Overview Of Financial Management PDF

BM2213 OVERVIEW OF FINANCIAL MANAGEMENT Introduction to Finance Finance studies how individuals, institutions, governments, and businesses acquire, spend an...

BM2213 OVERVIEW OF FINANCIAL MANAGEMENT Introduction to Finance Finance studies how individuals, institutions, governments, and businesses acquire, spend and manage money and other financial assets (Melicher & Norton, 2019). According to Merriam-Webster’s Dictionary, finance is a system that includes the circulation of money, granting credit, making investments, and providing banking facilities. Three (3) Common Areas of Finance (Brigham & Houston, 2022): Financial management, also known as corporate finance, focuses on decisions relating to how much and what types of assets to acquire, how to raise the capital needed to purchase assets, and how to run the firm to maximize its value. The same principles apply to both for-profit and not-for-profit organizations. Capital markets relate to where interest rates and stock and bond prices are determined. Also studied here are the financial institutions that supply the capital to businesses. Banks, investment banks, stockbrokers, mutual funds, insurance companies, and the like bring together “savers” who have money to invest and businesses, individuals, and other entities that need capital for various purposes. Investments relate to decisions concerning stocks and bonds and include the following activities: o Security analysis, which deals with finding the proper values of individual securities (i.e., stocks and bonds); o Portfolio theory deals with the best way to structure portfolios, or “baskets,” of stocks and bonds. Rational investors want to hold diversified portfolios to limit risks, so choosing a properly balanced portfolio is an important issue for any investor; and o Market analysis deals with the issue of whether stock and bond markets at any given time are “too high,” “too low,” or “about right.” Finance versus Economics and Accounting Modern finance grew out of economics and accounting nowadays. Economists developed the notion that an asset’s value is based on the future cash flows the asset will provide. Accountants provided information regarding the likely size of those cash flows. People working in finance need knowledge of economics and accounting (Brigham & Houston, 2022). Board of Directors Chief Executive Officer (CEO) Chief Operating Officer (COO) Chief Financial Officer (CFO) Marketing, Production, Human Accounting, Treasury, Credit, Resources, and Other Operating Legal, Capital Budgeting, and Departments Investor Relations Figure 1. Finance within the Organization Source: Fundamentals of Financial Management, 2022 Jobs in Finance Finance prepares students for banking, investments, insurance, corporations, and government jobs. Accounting students need to know other business areas such as marketing, management, and human resources; they also need to understand finance, as it affects decisions in all those areas. For example, marketing people propose advertising programs, but finance people examine those programs to judge the effects of advertising on the 01 Handout 1 *Property of STI  [email protected] Page 1 of 5  BM2213 firm’s profitability. Therefore, to be effective in marketing, one needs to have a basic knowledge of finance. The same holds for management, wherein management decisions are evaluated regarding their effects on the firm’s value. It is also worth noting that finance is vital to individuals regardless of their jobs. For a finance major individual, there are vast and varied opportunities in this industry. Here are some interesting jobs in finance (Interesting Jobs in Finance, 2022): Investment Banker – Helps an organization raise capital by selling bonds or equity and advises different clients on various financial opportunities depending on the nature of the finance person's business. Financial Analyst – Works for a company or a non-profit rather than a bank and helps decision-makers determine an investment strategy for an organization. Chief Financial Officer (CFO) – Leads and manages the overall financial dealings of the company. Tracking profit and loss, then strategizing how to make the company more profitable are the main tasks of CFOs. Management experience is needed to direct staff on maximizing the company's finances, including various departments or divisions. Finance Director – Instead of having a CFO, a finance director helps the company manage its financial operations. Strategic planning, mergers and acquisitions, forecasting, budgeting, and financial modeling are the expected skills for this job. Controller – Directs a company’s accounting practices. The responsibilities of controllers include the development of profit and loss statements, balance sheets, financial prospectuses, and preparing reports that predict the organization's financial performance. Accountant – Manages and interprets financial statements. Depending on the specific career interest and skills, an accountant may want to focus on one of the following specialties: forensic accounting, managerial accounting, public accounting, internal auditing, or government accounting. Financial Examiner – Checks if the company complies with laws and regulations governing financial, securities institutions, and financial and real estate transactions. Securities, Commodities, and Financial Services Sales Agent – Combines a job in sales with a finance background. S/he works with buyers and sellers in financial markets to sell securities, counsel companies, and handle trades. Portfolio Manager – Often works at investment management firms and oversees a fund or group of funds, makes investment decisions, and tracks trends. Trader – Works closely with portfolio managers, buying and selling securities based on their requests. Stockbroker – Like traders, brokers buy and sell securities. Rather than working with a portfolio manager, however, most brokers operate on behalf of a client. Personal Financial Advisor – Prefers working with individuals rather than companies. This role requires a thorough knowledge of taxes, investments, financial planning goals, etc. Forms of Business Organization The basics of financial management are the same for all businesses, large or small, regardless of how they are organized. Still, the firm's legal structure affects its operations and thus should be recognized (Brigham & Houston, 2022). Sole proprietorship is an unincorporated business owned by one (1) individual. Proprietorship has advantages: (1) easy and inexpensive to form; (2) subject to few government regulations; and (3) subject to lower income taxes. However, some limitations are (1) unlimited personal liability for the business's debts, (2) the life of the business is limited to the life of the individual who created it, and (3) difficulty obtaining large sums of capital. Partnership is a legal arrangement between two (2) or more people who decide to do business together. As to proprietorship, this form is also easy and inexpensive to form. As for income allocation, each partner will receive equity on a pro-rata basis. However, all partners are generally subject to unlimited personal liability. Suppose a partnership goes bankrupt and any partner cannot meet his/her pro-rata share of the firm’s liabilities. In that case, the remaining partners will be responsible for making good on the unsatisfied claims. 01 Handout 1 *Property of STI  [email protected] Page 2 of 5  BM2213 Corporation is a legal entity separate and distinct from its owners and managers. In case of losses, the corporation can lose all of its money, but its owners can lose only the funds they invested in the company. Corporations also have unlimited lives, and it is easier to transfer shares of stock in a corporation than one’s interest in an unincorporated business. These factors make it much easier for corporations to raise the capital necessary to operate large companies. Cooperative is a business organization in which the business is owned and controlled by those who use its services. A cooperative may be organized as a legal entity, or it may be an unincorporated association. Cooperatives are organized primarily to provide service to their user-owners rather than generate profit for investors (Hall, 2022). When deciding on its form of organization, a firm must trade off the advantages of incorporation against a possibly higher tax burden. However, for the following reasons, the value of any business other than a relatively small one will probably be maximized if it is organized as a corporation (Brigham & Houston, 2022): 1. A firm’s value depends on its growth opportunities, which rely on its ability to attract capital. Because corporations can attract capital more easily than other types of businesses, they are better able to take advantage of growth opportunities. 2. The value of an asset also depends on its liquidity, which means the time and effort it takes to sell the asset for cash at fair market value. Because the stock of a corporation is more straightforward to transfer to a potential buyer, and more investors are willing to invest in stocks than in partnerships (with their potential unlimited liability), corporate investment is relatively liquid. It enhances the value of a corporation. Creating Value for Investors In public corporations, managers and employees work on behalf of the business's shareholders; therefore, they should pursue policies promoting stockholder value. While many companies focus on maximizing a broad range of financial objectives, such as growth, earnings per share, and market share, these goals should not take precedence over the main financial goal, which is to create value for investors (Brigham & Houston, 2022). Stockholders are not just an abstract group; they represent individuals and organizations who have chosen to invest their hard-earned cash into the company and are looking for a return on their investment to meet their long-term financial goals. 1 Managerial Actions, the Economic Environment, Taxes, and the Political Climates 2 “True” Investor “Perceived” “Perceived” “True” Risk Cash Flows Investor Cash Risk Flows 3 Stock’s Intrinsic Value Stock’s Market Price 4 Market Equilibrium: Intrinsic Value = Stock Price Figure 2. Determinants of Intrinsic Values and Stock Prices Source: Fundamentals of Financial Management, 2022 1. Managerial actions, combined with the economy, taxes, and political conditions, influence the level and riskiness of the company’s future cash flows, which ultimately determine the company’s stock price. Investors expected to like higher cash flows but dislike risk; so the larger the expected cash flows and the lower the perceived risk, the higher the stock price. 01 Handout 1 *Property of STI  [email protected] Page 3 of 5  BM2213 2. “True” means investors expect cash flows and risk if they have all of the information about a company. “Perceived” means what investors expect, given their limited information. 3. “Intrinsic Value” means that an estimate of a stock’s “true” value is based on accurate risk and return data. The intrinsic value can be estimated but not measured precisely. While in the “Market Price,” the stock value is based on perception but possibly incorrect information as seen by the marginal investor. 4. When a stock’s actual market price equals its intrinsic value, it is in equilibrium. When equilibrium exists, there is no pressure for a stock price change. Market prices can—and do—differ from intrinsic values, but eventually, as the future unfolds, the two (2) values tend to converge. Actual stock prices are easy to determine and can be found on the Internet. However, intrinsic values are estimates; different analysts with different data and views about the future form different estimates of a stock’s intrinsic value. Investing would be easy, profitable, and riskless if all stocks’ intrinsic values were known, but it is not. Intrinsic values can be estimated, but the estimates cannot be assured it is right. A firm’s managers have the best information about the firm’s prospects, so managers’ estimates of intrinsic values are generally better than those of outside investors (Brigham & Houston, 2022). Management’s goal should be to take actions designed to maximize the firm’s intrinsic value, not its current market price. Note, though, that maximizing the intrinsic value will maximize the average price over the long run, but not necessarily the current rate at each point in time (Brigham & Houston, 2022). Conflicts between Stockholders and Managers It has long been recognized that managers’ personal goals may compete with shareholder wealth maximization. In particular, managers might be more interested in maximizing their wealth than their stockholders’ wealth; therefore, managers might pay themselves excessive salaries (Brigham & Houston, 2022). Effective executive compensation plans motivate managers to act in their stockholders’ best interests. Useful motivational tools include (1) reasonable compensation packages, (2) firing of managers who do not perform well, and (3) the threat of hostile takeovers (Brigham & Houston, 2022). Compensation packages should be sufficient to attract and retain skilled managers, but they should not go beyond what is needed. Compensation policies need to be consistent over time. Also, compensation should be structured so that managers are rewarded by the stock’s performance over the long run, not the stock’s price, on an option exercise date. It means that options (direct stock awards) should be phased in over some years so that managers have an incentive to keep the stock price high over time. When the intrinsic value can be measured objectively and verifiably, performance pay can be based on changes in intrinsic value. However, because the intrinsic value is not observable, compensation must be based on the stock’s market price—but the price used should be an average over time rather than on a specific date. Corporate raiders are individuals who target corporations for takeover because they are undervalued. Hostile takeover is the acquisition of a company over the opposition of its management. Conflicts between Stockholders and Debtholders Conflicts can also arise between stockholders and debtholders. Debtholders, which include the company’s bankers and its bondholders, generally receive fixed payments regardless of how well the company does, while stockholders do better when the company does better. This situation leads to conflicts between these two (2) groups to the extent that stockholders are typically more willing to take on riskier projects. Balancing Interests of Shareholders and Society Shareholder Wealth Maximization, the primary financial goal of managers of publicly owned companies, implies that decisions should be made to maximize the long-run value of the firm’s common stock. Most managers understand that maximizing shareholder value does not mean they are free to ignore the larger interests of society. Consider, for example, what would happen if Linda Smith narrowly focused on creating shareholder value. Still, in the process, her company was unresponsive to its employees and customers, hostile to its local community, and indifferent to its actions' effects on the environment. Likely, society would impose a 01 Handout 1 *Property of STI  [email protected] Page 4 of 5  BM2213 wide range of costs on the company. It may find it hard to attract top-notch employees; its products may be boycotted; it may face additional lawsuits and regulations, and it may be confronted with negative publicity. These costs would ultimately lead to a reduction in shareholder value. Thus, enlightened managers must also consider these society-imposed constraints when taking steps to maximize shareholder value. From a broader perspective, firms have many different departments, including marketing, accounting, production, human resources, and finance. The finance department’s principal task is to evaluate proposed decisions and judge how they will affect the stock price and, thus, shareholder wealth. For example, suppose the production manager wants to replace some old equipment with new automated machinery that will reduce labor costs. The finance staff will evaluate that proposal and determine whether the savings are worth the cost. Similarly, suppose marketing wants to spend P10 million for advertising during the Ms. Universe event. In that case, the financial staff will evaluate the proposal, look at the probable increase in sales, and determine whether the money spent will lead to a higher stock price. Most significant decisions are evaluated in terms of their financial consequences, but astute managers recognize that they also need to consider how these decisions affect society at large (Brigham & Houston, 2022). References Brigham, E. F., & Houston, J. F. (2022). Fundamentals of Financial Management. Cengage Learning. Chartered Financial Analyst Institute. (2018). Careers in Finance. Retrieved from Wall Street Mojo: https://www.wallstreetmojo.com/careers-in-finance/ Hall, A. (2022). Special Types of Business Organizations. Retrieved from Attorney AAron Hall: https://aaronhall.com/special-types-of-business-organizations-cooperatives/ Interesting Jobs in Finance. (2022). Retrieved from Bently University: https://www.bentley.edu/prepared/12- interesting-jobs-finance Melicher, R. W., & Norton, E. A. (2019). Introduction to Finance (Markets, Investments, and Financial Management). Wiley. 01 Handout 1 *Property of STI  [email protected] Page 5 of 5