is financed by debt and how much is financed by equity. To be able to acquire assets, our funds must have come somewhere. If it has been bought using cash from our pockets, it was financed by equity. On the other hand, if we used money from our borrowings, the asset bought was financed by debt. Functions of a financial manager 1. Financing decisions – Deciding how to finance long-term investments and working capital, which deals with the company's day-to-day operations. 2. Investing Decisions – Relates to the decision made by the investors or the top level management with respect to the amount of funds to be deployed in the investment opportunities. 3. Operating Decisions – Deal with the company’s daily operations, especially on how to finance working capital accounts such as accounts receivable and inventories. 4. Dividend Policies – Dividend is a part of profits available for distribution to equity shareholders. The Finance Manager must decide whether the firm should distribute all the profits, retain them, or distribute a portion and retain the balance. 01 Handout 1 *Property of STI  [email protected] Page 2 of 8  BMSH2201 Key Financial Concepts (Titman, Keown, & Martin, 2018) Principle 1: Money has a time value A peso received today is worth more than a peso received in the future. Conversely, a peso received in the future is worth less than a peso received today. The most fundamental principle of finance is that money has a time value. A peso received today is more valuable than a peso received one year from now. We can invest the peso we have today to earn interest so that at the end of one year, we will have more than one peso. Because we can earn interest on money received today, it is better to receive money sooner than later. For example, suppose you choose to receive P1,000 either today or a year from now. If you decide to receive it a year from now, you will have passed up the opportunity to earn a year’s interest on the money. Economists would say you suffered an “opportunity loss” or an opportunity cost. Principle 2: There is a risk-return tradeoff This is based on the idea that individuals are risk-averse, which means they prefer to get a certain return on their investment rather than an uncertain return. However, the world is an inherently risky place, so at least some individuals will have to make risky investments. How are investors induced to hold these risky investments when there are safer alternative investments? By offering investors a higher expected rate of return on riskier investments. Principle 3: Cash flows are the source of value Profit is an accounting concept designed to measure a business’s performance over an interval of time. Cash flow is the amount of cash that can be taken out of the business over this same interval. a company’s profits can differ dramatically from its cash flows. Cash flows represent actual money that can be spent, and they are what determines an investment’s value. Profits are different. To determine a company’s accounting profit, its accountants have to judge how the business’s costs and revenues are allocated to each time period. Consequently, different judgments result in different profit measurements. A firm can show a profit on paper even when it is generating no cash at all. This isn’t to say that accounting profits are unimportant to investors. Investors see accounting profits as an important indicator of a firm’s ability to produce cash flows for its investors in the past—and perhaps in the future. Therefore, to the extent that profits affect investors’ expectations, they are an important source of information. Principle 4: Market prices reflect information Investors respond to new information by buying and selling their investments. The speed with which investors act and how prices respond to the information determine the efficiency of the market. The prices of financial claims traded on public financial markets react quickly as fresh information is released. As a result, when earnings reports are released, prices rapidly react to the new information, moving upward if the news is better than predicted and downward if the news is worse. In efficient markets, such as those in the United States and other developed countries, this process takes place very quickly. As a result, it’s hard to profit from trading on publicly released information. Principle 5: Individuals respond to incentives Incentives motivate, and the actions of managers are often motivated by self-interest, which may result in managers not acting in the best interests of the firm’s owners. When this happens the firm’s owners will lose value. 01 Handout 1 *Property of STI  [email protected] Page 3 of 8  BMSH2201 Managers respond to the incentives they are given in the workplace. When their incentives are not properly aligned with the firm’s stockholders, they may not make decisions consistent with increasing shareholder value. For example, a manager may be in a position to evaluate an acquisition that happens to be owned by his brother-in-law. Other situations are much less straightforward. For example, a financial manager may be asked to decide whether or not to close a money-losing plant, a decision that, although saving money for the firm, will involve the personally painful act of firing the employees at the plant. Forms of Business As to nature or purpose o Service – These refer to businesses or professionals who render personal service. o Trading or merchandising – These businesses are engaged in buying and selling products. o Manufacturing – These include firms who buy raw materials to process and convert them to finished products, which they sell. o Banking and finance – These organizations focus on money as the main product of their business. Their products are money and credit. o Mining or extractive industry – These companies extract natural resources like oil, gas, gold, copper, and cement. o Construction – These businesses build houses, buildings, schools, roads, and other infrastructures. They are similar to manufacturing because they start with raw materials, but their end product is different. o Genetic industries – These are firms involved in producing or reproducing certain species of plants and animals, either for sale or for reproduction. As to ownership o Sole or single proprietorship ▪ Advantages Ease of formation – The business is easy to start because only one (1) person decides to go into the business. Needs only minimum capitalization – These businesses only have one (1) owner who can provide capital; the starting capital is usually small. Sole decision-maker – The owner has total control of his business. Easy to terminate – The business is easy to discontinue because only one (1) person owns it and there are not many assets to sell and liabilities to pay. ▪ Disadvantages Unlimited liability – A sole proprietor is responsible for the liabilities of the business to the extent of his personal assets. That is, the creditors of a sole proprietorship can run after the owner's personal assets to the extent of the liabilities of the business. Limited access to capital – If the business has large earning potential, it is possible that the owner, being alone, will not be able to provide the capital needed to expand the business. Limited skills, talents, and capabilities – The owner can only use his/her own skills, talents, and capabilities. If the business grows, the owner may need additional training or knowledge. Inability to attack or retain good employees – The owner may not give a good employee a competitive salary because the business is small. Limited-term of existence – A sole proprietorship's life depends on its owner. 01 Handout 1 *Property of STI  [email protected] Page 4 of 8  BMSH2201 Difficulty in measuring success – In a sole proprietorship, business funds and expenses usually mix with the funds and expenses of the owner, making it difficult to measure the business's actual business performance and profitability. Personal problems may hinder operation/ success – Personal problems may interrupt or hinder effective decision-making. o Partnership ▪ Advantages Ease of formation – Mere agreement between partners can create a partnership even if it is not written. Allows pooling of financial resources – Partnerships can pool resources and raise more capital for the business. Allows pooling of partners' skills, expertise, and experience that may contribute to successful business operation. Less government control and supervision than corporations ▪ Disadvantages Limited life – A partnership is dissolved when a partner dies, withdraws, becomes insolvent or bankrupt, becomes incapacitated, or when a new partner joins the partnership. Unlimited liability – General partners are answerable to debts to the extent of their personal assets. Limited partners have only limited liabilities. Mutual agency – All partners may be held liable for the actions of any other partners, so long as their actions are within the scope of the partnership's business operations. o Corporation ▪ Advantages Legal capacity to act as a legal entity –The corporation is considered a legal person with perpetual existence. It exists until it is liquidated. Death or change in ownership does not affect the organization. Limited liability of shareholders – The owners' liability towards the creditors is limited to their investment in the company. In the case of liquidation of the company, if the company’s assets are insufficient to meet the liability, nothing is required to be contributed by the owners. Transferability of shares – The ownership is represented by the number of share certificates held by a person, which makes the transfer of ownership very easy. Greater ability to acquire funding – Additional capital can be easily raised through stock markets. A publicly-held corporation, in particular, can raise substantial amounts by selling shares or issuing bonds. ▪ Disadvantages Complex formation – Establishing a corporation is a complex process and requires registration with the government and listing on the stock exchange. Agency problem – Normally, corporations have a large number of shareholders. They delegate the governance function to a group called the board of directors. The board of directors would then hire management to look after the corporation's operations. In this situation, the management is an agent of the owner. The agency problem occurs when the management acts in their own interests rather than the interest of the corporation owners. Double taxation – In corporations, there is double taxation. First of all, the corporate income is taxed at a flat rate. Then, the dividends paid to the shareholders are also taxed. o Cooperative 01 Handout 1 *Property of STI  [email protected] Page 5 of 8  BMSH2201 ▪ Advantages Easy formation – Compared to forming a company, the formation of a cooperative is easy. People who would like to form cooperatives only need to register themselves with the Cooperative Development Authority. Limited liability – Like the corporation, the liability of members is limited to the extent of their capital. Perpetual existence – A cooperative has a separate legal entity. Therefore, the death, insolvency, or retirement of the members do not affect the cooperative society's existence. Social service – The basic philosophy of cooperatives is self-help and mutual help. Democratic management – The elected members manage the cooperative. Every member has equal rights through its single vote and can take part in the formulation of society's policies. Unlike corporations, all the members have only one vote, regardless of their contribution. ▪ Disadvantages Limited sources – The financial strength of cooperatives depends on the contributions of its members. Because most members of cooperatives belong to the lower and middle class, cooperatives are not suitable for large-scale businesses which require huge capital. Insufficient management – A cooperative is managed by the members only. Minimal financial returns – Cooperatives are formed to provide service to members rather than a return on investment. It may be difficult to attract potential members seeking a financial return. Areas of Finance (Cayanan, et al., 2016) The Role of Money Money is anything that is generally accepted in payment for goods and services or the retirement of the debt. This definition has several important words, especially anything, and is generally accepted. Anything may perform the role of money, and many different items, including shells, stones, and metals, have served as money. Money may also be used to transfer purchasing power to the future. In this second role, money acts as a store of value from one time period to another. Money, however, is only one of many assets that may be used as a store of value. Stocks, bonds, savings accounts, bonds, real estate, gold, and collectibles are various assets you may use to store value. A. Financial Institutions are companies in the financial sector that provide a broad range of business and services, including banking, insurance, and investment management. Banks o Thrift banks – These are deposit-taking financial institutions that also extend credit to the consumer market. They usually cater to the countryside or rural areas. o Commercial banks – These are deposit-taking financial institutions that extend credit to the retail and consumer markets. They collect and safely keep the funds of savers and depositors. Savings and checking accounts provide a fast and efficient way for clients to access their money. They also lend to small-medium enterprises that regularly pay them an interest to use their funds. o Universal banks – Universal banks lend to multinational companies. Their transactions are larger than commercial banks and are denominated in multi-currencies, not just local currency. They also have an expanded line of services compared to commercial banks. 01 Handout 1 *Property of STI  [email protected] Page 6 of 8  BMSH2201 o Investment banks – These banks focus on raising funds for big corporations and governments through bond issuances and initial public offerings. Nonbanks o Leasing companies – Leasing companies are not banks and are not governed by a central bank. However, they also extend credit or financing to companies. o Investment companies – These are institutions regulated by the Securities and Exchange Commission and perform similar functions as banks. o Mutual funds – These are collective investments or funds of small investors pooled together and managed to reach maximum returns. Mutual funds, though small individually, are big collectively. o Insurance companies – These companies sell insurance coverage to provide a guarantee of compensation for specified death, illness, accident, loss, or damage to property in exchange for payment of a premium. They may sell life and non-life insurance products. The premiums collected are entrusted to a portfolio manager who cares about the funds. o Private equity funds – These entities are not regulated by the government or any other regulatory body. B. Financial Instruments is a real or a virtual document representing a legal agreement involving some sort of monetary value. These can be debt securities like corporate bonds or equity-like shares of stock. When a financial instrument is issued, it gives rise to a financial asset and a financial liability or equity instrument on the other. a. A Financial Asset is any asset that is: i. Cash ii. An equity instrument of another entity iii. A contractual right to receive cash or another financial asset from another entity. iv. A contractual right to exchange instruments with another entity under potentially favorable conditions. (IAS 32.11) Examples: Notes Receivable, Loans Receivable, Investment in Stocks, Investment in Bonds b. A Financial Liability is any liability that is a contractual obligation: i. To deliver cash or other financial instruments to another entity. ii. To exchange financial instruments with another entity under potentially unfavorable conditions. (IAS 32) Examples: Notes Payable, Loans Payable, Bonds Payable c. An Equity Instrument is any contract that evidences a residual interest in an entity's assets after deducting all liabilities. (IAS 32) Examples: Ordinary Share Capital, Preference Share Capital i. Identify common examples of Debt and Equity Instruments. d. Debt Instruments generally have fixed returns due to fixed interest rates. Examples of debt instruments are as follows: i. Treasury Bonds and Treasury Bills issued by the Philippine government. These bonds and bills usually have low-interest rates and have a very low risk of default since the government assures that these have been paid, received any return from their investment, and even their principal investment has wiped out. 01 Handout 1 *Property of STI  [email protected] Page 7 of 8  BMSH2201 e. Equity Instruments generally have varied returns based on the issuing company's performance. Returns from equity instruments come from either dividends or stock price appreciation. The following are types of equity instruments: i. Preferred stock has priority over common stock in terms of claims over a company's assets. This means that if a company has liquidated and its assets have to be distributed, no asset be distributed to common stockholders unless all the claims of the preferred stockholders have given. Moreover, preferred stockholders also have priority over common stockholders in cash dividend declaration. Dividends to preferred stockholders are usually at a fixed rate. No cash dividends are given to common stockholders unless all the dividends due to preferred stockholders are paid first. ii. Holders of Common stock on the other hand, are the real owners of the company. If the company’s growth is encouraging, the common stockholders will benefit from the growth. Moreover, during a profitable period for which a company may decide to declare higher dividends, the preferred stock will receive a fixed dividend rate while common stockholders receive all the excess. C. Financial Market refers to a marketplace where the creation and trading of financial assets, such as shares, debentures, bonds, derivatives, currencies, etc. occur. Classification of financial markets into comparative groups: a. Primary vs. Secondary Markets - To raise money, users of funds will go to a primary market to issue new securities (either debt or equity) through a public offering or a private placement. i. The sale of new securities to the public was referred to as a public offering and the first offering of stock was an initial public offering. The sale of new securities to one investor or a group of investors (institutional investors) is referred to as a private placement. ii. However, suppliers of funds or the holders of the securities may decide to sell the securities that have been purchased. The sale of previously owned securities takes place in secondary markets. iii. The Philippine Stock Exchange (PSE) is both a primary and secondary market. b. Money Markets vs. Capital Markets - Money markets are a venue wherein securities with short-term maturities (1 year or less) are sold. They have been created because some individuals, businesses, governments, and financial institutions have temporarily idle funds that they wish to invest in a relatively safe, interest-bearing asset. At the same time, other individuals, businesses, governments, and financial institutions find themselves in need of seasonal or temporary financing. i. On the other hand, securities with longer-term maturities are sold in capital markets. The key capital market securities are bonds (long-term debt) and both common and preferred stock (equity or ownership). References Cayanan, A. S., Barrido, A. P., Dy, D. C., Rodriguez, J. A., Rodriguez, R. A., & Yusoph, A.-H. B. (2016). Business FInance: Specialized Subject. Quezon City: Commission on Higher Education. Mayo, H. B. (2017). Business Finance: Theory and Practice. Quezon City: Abiva Publishing House, Inc. Titman, S., Keown, A. J., & Martin, J. D. (2018). Financial Management: Principles and Applications (13th ed.). New York: Pearson Education Inc. 01 Handout 1 *Property of STI  [email protected] Page 8 of 8