Introduction

Framework for financial decision making

Notes
Why not maximize profit? The true owners of a company are the stockholders and the shareholders. The company
exists for them. Every group of financial management should be to the welfare/benefit of the stockholders,
because they put in their own money to the organization.
How about creditors? Lend money to the company, but the return money is fixed. For the stockholders, there are
no guaranteed returns. This is why common stockholders are called as residual owners.
Then why would anyone be interested in being a common stockholder? Because yes you are after the residue, but
the return has no limit. The creditors are only paid according to the agreed interest rate. They don’t have the
opportunity to expand their return.

Major Decisions by Financial Manager

• Investment Decision – what assets to own? What mix of fix assets? What mix of current assets?
• Financing Decision – what securities to issue? What mix of short-term credit, long-term debt and equity?
• Dividend Decision – what percentage of earnings should be given out in cash? Or should it be given out as
stocks?

Notes
Investment decision primarily forms the assets of the company. Whatever you see in the balance sheet of the
company, that’s the offshoot of the investing decision of the finance guys while the liabilities and equities side of
the balance sheet is the offshoot of the funding and dividends decision of the finance guys.
Financing decision: where to get money.
Dividends: not limited to cash, can also have stocks and property dividends.

The Financial Function (by RKS Rao)

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Profit Maximization vs Wealth Maximization

Alternative A:
Co. A sells the rights to gold mining on its land to Co. B, for $100M in cash. However, the rights expire in
30 years and Co. A must spend an estimated $101M to eliminate environmental damage caused by the
mining operation.
Alternative B:
Co. A can buy the mining equipment for $150M today and do its own mining and get $151M after 30 years
after clean-up. Note that Co. A has no experience in mining.

Notes
Profit Maximization: Alternative B. The company is thinking is more in terms of to get the profit, opportunity to
get the gold. Thinks more in the present. The company might be putting itself at risk due to its inexperience. Also,
$151M, moving it to PV, might be lesser than the investment.
Wealth Maximization: Alternative A. It doesn’t really consider profit. Mindset: I don’t have any exp in mining and
I’ll use the $100M to my other businesses. Yes, I might be spending more in 30 years, but it’s irrelevant
considering the opportunities I can get with the $100M right now.

Weaknesses of Profit Maximization

• Difficulty of incorporating risk in a profit based criterion.
• Too much emphasis on profit overshadows the timing when the returns could or would be
obtained.
• Profit is an accounting measure that may not necessarily reflect the economic realities of a firm.
It is a book concept that is sensitive to how accounting books of the company are kept.
Notes
1. There is no criterion, for risks, when it comes to profit.
2. Obscures the timing of returns.
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3. Recall that concept of profit is obtained in income statement. Profit is sensitive in terms of the accounting rules
you follow. Profit measures can look small just by overstating depreciation. Depreciation: systematic reduction in
the value of the fixed asset. There are times where we want to have a small profit, since tax. Lower profit: lower
tax. Tax: gotta pay in cash.
Another example: inventory costing technique, FIFO LIFO. Iba-iba yung Costings per technique.
By the accounting rules, we can play around profit.

How to Maximize Stockholder Wealth and Welfare?

- Increase cash flow, this is not artificial
But first, One has to know: how do <common> stockholders earn money?
Two ways: Capital Appreciation, Dividends
1. Capital Appreciation
- Increase in stock price.
2. Dividends
- Garnered from the earnings of a company.

Cash flow calculation not only recognize profits but go a little further and measure the actual cash
available for the firm. It captures the economic impact of managerial decisions.
Stocks will always move, depending on the future cash flow of the organization.

Accounting vs Finance

Notes
Accounting vs Finance
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Both are distinct and not the same, and are highly connected.
Accounting
- Standardizes record keeping (debit credit entry system)
- We don’t have the freewill to keep the records in the way we want it to. There’s a specific structure.
- Practically just recording
Finance
- More often than not, decision making,, about investments
- Also deals with funding decisions (where to get money, from new capital, retained cash?)
- Also deal with dividends, give out dividends to stockholders or keep the earnings? If keep earnings, gotta
reinvest.
The finance decision making feeds the work of accounting. The records and reports done by accounting, becomes
the feedback to the decisions of the finance. How good were arrived at.

Ten Axioms/Principles of Basic Financial Management

• The Risk-Return Trade-off - We Won’t Take on Additional Risk Unless We Expect to Be
Compensated with Additional Return.
• The Time Value of Money - A Dollar Required Today is Worth More Than A Dollar Received in the
Future
• Cash - Not Profit - Is King
• Consider Incremental Cash Flows - It’s Only What Changes that Counts
• The Curse of Competitive Markets - Why Its Hard to Find Exceptionally Profitable Projects
Key: Invest in Markets That Are Not Perfectly Competitive
How? 1. Differentiate your product.
2. Achieve a cost advantage over competitors.
• Efficient Capital Markets - The Markets Are Quick and The Prices Are Right
- Efficient Market - market in which the values of all assets and securities at any instant in time
fully reflect all available public information. The market price of a security is a consensus among
market players.
- Characteristics:
1. Security prices should reflect all available public information about the economy, about
financial markets and about the specific co. involved.
2. Market prices of individual securities adjust very rapidly to new information which can
result in a change in the “intrinsic” value of a security but subsequent security price
movements will follow what is known as “random walk”.
3. One simply cannot use past security prices to predict future prices in such a way as to
profit on average.
4. Unanticipated portion of return (expected return - actual return) earned on a security
is unpredictable and does not systematically differ from zero over a sufficient no. of
observations. It is also not correlated to any information be it publicly available or insider.
5. There is sufficiently large number of market who in their attempts to earn profits
promptly receive and analyze all information that is publicly available concerning companies
whose
securities they follow.
• The Agency Problem - Managers Won’t Work for the Owners Unless Its in Their Best Interest
• Taxes Bias Business Decisions
• All Risk is Not Equal - Some Risk Can Be Diversified Away and Some Cannot

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 - Diversification - allows good and bad events or observations to cancel each other out
thereby reducing total variability without affecting expected return.
Two Types of Risk:
1. Systematic/Market/Unavoidable Risks. Ex: changes in nation’s economy, tax reform by
Congress. These are risk that affect securities overall and consequently, cannot be diversified away.
2. Unsystematic/Diversifiable/Avoidable Risks. Ex: wildcat stirke, entry of new competitor,
technological breakthrough that make product obsolete. These risks are unique to a particular company,
being independent of economic, political and other factors that affect securities in a systematic manner.
• Ethical Behavior is Doing the Right Thing and Ethical Dilemmas are Everywhere in Finance

Notes
The risk-return trade off until key:invest in markets…how?..
1. People wont take additional risk unless they have the potential to become compensated with an additional
return. No one is going to invest in a risky product. One shouldn’t expect to get the same interest rate with
big businesses, say, Ayala Corporation.
3. Cash is more important.
4. Apply methods to that, like in IEECONO.
5. There is always competition. Something that is profitable right now might not be profitable in the future. Have
more players going in the market, one cannot command the price anymore. “Curse of the competitive market”
Principle of debt: investment opportunity of which you use the debt should be higher than the debt investment.
No such thing as a infinite/perpetual debt.

Efficient Capital Markets – the market.. until characteristic #2

Financial markets can only work for the premist: markets are quick and prices are right. If the market doesn’t
depict the correct prices, this defeats the purpose of the stock market. Markets have to react quickly. Example:
lockdown was announced.
Capital markets always try to price the current and potential development ( now and in the future) rather than in
the past.
The Agency problem until diversification
The agency problem.
The stockholder is not involved in the day to day operations of the company. If one wants to become a
stockholder, just find a broker and buy stocks. These companies hire managers to manage the company for them.

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Managers are paid people and might not necessarily consider the stockholders. They have their own vested interest
(for the salary). The agency problem always asks how managers can work for the best interests of the owners. This
problem always exists for corporations.
To address this problem, can have stock incentives for the workers. Also, can use debt. Managers have to consider
the interest of the debt be paid and if they don’t manage it properly, their career/job might be doomed. This is
however, very negative as compared to stock incentive program.
Taxes Bias
Taxes eat up cash flow; cash is key. Always have to make decisions on an after tax basis rather than before tax.
Two types of risk
Unavoidable risks- risk brought about by government. For example: changes in tax.
Avoidable risk- unique to the particular company.
Best to invest in ETF/mutual funds.
Diagram section
Capital Market is a major type of a financial market.
Treasury bills: Government needs the money
Government has direct access to financial markets. Individuals and businesses have to pass through financial
institutions.

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