Role of Financial Management PDF

TERMINOLOGIES 2. Balance Sheet o summary statement of the firm’s financial position at a ROLE OF FINANCIAL MANAGEMENT given point in time...

TERMINOLOGIES 2. Balance Sheet o summary statement of the firm’s financial position at a ROLE OF FINANCIAL MANAGEMENT given point in time ▪ Current Assets -short-term assets, expected to What does Financial Managers do? be converted into cash within 1 year 1. Maximization of shareholder’s wealth. ▪ Current Liabilities - short-term liabilities, Act on behalf of the firm’s owners by making operating and expected to be paid within 1 year investment decision, benefits exceeds cost ▪ Long-Term Debt - debt for which payment is not To deliver value to the investors - raise funds on ongoing due in the current year firm’s operations, future investment opportunities ▪ Paid-in-Capital in Excess of Par - The amount of proceeds in excess of the par value received Personal from the original sale of common stock 1. spend ▪ Statement of Stockholders’ Equity - Shows all 2. save equity account transactions that occurred during 3. invest a given year Business 3. Statement of Retained Earnings 1. raise money o Reconciles the net income earned during a given year, 2. invest money and any cash dividends paid, with the change in 3. reinvest profits or distribute retained earnings between the start and the end of that year I. FINANCIAL RATIOS 4. Statement of Cash Flows The Four Key Financial Statements o Provides a summary of the firm’s operating, 1. Income Statement investment, and financing cash flows and reconciles o Provides a financial summary of the firm’ operating them with changes in its cash and marketable results during a specified period securities during the period. o Dividends Per Share Interest Parties The dollar amount of cash distributed during the Shareholders period on behalf of each outstanding share of Creditors common stock Management Types of Ratio Comparisons Degree of Indebtedness - Ratios that measure the 1. Cross-Sectional Analysis amount of debt relative to other significant balance o Comparison of different firms’ financial ratios at the sheet amounts same point in time; involves comparing the firm’s ratios with those of other firms in its industry or with D. PROFITABILITY RATIOS industry averages. Common-Size Income Statements - An income o Benchmarking statement in which each item is expressed as a - A type of cross-sectional analysis in which the firm’s ratio percentage of sales. values are compared with those of a key competitor or with a group of competitors that it wishes to emulate. Operating Profit Margin “pure profits” – Measures the percentage of each sales dollar remaining after all costs 2. Time-Series Analysis and expenses other than interest, etc are deducted. Evaluation of the firm’s financial performance over time Net Profit Margin – including the interest using financial ratio analysis. E. MARKET RATIOS 3. Combined Analysis Provides an assessment of how investors view the Combines cross-sectional and time-series analyses firm’s performance. A. LIQUIDITY RATIOS DuPONT ANALYSIS Liquidity - A firm’s ability to satisfy its short-term Modified Dupont Formula obligations as they come due Relates the firm’s return on total assets (ROA) to its return on equity (ROE) using the financial leverage B. ACTIVITY RATIOS multiplier (FLM) Measure the speed with which various accounts are converted into sales or cash, or inflows or outflows II. TIME VALUE OF MONEY Future Value vs. Present Value C. DEBT RATIOS Compounding - Used to find the future value of each Financial Leverage - The magnification of risk and cash flow at the end of an investment’s life. return through the use of fixed-cost financing, such Discounting - Used to find the present value of each as debt and preferred stock cash flow at time zero Future Value - The value on some future date of money that where the weights reflect the percentage of each type of you invest today. financing used by the firm. Compound Interest - Interest that is earned on a given deposit and has become part of the principal at the end of a specified Sources of Long-Term Capital period. ▪ Long-term capital for firms derives from four basic Principal – The amount of money on which interest is paid sources: long-term debt, preferred stock, common stock, and retained earnings. Types of Annuities: ▪ Not every firm will use all of these financing sources Annuity o A stream of equal periodic cash flows over a specified Cost of Long-term Debt time period. The financing cost associated with new funds raised o These cash flows can be inflows or outflows of funds through long-term borrowing. Ordinary Annuity o An annuity for which the cash flow occurs at the end of Net Proceeds each period. - The funds received by the firm from the sale of a security. Annuity Due Flotation Costs o An annuity for which the cash flow occurs at the - The total costs of issuing and selling a security. beginning of each period. - Increase the cost of common equity. III. COST OF CAPITAL Capital Structure Weights Basic Concepts: Market Value Weights Capital - A firm’s long-term sources of financing, which Weights that use market values to measure the include both debt and equity. proportion of each type of capital in the firm’s Capital Structure -The mix of debt and equity financing financial structure. that a firm employs. In calculating a firm’s WACC, market value weights Cost of Capital - Represents the firm’s cost of financing should be used rather than book or par values and is the minimum rate of return that a project must earn to increase the firm’s value. Target Capital Structure Weighted Average Cost of Capital (WACC) - A weighted The mix of debt and equity financing that a firm average of a firm’s cost of debt and equity financing, desires over the long term.  The target capital structure should reflect the optimal 3. Decision Making mix of debt and equity for a particular firm. Firms typically delegate capital expenditure decisions on the basis of dollar limits. IV. CAPITAL BUDGETING TECHNIQUES Generally, the board of directors or a team of very senior executives must authorize expenditures Capital Budgeting beyond a certain amount - The process of evaluating and selecting long-term Often, plant managers have authority to make investments that contribute to the firm’s goal of decisions necessary to keep the production line maximizing owners’ wealth moving. Motives for Capital Expenditure 4. Implementation Capital Expenditure Following approval, firms make expenditures and An outlay of funds by the firm that the firm expects to implement for a large project often occur in phases. produce benefits over a period of time greater than 1 year 5. Follow-up Operating Expenditure Managers monitor results and compare actual costs An outlay of funds by the firm resulting in benefits and benefits to the projections that they originally received within 1 year used to justify making the investment. Managers may take actions to expand, contract, or Capital Budgeting Process shut down investments when actual outcomes differ Consists of five distinct but interrelated steps: from projected ones. 1. Proposal Generation Independent versus Mutually Exclusive Projects Managers at all levels in a business make proposals for Independent Projects new investment projects that are reviewed by finance Projects whose cash flows are unrelated to (or personnel. Proposals that require large outlays receive independent of) one another; accepting or rejecting greater scrutiny than less costly ones. one project does not change the desirability of other projects.’ 2. Review and Analysis Financial managers perform formal review and analysis to assess the merits of investment proposals. Mutually Exclusive Projects Decision Criteria Projects that compete with one another so that the If the payback period is less than the maximum acceptance of one eliminates from further acceptable payback period, accept the project consideration all other projects that serve a similar If the payback period is greater than the function. maximum acceptable payback period, reject the project Unlimited Funds versus Capital Rationing Unlimited Funds Net Present Value The financial situation in which a firm is able to A capital budgeting technique that measures an accept all independent projects that provide an investment’s value by calculating the present value of acceptable return its cash inflows. Capital Rationing The financial situation in which a firm has only a fixed Decision Criteria number of dollars available for capital expenditures If the NPV is greater than $0, accept the project and numerous projects compete for these dollars If the NPV is less than $0, reject the project Accept–Reject versus Ranking Approaches Profitability Index Accept–Reject Approach is simply equal to the present value of cash inflows The evaluation of capital expenditure proposals to divided by the absolute value of the initial cash determine whether they meet the firm’s minimum outflow acceptance criterion. Internal Rate of Return Ranking Approach The discount rate that equates the NPV of an The ranking of capital expenditure projects on the investment opportunity with $0 (because the present basis of some predetermined measure, such as how value of cash inflows equals the initial investment); it much value the project creates for shareholders. is the rate of return that the firm will earn if it invests in the project and receives the given cash inflows. Payback Period The time it takes an investment to generate cash Decision Criteria inflows sufficient to recoup the initial outlay required If the IRR is greater than the cost of capital, accept the to make the investment. project If the IRR is less than the cost of capital, reject V. STOCK VALUATION market price, in direct proportion to their fractional ownership. Common Stock Ownership Privately Owned (Stock) - owned by private investors; Authorized, Outstanding, and Issued Shares not publicly traded Authorized Shares - Shares of common stock that a Publicly Owned (Stock) - owned by public investors firm’s corporate charter allows it to issue Closely Owned (Stock) - owned by an individual or a Outstanding Shares - Issued shares of common stock small group of investors (such as a family); they are held by investors, including both private and public usually privately owned companies investors Widely Owned (Stock) - owned by many unrelated Treasury Stock - Issued shares of common stock held individual and institutional investors. by the firm; often these shares have been repurchased by the firm COMMON STOCK Issued Shares - Shares of common stock that have Par Value Common Stock - An arbitrary value that is been put into circulation; the sum of outstanding established for legal purposes in the firm’s corporate charter shares and treasury stock. and that can be used to find the total number of shares outstanding by dividing it into the book value of common stock Voting Rights Proxy Statement - A statement transferring the votes Preemptive Rights - Allows common stockholders to maintain of a stockholder to another party. their proportionate ownership in the corporation when new Proxy Battle - The attempt by a nonmanagement group shares are issued, thus protecting them from dilution of to gain control of the management of a firm by ownership. soliciting a sufficient number of proxy votes. Supervoting Shares - Stock that carries with it multiple o Dilution of Ownership - A reduction in each previous votes per share rather than the single vote per share shareholder’s fractional ownership resulting from the typically given on regular shares of common stock. sale of new common shares. Nonvoting Common Shares - Common stock that o Dilution of Earnings - A reduction in each previous carries no voting rights; issued when the firm wishes to shareholder’s fractional claim on the firm’s earnings raise capital through the sale of common stock but resulting from the sale of new common shares. does not want to give up its voting control o Rights - Financial instruments that allow stockholders to purchase additional shares at a price below the Dividends o Preferred stock gives its holders privileges that make The payment of dividends to the firm’s shareholders them senior to common stockholders is at the discretion of the company’s board of o Preferred stockholders are promised a fixed periodic directors. dividend, stated either as a percentage or as a dollar Most corporations that pay dividends distribute them amount quarterly. Cash dividends are the most common Basic Rights of Preferred Stockholders o Preferred stock is often considered quasi-debt because, much like interest on debt, it specifies a fixed periodic International Stock Issues payment, but unlike debt, preferred stock has no American Depositary Shares (ADSs) maturity date. Dollar-denominated receipts for the stocks of foreign o Preferred stockholders are also given preference over companies that are held by a U.S. financial institution common stockholders in the liquidation of assets in a overseas. legally bankrupt firm, although they must “stand in American Depositary Receipts (ADRs) line” behind creditors. Securities, backed by American depositary shares (ADSs), that permit U.S. investors to hold shares of Features of Preferred Stock non-U.S. companies and trade them in U.S. markets Restrictive Covenants - These covenants include provisions about passing (i.e., skipping) dividends, the PREFERRED STOCK sale of senior securities, etc. Par-Value Preferred Stock – With stated face value that is used Cumulative – All passed (unpaid) dividends in arrears, with the specified dividend percentage to determine the along with the current dividend, must be paid before annual dollar dividend dividends can be paid to common stockholders Noncumulative - Passed (unpaid) dividends do not No-Par Preferred Stock – With no stated face value but with a accumulate. stated annual dollar dividend Callable Feature – Allows the issuer to retire the shares within a certain period of time and at a specified price o Most corporations do not issue preferred stock, but Conversion Feature – Allows holders to change each preferred shares are common in some industries such share into a stated number of shares of common stock. as financial services Market Efficiency and Stock Valuation Because the flow of new information related to a stock is continual and the content of that information is unpredictable (otherwise, it would not be new information), stock prices fluctuate, always moving toward a new equilibrium that reflects the most recent information available This general concept is known as market efficiency Zero-Growth Dividend Model An approach to dividend valuation that assumes a constant, nongrowing dividend stream. Constant-Growth Dividend Model A widely cited dividend valuation approach that assumes dividends will grow at a constant rate, but a rate less than the required return Gordon Growth Dividend Model common name for the constant-growth dividend model that is widely cited in dividend valuation. Variable-Growth Dividend Model allows for a change in the dividend growth rate.