Topic 1: An Overview of Financial Management PDF

TOPIC 1 An Overview of Financial Management  Learning Goals 1. Define finance, its major areas and opportunities available in this field, and the legal forms of business organization. 2. Describe the managerial finance function and its relationship to economics and accounti...

TOPIC 1 An Overview of Financial Management  Learning Goals 1. Define finance, its major areas and opportunities available in this field, and the legal forms of business organization. 2. Describe the managerial finance function and its relationship to economics and accounting. 3. Identify the primary activities of the financial manager. 4. Explain the goal of the firm, corporate governance, and the agency theory. What is Finance  Finance can be defined as the art and science of managing money.  Finance is concerned with the process, institutions, markets, and instruments involved in the transfer of money among individuals, businesses, and governments. What is Finance  At the personal level, finance is concerned with individuals’ decisions about how much of their earnings they spend, how much they save, and how they invest their savings.  In a business context, finance involves the same types of decisions: how firms raise money from investors, how firms invest money in an attempt to earn a profit, and how they decide whether to reinvest profits in the business or distribute them back to investors. What is Finance  At the macro level, finance is the study of financial institutions and financial markets and how they operate within the financial system globally.  At the micro level, finance is the study of financial planning, asset management, and fund raising for businesses and financial institutions. Managing both sides of balance sheet.  They are also more involved in developing corporate strategy and improving the firm’s competitive position.  Increasing globalization has complicated the financial management function by requiring them to be proficient in managing cash flows in different currencies and protecting against the risks inherent in international transactions.  Changing economic and regulatory conditions also complicate the financial management function. Professional Certifications in Finance:  Chartered Financial Analyst (CFA) – Offered by the CFA Institute, the CFA program is a graduate-level course of study focused primarily on the investments side of finance.  Certified Financial Planner (CFP) – To obtain CFP status, students must pass a ten-hour exam covering a wide range of topics related to personal financial planning. Legal Forms of Business 1) Sole Proprietorship  A business owned by a single individual.  Owner maintains title to the firm’s assets.  Owner has unlimited liability. 2) Partnership  Similar to a sole proprietorship, except that there are two or more owners. 2a) General Partnership  All partners have unlimited liability. 2b) Limited Partnership  Consists of one or more general partners, who have unlimited liability.  One or more limited partners (investors) whose liability is limited to the amount of their investment in the business. 2c) Limited Liability Partnership (LLP)  All partners have limited liability.  They are liable for the own acts of malpractice, but not for that of other partners. Common for law firms and accounting firms. 3) Corporation  A business entity that legally functions separate and apart from its owners.  Owners’ liability is limited to the amount of their investment in the firm (the paid-up capital for equity shares).  Owners hold common stock certificates, and ownership can be transferred by selling the certificates.  Private limited companies (Sdn. Bhd.) and Public listed companies (Bhd.) Strengths and Weaknesses of the Common Legal Forms of Business Organization  The Trade-offs: Corporate Form 12  Benefits:  Limited liability  Easy to transfer ownership  Unlimited life (unless the firm goes through corporate restructuring such as mergers and bankruptcies)  Drawbacks:  No secrecy of information  Maybe delays in decision making  Greater regulation  Double taxation  Double Taxation example 13  Income = $1,000 Federal Tax @25% = $250 After tax Income = $750  What will be the total tax if the company chooses to distribute the after-tax profits to shareholders as dividends?  Double taxation 14  If corporation distributes the profits as dividends to shareholders, shareholders will have to pay taxes on dividends.  Assume shareholders are taxed @20% on dividend income or 20% of $750 = $150  Total tax = 250 + 150 = $400 or 40% Corporate Organization 15 The Financial Management Function  The importance of the financial management function depends on the size of the firm.  In small companies, the finance function may be performed by the company president or accounting department.  As the business expands, finance typically evolves into a separate department linked to the president as was previously described. Financial Management Function: Relationship to Economics  The field of finance is actually an outgrowth of economics. Finance is sometimes referred to as financial economics.  Finance managers must understand the economic framework within which they operate in order to react or anticipate to changes in economic conditions.  The primary economic principal used by finance managers is marginal cost-benefit analysis which says that financial decisions should be implemented only when added benefits exceed added costs.  Financial Management Function: Relationship to Accounting  The firm’s finance (treasurer) and accounting (controller) functions are closely-related and overlapping.  In smaller firms, the financial manager generally performs both functions.  One major difference in perspective and emphasis between finance and accounting is that accountants generally use the accrual method while in finance, the focus is on cash flows. Refer to following example.  The A Berhad experienced the following activity last year: Sales RM100,000 (1 yacht sold, 100% still uncollected) Costs RM80,000 (all paid in full under supplier terms)  Contrast the differences in performance under the accrual method (accounting) vs. the cash method (finance). ACCRUAL CASH Sales RM100,000 RM 0 Less: Costs (80,000) (80,000) Net Profit/(Loss) RM20,000 RM(80,000)  Finance and accounting also differ with respect to decision-making.  While accounting is primarily concerned with the presentation of financial data, the financial manager is primarily concerned with analysing and interpreting this information for decision-making purposes.  The financial manager uses this data as a vital tool for making decisions about the financial aspects of the firm.  Financial Management Decisions Macro Finance XYZ Berhad Statement of Financial Position As of December 31, 2022 Assets: Liabilities & Equity: Current Assets Current Liabilities Working Cash & M.S. Accounts payable Working Capital Accounts receivable Notes Payable Capital Inventory Total Current Liabilities Total Current Assets Long-Term Liabilities Fixed Assets: Total Liabilities Investment Gross fixed assets Equity: Financing Less: Accumulated dep. Common Stock Decisions Decisions Goodwill Paid-in-capital Other long-term assets Retained Earnings Total Fixed Assets Total Equity Total Assets Total Liabilities & Equity Financial Management Decisions  There are 3 main types of decisions facing finance managers: investment decisions, financing decisions, and dividend decisions.  Investment decisions involve committing funds to:  internal investment projects (and withdrawing from such projects should they turn out to be unprofitable)  external investment decisions, involving takeover of another company or a merger  divestment decisions, involving selling a part of the business such as an unwanted subsidiary company  Financing decisions: The assets of a company must be financed by share capital and reserves, long-term liabilities or short-term liabilities. When a company is growing, it will need additional finance from one or more of these sources. A finance manager must know:  where additional funds can be obtained and at what costs  the effect on a company’s profitability and value of using any particular source of funds  the effect on financial risk  A company ought to be profitable, but it must be ‘liquid’ too, so that it always has enough cash to pay for creditors and to hold inventories. Financing decisions therefore include cash management.  Ordinary shareholders expect to earn dividends, and that the value of a company’s shares will be related to the amount of dividends that a company has been paying, and also related to prospects for future dividends.  Dividend decisions are also directly related to financing decisions, since retained profits are the most important source of new funds for companies. What a company pays as dividends out of profits cannot be retained in the business to finance future growth.  Dividend Payout ratio = 1 – Retention ratio Goal of the Firm: Maximize Profit? Which Investment is Preferred? Profit maximization may not lead to the highest possible share price for at least three reasons: 1. Timing is important—the receipt of funds sooner rather than later is preferred 2. Profits do not necessarily result in cash flows available to stockholders 3. Profit maximization fails to account for risk  Why is Profit Maximisation not the appropriate goal? 27  Profit maximisation goal is unclear about the time frame over which profits are to be measured.  It is easy to manipulate the profits through various accounting policies.  Profit maximisation goal ignores risk and timing of cash flows. Goal of the Firm: Maximize Shareholder Wealth!!!  Why? Because maximizing shareholder wealth properly considers cash flows, the timing of these cash flows, and the risk of these cash flows.  This can be illustrated using the following simple stock valuation equation: level & timing of cash flows Share Price = Future Dividends risk of cash Required Return flows Goal of the Firm: Maximise Shareholder Wealth  The goal of the firm is to maximise shareholder wealth. Good corporate decisions are those that create wealth for the shareholder.  Shareholder wealth is measured by share prices. Thus shareholder wealth maximisation would imply maximising the price of common stock. Goal of the Firm: Maximise Shareholder Wealth  Share Price Changes (during last two years as of June 29, 2007) Google: Share price increased by nearly $200 or around 67% (from around $300 to $500) … wealth created. Yahoo: Share price decreased by nearly $8 or around 23% (from around $35 to $27) … wealth destroyed. Goal of the Firm: Maximize Shareholder Wealth  The objective of management is to maximise the market value of the firm, i.e. maximise the wealth of its ordinary shareholders.  A company is financed by ordinary shareholders, preferred stockholders and other short-term and long-term creditors.  All surplus funds and retained earnings are undistributed wealth of its legal owners – ordinary equity shareholders. Linking NPV to SHWM How to measure wealth of shareholders and the value of a company?  For public listed companies, the market value of a company can be measured by the price at which its shares are currently being traded in the stock market, such as Bursa Malaysia, NYSE etc.  For private limited companies, their shares are not traded on any stock market. Hence, there is no easy way to measure their market value.  A shareholder’s wealth comes from dividends received and market value of the shares.  Shareholder’s return = dividends + capital gains/losses (increase/decrease in MV of shares) Short-Term and Long-Term Financial Objectives  Maximization of shareholders’ wealth is a long-term objectives. Daily fluctuations of share price in the market due to pattern of demand and supply or other external factors should be ignored by long-term shareholders.  Only share traders/ margin traders focus on short-term movements in share prices.  Short term measure of return (profit for a year) can mislead a company managers to pursue short-term objectives at the expense of long-term ones. For example, spending a small amount on R&D and training, delaying new capital investments etc in order to report higher profits for current financial year end. Goal of the Firm: What About Other Stakeholders?  Stakeholders include all groups or individuals whose interests are directly affected by activities of the firm, including owners, employees, customers, suppliers, creditors, government and local community.  The "Stakeholder View" prescribes that the firm make a conscious effort to avoid actions that could be detrimental to the wealth position of any of its stakeholders.  Such a view is considered to be "socially responsible."  Ordinary equity shareholders are the provider of risk capital of a company and usually their goal will be to maximise their wealth which they have as a result of the ownership of the shares in the company.  Employees usually want to maximise the rewards paid to them in the form of salaries, bonuses or allowances according to their skills, performance and rewards available in alternative employment. Employees will also want continuity of employment, safety and comfort workplace. Also include managers.  Trade creditors supplied goods and services to the firm. Have objective of being paid the full amount by the due date of invoice. Also would ensure continue trading relationship with the firm. Sometimes prepared to accept later payment to avoid jeopardizing that relationship.  Long-term creditors, often include banks and other holders of secured and unsecured debt securities. Have the objective of receiving the payments of interest and principal on the loan by the due date of repayment. For secured loan, the lender will be able to appoint a receiver to dispose off the company’s assets if the company defaults. For unsecured loans, lenders may apply for the company to be wound up if the company defaults.  Customers concerns about the quality, durability, warranty, after sales service and safety of the products sold by the firm. Also expect delivery of products on time.  Government agencies impinges on firm’s activities in different ways including through taxation of firm’s profits, the provision of grants and implementing policies to achieve macroeconomic objectives such as reducing unemployment and fostering growth in productivity and national income.  Local community concerns whether firms protect the environment and take measures to reduce pollution from the production process. Also hope firms will sponsor some community events. The agency problem  Why does it arise?  Divergence of ownership and control  Managers’ goals differ from shareholders’  Asymmetry of information  What are the consequences?  Managers will follow their own objectives, such as increasing their power, job security, pay and rewards  Shareholder wealth is no longer maximised Signs of an agency problem  Managers mainly finance company with equity finance.  Managers accept low risk, short-payback investment projects.  Managers diversify business operations.  Managers follow ‘pet projects’.  Managers are rewarded for performance that is ‘below average’. Options to mitigate agency problem  Excessive Executive Compensation  Conflict arises when managers negotiate high salaries, bonuses, and stock options that may not be directly linked to the company's long-term performance. This misalignment of incentives can incentivise managers to prioritise short-term gains over long-term value creation.  To mitigate this conflict, companies can implement performance-based compensation structures that tie executive remuneration to key performance indicators (KPIs) or the achievement of specific financial targets.  This approach ensures that managers are rewarded for actions that contribute to long-term shareholder wealth. Options to mitigate agency problem  Information Asymmetry  Managers may possess more information about the company's operations, financials, and prospects than shareholders, leading to information asymmetry. This can allow managers to manipulate or selectively disclose information, potentially harming shareholders' interests.  To address this conflict, companies can enhance transparency and disclosure practices.  Regular and comprehensive reporting of financial performance, strategic initiatives, and risk factors can provide shareholders with more accurate and timely information, reducing information asymmetry and enabling better-informed investment decisions. Options to mitigate agency problem  Empire Building  Managers may pursue projects or acquisitions that increase the size and power of the organization but do not necessarily create value for shareholders. This behavior, known as empire building, can lead to inefficient allocation of resources and suboptimal financial performance.  To mitigate this conflict, companies can establish clear and well-defined corporate governance structures.  Independent boards of directors with diverse expertise can provide oversight and challenge managerial decisions that are not aligned with long-term shareholder interests. Additionally, regular evaluation of investment projects based on their potential to generate shareholder value can help prevent empire-building activities. Options to mitigate agency problem  Corporate governance is about promoting corporate fairness, transparency and accountability.  It can be seen as an attempt to solve agency problem using externally imposed regulation.  Market forces such as hostile corporate takeover could also sometimes help to discipline managers to look after benefits of shareholders. This is because the inefficient management will often be replaced by the acquirer. Financial MAXIMISE VALUE OF THE FIRM/ Objective MAXIMIZE SHAREHOLDERS’ WEALTH Investment Financing Dividend Decision If there are not enough investments Decision Decision that earn the hurdle rate, return Invest in projects that yield a return Choose a financing mix that cash to owners greater than the minimum maximizes the value of the projects acceptable hurdle rate taken and matches the assets being financed How much? What form? Financing Excess cash after Whether the Hurdle rate Returns Financing meeting all cash should be Should be higher Should be time- Mix Type business needs returned as for riskier weighted, cash Includes Debt Should be as dividends or projects and flow based, and Equity and close as possible stock buybacks reflect financing incremental can affect both to the asset or spin offs will mix uses returns, the hurdle rate being financed depend upon reflecting all and the cash the stockholder side costs and benefits flows Working capital preferences decisions Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved