Chapter 1 Introduction To Financial Management PDF

Chapter 1 Introduction To Financial Management Definition of Finance can be defined as the science and art of managing money/ allocating funds/ capital over time. It is the study of how individuals and businesses evalu...

Chapter 1 Introduction To Financial Management Definition of Finance can be defined as the science and art of managing money/ allocating funds/ capital over time. It is the study of how individuals and businesses evaluate investments and how to raise funds to finance them. is related to how individuals and businesses make choices between current spending or receiving money at the present time versus sometime in the future. Finance Function Can Exercise At: 1. the individual level Finance is concerned with individual activities or decision-making process related to how an individual manages his money. That is, how much of earnings / income will spend now (current spending), how much funds will be put aside (saved, that is; postponed spending), and how such savings will be invested (in the form of financial or / and real investments (assets). 2. business level finance is related to activities or decision-making process involving mainly: planning and managing long term investment (which called capital budgeting) managing long term sources of funds (that is the mix between debt and equity) a firm utilized to finance its operations (which called capital structure), managing the firm’s working capital in the form of short-term investment (that is, current assets) and short-term sources of funds (that is, current liabilities) and safeguarding that the firm in good liquidity position to maintain its day-to-day operations. The Balance Sheet Model of the Firm Financing decision Investment decision Current Assets Current Liabilities Net Working capital Fixed Assets Long term debt capital structure Tangible Shareholders’ Intangible equity 1. A.Hossam Finance is concerned with the decision-making process, financial institutions financial markets, and financial instruments involved in the transfer of savings from savers (saving or surplus sectors: different economic sectors of the economy such as; individuals, businesses, and government) with excess cash to borrowers (deficit sectors: different economic sectors of the economy such as; individuals, businesses, and government) who have less cash than they need so, they have financial requirements or needs). Such flow of funds is the main responsibility of the financial system. Financial Management and Financial Services Financial Management Financial Services It is concerned with the It is the area of finance concerned with tasks/duties/activities of the financial the design and delivery of financial manager working in a business. advice and financial products for On the other hand, it is also concerned different economic sectors of the with how to manage capital and how to economy such as individuals, make financial decisions within a businesses, and government. business. The organizational level of the finance function The organizational level of the finance function and its importance depends on the size of the firm in addition to other factors. small ▪ the finance function, may performed by the company firms/companies owner, or its president or the accounting department. ▪ the finance function typically develops into a separate department or sector and headed by Vice President of Finance or any other title like Chief Financial officer (CFO) who reports directly to the president of the firm (CEO ). In such case, the Chief Financial officer (CFO) is managing all the firm's financial activities through two main offices of the large firm: firms/companies 1. Treasurer: which is responsible for the financial affairs/activities such as cash management, credit management, capital expenditure, raising funds, financial planning, management of foreign currencies. 2. Controller: which is responsible for the accounting affairs/activities such as taxes, preparing financial statements, cost control… A.Hossam  Objectives of Financial Management (The Goal Of The Firm) There are several goals or objectives that can be selected, each of them would have some strengths and some weaknesses. The most known goals are : 1. Profit maximization 2. shareholder's Wealth maximization ▪ First Profit maximization According to this goal, management only looks for maximizing profits. But the question here is: what kind of profits need to maximize? earnings before interest and taxes (EBIT), net income (NI), or earnings per Share (EPS)... In brief, according to this goal, there is collective agreement to maximize the Earnings per Share (EPS) through applying the following criterion: Criterion: Select activities that increase Earnings per Share (EPS) However, this goal has several shortcomings (Disadvantages) such as: It is based on accounting numbers and principles; hence profits can vary significantly depending on accounting policies and methods employed by the firm. It does not take risk into consideration; two firms may report identical profit figures, but one firm's return is more volatile (riskier) than the other. It does not take the time value of money into consideration; (any unit of currency today does not worth the same unit of currency in the future. It does not take the future value prospects into consideration; two firms may report identical profits, but one firm is more highly valued due to its higher relative future value potential. ▪ Shareholder Wealth Maximization. According to this goal, management only looks for maximizing shareholder's (owners of the firm) wealth applying the following criterion: Criterion: Select activities that increase the wealth of shareholders (owners). Shareholder wealth maximization (owners of the firm) can be accomplished through the increase of stock market price. The stock price is equal to the present value of all expected future cash flows shareholders expected to receive. The main advantages of shareholder wealth maximization goal is: It is based on the cash flow concept; through calculating the relevant cash flow of any alternative. Hence avoiding the impact of accounting policies and methods employed by the firm. It does take risk into consideration associated with the return. It does take the time value of money into consideration. It does take the future value prospects into consideration. A.Hossam So, according to this criterion: if the alternative increases the stock price it should accepted by management if it will decrease the stock market price it should rejected by management. Because finance is concerned with expected future cash flows, hence the forecasting of the amounts and the timing of such expected future cash flows, and the risks associated with them, is amongst the biggest challenges the financial managers face. Cash flows with high variability are risky. Financial managers must take two factors into consideration when they evaluate each alternative or course of action which are: 1- Return (measured on a cash flow basis and its timing) 2- The Degree of Risk associated with this return. Comparison Between Profit Maximization & Shareholders Wealth Maximization Profit Maximization Shareholders Wealth Maximization Profit is based upon accrual Financial decision making accounting principles based on cash flow principal Profit measurement depends on Measurement depends upon present accounting policies and techniques value of future cash flows adopted by company Realism (timing and risk of cash flows Conservatism/Carefulness are explicitly taken into consideration) So, The goal of the firm should be shareholder's(owners) wealth maximization does not profit maximization. Financial activities (the role of the financial manager) Financial managers actively manage the financial affairs/activities of all types of businesses whether private or public, large, or small, profit-seeking, or non-profit seeking firms. They are responsible for the financial health of a firm; they perform such varied tasks/activities such as: 1- developing strategic and tactical financial plans. 2- participating in formulating corporate strategy and implementing the financial strategy. 3- looking for the most efficient short/long sources of founds. 4- making strategic financing decisions. 5- making strategic investment decisions. 6- managing working capital. 7- financial analysis for performance. 8- managing risk. 9- managing foreign exchange. A.Hossam  Financial Decisions 1- The first view or perspective of the classifications of financial activities/ decisions:- The primary activities of the financial manager, in addition to ongoing involvement in financial analysis and planning…, are making investment decisions and making financing decisions. Investment decisions Financing decisions Can be classified in 2 groups: Can be classified in 2 groups: ▪ Short-term investment decisions ▪ Short-term financing decisions (managing current assets ). (managing current liabilities ). ▪ Long-term investment decisions ▪ Long-term financing decisions (managing long term assets ). (managing long term liabilities and stockholders equity ). Investment decisions related to the left Financing decisions related to the -hand side of the balance sheet right- hand side of the balance sheet (assets) (liabilities and stockholders equity ) Important equations :- Total Assets = Total Liabilities + Stockholders‟ Equity “ Long term assets + Current Assets = Current Liabilities +Long Term Liabilities + Stockholders‟ Equity” Stockholders‟ Equity” = Total Assets - Total Liabilities. 2- The second view or perspective of the classifications of financial decisions states that: The primary activities of the financial manager, in addition to ongoing involvement in financial analysis and planning, are making Operating/Tactical financial decisions and making strategic financial decisions. Operating/tactical financial decisions Strategic financial decisions are those related to working capital are those which include: decisions, including: ▪ Long-term investment decisions or ▪ Short-term investment decisions strategic investment decisions or operating investment decisions (related to long term assets/long term (managing current assets/short term investments). investments). ▪ Long-term financing decisions or ▪ Short-term financing decisions strategic financing decisions operating financing decisions (related to long-term liabilities and (managing current liabilities/short- stockholders' equity/long-term term sources of funds). sources of funds). A.Hossam  The main principles of finance Money has a time means any unit of currency today does not worth the same value unit of currency in future. There is a risk – means individuals would not take on additional risk unless return tradeoff they expect to be compensated with additional return. profit is an accounting concept designed to measure a Cash flows are the firms performance over a period. Cash flow is the amount source of value of cash that has been taken in or out of the firm over the same period. ▪ means investors react to new information through buying and selling securities. Market prices ▪ The efficiency of the market states that the prices of reflect information securities fully and fairly reflect all relevant available information. Ethical and Agency Considerations in Corporate finance Ethical issue refers to, the way the management of a firm is acting in an ethical manner or morally correct. Such issue is so important for the firm success and staying in the market. Recent famous examples of financial scandals at companies are Enron and WorldCom. Agency problem is referring to, the conflict of interest between shareholders and the managers of the firm. Such conflict appears because of the separation between management and ownership of the firm. The managers act as the agents of the owner or owners of the firm. When the managers have less than 100% of the ownership in the firm, they may act active on their own benefits rather than the owner’s interest The End of Chapter 1 ‫ال تنسوا الدعاء لوالدي بالرحمة والمغفرة‬ A.Hossam