Financial Planning Lecture Notes PDF

FINANCIAL PLANNING By Dr. M.Abd Elnaby Financial Manager  The Goal of the Financial Manager The goal of the financial manager must be consistent with the mission of the corporation. What is the generally accepted mission of a corporation? Corporate Mission To...

FINANCIAL PLANNING By Dr. M.Abd Elnaby Financial Manager  The Goal of the Financial Manager The goal of the financial manager must be consistent with the mission of the corporation. What is the generally accepted mission of a corporation? Corporate Mission To maximize firm value shareholder’s wealth (as measured by share prices) Corporate Mission: Coca-Cola “To achieve sustainable growth, we have established a vision with clear goals: Maximizing return to shareholders while being mindful of our overall responsibilities” (part of Coca-Cola’s mission statement)  Corporate Mission: Johnson & Johnson “Our final responsibility is to our stockholders …when we operate according to these principles, the stockholders should realize a fair return” (part of Johnson & Johnson’s credo) Corporate Mission: Google “Optimize for the long-term rather than trying to produce smooth earnings for each quarter” Corporate Mission While managers have to cater to all the stakeholders (such as consumers, employees, suppliers etc.), they need to pay particular attention to the owners of the corporation i.e. shareholders. If managers fail to pursue shareholder wealth maximization, they will lose the support of investors and lenders. The business may cease to exist and ultimately, the managers will lose their jobs! Ethics in Finance What do we mean by Ethics? Give examples of recent financial scandals and discuss what went wrong from an ethical perspective. Agency Considerations in Corporate Finance Agency relationship exists when one or more persons (known as the principal) contracts with one or more persons (the agent) to make decisions on their behalf. In a corporation, the managers are the agents and the stockholders are the principal. Agency Considerations in Corporate Finance (cont.) Agency problems arise when there is conflict of interest between the stockholders and the managers. Such problems are likely to arise more when the managers have little or no ownership in the firm. Examples: – Not pursuing risky project for fear of losing jobs, stealing, expensive perks. All else equal, agency problems will reduce the firm value. How to Reduce Agency Problems? 1. Monitoring (Examples: Reports, Meetings, Auditors, board of directors, financial markets, bankers, credit agencies) 2. Compensation plans (Examples: Performance based bonus, salary, stock options, benefits) 3. Others (Examples: Threat of being fired, Threat of takeovers, Stock market, regulations such as SOX) The above will help to reduce agency problems/costs. THE FOUR BASIC PRINCIPLES OF FINANCE PRINCIPLE 1: Money Has a Time Value. A dollar received today is more valuable than a dollar received in the future. – We can invest the dollar received today to earn interest. Thus, in the future, you will have more than one dollar, as you will receive the interest on your investment plus your initial invested dollar. PRINCIPLE 2: There is a Risk- Return Trade-off. We only take risk when we expect to be compensated for the extra risk with additional return. Higher the risk, higher will be the expected return. 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 actually be taken out of the business over this same interval. Profits versus Cash It is possible for a firm to report profits but have no cash. For example, if all sales are on credit, the firm may report profits even though no cash is being generated. Incremental Cash Flow Financial decisions in a firm should consider “incremental cash flow” i.e. the difference between the cash flows the company will produce with the potential new investment it’s thinking about making and what it would make without the investment. PRINCIPLE 4: Market Prices Reflect Information. Investors respond to new information by buying and selling their investments. The speed with which investors act and the way that prices respond to new information determines the efficiency of the market. In efficient markets like United States, this process occurs very quickly. As a result, it is hard to profit from trading investments on publicly released information. PRINCIPLE 4: Market Prices Reflect Information. (cont.) Investors in capital markets will tend to react positively to good decisions made by the firm resulting in higher stock prices. Stock prices will tend to decrease when there is bad information released on the firm in the capital market. Key Terms Agency problem Capital budgeting Capital structure Corporation Debt Equity Financial market Key Terms (cont.) General partner General partnership Limited liability company (LLC) Limited partner Limited partnership Opportunity cost Partnership Key Terms (cont.) Shareholder Shares Sole proprietorship Stock Stockholders Working capital management THANK YOU