Basics of Financial Management

INTRODUCTORY
CLASS

Dr. Roxanne Selmo

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 Subject Overview - Objectives
 To familiarize the student with the concept of finance and
the role financial managers.
 Recognize the ten different principles of financial
management.
 To understand the concept of corporate world, time value of
money, financial statements and cash flow, tradeoff
between risk and return, difference between simple interest
and compound interest, financial ratios and their
limitations.
 How to calculate both present value and future value, the
value of bonds, and the major financial ratios.

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 Subject Overview-Learning Methods

 Lectures (interactive).
 Tutorials (class exercise).

– Problem solving Group (home

work)

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 Subject Overview – Course Materials
 Recommended textbook
Ross/ Westerfield/ Jordan (2010), Fundamentals
of Corporate Finance, 9th Edition, McGraw-Hill/
Irwin, NY, USA (any edition can be used).

 Other References; (Journals, Reports,

Websites, E. Library…etc.)

 Lecture slides
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 The
The Firm
Firm and
and the
the
Financial
Financial Manager
Manager

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 Chapter Objectives
 What is Financial Management?
 10 principles of financial management.
 What are the Decisions that Financial
Manager must be Concern?
 The Goal of the Firm.
 Organization of the Financial
Management Function.
 Understand the agency problems.
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 What is Financial
Management?
Financial Management means
planning, organizing, directing
and controlling the financial
activities of the organization.
It refers the efficient and effective management of
money (funds) in such a manner as to achieve the
goals of the organization.

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 Ten Principles of
Financial Management

“It is necessary to understand

these principles in order to
understand finance.”

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 Principle 1: The Risk-
Return Trade-off
 We won’t take on additional risk unless we
expect to be compensated with additional
return.
 Investment choices have different
amounts of risk and expected returns.
 The more risk an investment has, the
higher its expected return will be.

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 Principle 2: The Time
Value of Money
 A dollar received today is worth more than
a dollar received in the future.
 Because we can earn interest on money
received today, it is better to receive
money earlier rather than later.

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 Principle 3: Cash—
Not Profits—Is King
 Cash Flow, not accounting profit,
is used as our measurement
tool.
 Cash flows, not profits, are
actually can be reinvested.

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 Principle 4: Incremental
Cash Flows
 The incremental cash flow is the
difference between the projected
cash flows if the project is
selected, versus what they will
be, if the project is not selected.

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 Principle 5: The Curse
of Competitive Markets
 It is hard to find exceptionally profitable
projects
 If an industry is generating large profits,
new entrants are usually attracted. The
additional competition and added capacity
can result in profits being driven down to
the required rate of return.
 Product Differentiation, Service and
Quality can separate products from
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 Principle 6: Efficient
Capital Markets
 The markets are quick and the
prices are right.
 The values of all assets and
securities at any instant in time
fully reflect all available
information.

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 Principle 7: The
Agency Problem
 Managers won’t work for the owners
unless it is in their best interest
 A agency problem resulting from conflicts
of interest between the manager/agent and
the stockholder/owners.
 Managers may make decisions that are not in
line with the goal of maximization of
shareholder wealth.

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 Principle 8: Taxes Bias
Business Decisions

 The cash flows we consider

are the after-tax incremental
cash flows to the firm as a
whole.

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 Principle 9: All Risk is
Not Equal

 Some risk can be diversified

away, and some cannot
 The process of diversification
can reduce risk, and as a result,
measuring a project’s or an
asset’s risk is very difficult.
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 Principle 10: Ethical Behavior is Doing
the Right Thing, and Ethical Dilemmas
Are Everywhere in Finance

 Each person has his or her own

set of values, which forms the
basis for personal judgments
about what is the right thing

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 Decisions of Financial
Manager
 Investment Decisions (Capital Budgeting)
(Investment decisions revolve around how to best
allocate money to maximize their value.)
 Financing Decisions (Capital Structure)
(Financing decisions revolve around how to pay
for investments and expenses)
 Asset Management Decisions
(Working Capital Management Decisions)
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 Investment Decisions
 how, when, where and how much
money will be spent on
investment opportunities.
 A firm has many options to invest
their funds but firm has to select
the most appropriate assets for
investment which will bring
maximum benefit for the firm.
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 Investment Decisions
 What specific assets should be
acquired?
 What assets (if any) should be
reduced or eliminated?

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 Financing Decisions
Determine how the assets will be financed.
 A company can raise finance from various
sources such as by issue of shares,
debentures or by taking loan and advances.
These sources of finance can be divided into
two categories: owners fund (no risk involve)
and borrowers fund (risk involve).
 Find the least expensive sources of fund.

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 Financing Decisions
 What is the best type of financing?
Mix type financing.
 What is the best financing mix?
Mixer debt and equity.
 What is the best dividend policy?
Paying a consistent percentage of net earnings.
 How will the funds be physically
acquired?

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 Asset Management
Decisions
 How do we manage existing assets
efficiently?
 Financial Manager has varying degrees
of operating responsibility over assets.
 Greater emphasis on current asset
management than fixed asset
management.

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 Interrelationship of the decisions
made by a Financial Manager

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 What are the Goals of the
Firm? (General Goals)
 Survival
 Avoid financial distress and bankruptcy
 Beat the competition
 Maximize sales or market share
 Minimize costs
 Maximize profits
 Maintain steady earnings growth.

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 Shortcomings of these
General Goals
Problems
 These goals are either associated with
increasing profitability or reducing risk.
 Could increase current profits while harming firm (e.g., defer
maintenance, issue common stock to buy Treasury-bills,
etc.).
 Does not specify timing or duration of expected returns.
 Calls for a zero payout dividend policy.
 They are not consistent with the long-term interests of
shareholders.

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 The Real Goal of
the Firm

Maximization of
Shareholder Wealth!
Shareholders’ wealth can be
measured as the current
value per share of existing
shares.
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 Strengths of Shareholder
Wealth Maximization
 Takes account of: current and future
profits and EPS; the timing,
duration, and risk of profits; dividend
policy; and all other relevant factors.
 Thus, share price serves as a
barometer for business performance.

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 The Modern Organization

Modern Organization

Shareholders Management

There exists a SEPARATION

between owners and managers.
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 Role of Management
Management acts as an agent
for the owners (shareholders)
of the firm.
 An agent is an individual
authorized by another person,
called the principal, to act in
the latter’s behalf.
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 Agency Theory

 Jensen and Meckling developed

a theory of the firm based on
agency theory.
 Agency Theory is a branch of
economics relating to the
behavior of principals and their
agents.
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 Agency Theory

 Principals must provide incentives

so that management acts in the
principals’ best interests and then
monitor results.
 Incentives include stock options,
perquisites, and bonuses.

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 Social Responsibility
 Wealth maximization does not stop the
firm from being socially responsible.
 Assume we view the firm as producing
both private and social goods.
 Then shareholder wealth maximization
remains the appropriate goal in
governing the firm.

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 Organization of the Financial
Management Function

Board of Directors

President
(Chief Executive Officer)

Vice President Vice President Vice President

Operations Finance Marketing

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 Organization of the Financial
Management Function

Vice President of Finance

Treasurer Controller
Capital Budgeting Cost Accounting
Cash Management Cost Management
Credit Management Data Processing
Dividend Disbursement General Ledger
Fin Analysis/Planning Government Reporting
Pension Management Internal Control
Insurance/Risk Mngmt Preparing Fin Stmts
Tax Analysis/Planning Preparing Budgets
Preparing Forecasts

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