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Financial Management (11
th
edt)
By E.F. Bringhamand M.C. Ehrhardt
An Overview of Financial
Management
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What Is Finance?
Finance is the art and science of
managing money
Why science?
because in some situations its fundamental
concepts, principles, theories, and models can be
applied universally to make decisions
Why art?
because in some situations precise models cannot
be created and intuition is used to make decisions
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What Is Finance?
Finance is concerned with
---the process, institutions, markets, and
instruments involved in the
---transfer of money among individuals,
businesses, and governments
Financial management or managerial
finance is the branch of Finance
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FM is the managerial activity concerned
with planning and controlling of a firms
financial resources
---to create and maintain the economic
value (wealth) of the firm, and
---to use corporate resources efficiently to
achieve the goals of the firm
What Is Financial Management?
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What Is Managerial Finance?
MF deals with the duties/responsibilities
of the financial manager working in a
business
Focuses on monetary decisions, tools and analysis
used to make these decisions
Shows how to improve financial conditions of a
company
Attempts to maximize shareholder value while
managing risks
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Finance VS Economics & Accounting
Finance grew out of Economics and
Accounting
Economics provides structure for decision
making and suggests that assets value is based
on its ability to generate cash CFs now and in
the future.
Accounting provides financial data regarding
the likely size of those CFs.
Finance links economic theory with the
numbers of accounting
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Finance Vs. Accounting
Accounting Finance
Backward looking
Accounting focuses
on collection and
presentation of
financial data
Accountant measures
firms performance
Forward looking
Finance focuses on evaluating
accounting statement,
developing additional data, and
making decisions based on
associated risk and return
Financial manager plans CFs to
maintain firms solvency
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Areas of Specialization in Finance
Financial Markets
Markets for users and savers of funds.
Financial Services
Design and delivery of financial advice and
products to individuals, businesses,
government.
Managerial Finance
Financial management of business firms.
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Functions of the Financial Manager
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Hypothetical Organization Chart
Chairman of the Board and
Chief Executive Officer (CEO)
Board of Directors
President and Chief
Operating Officer (COO)
Vice President and
Chief Financial Officer (CFO)
Treasurer Controller
Cash Manager
Capital Expendit ures
Credit Manager
Financial Planning
Tax Manager
Financial Accounti ng
Cost Accounting
Data Processing
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Financial Management Decisions
Capital budgeting
What LT investments should we engage in?
Where, when & how to make LT investments?
Capital structure
How should we pay for our assets?
Should we use debt or equity or both?
From which source should we raise capital?
Working capital management
How do we manage the day-to-day CFs?
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Financial Management Decisions
Risk Management
What financial risks should we take on or
hedge out
Capital Analysis
What is something worth?
How can we create value for the firm?
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The Balance-Sheet Model of the Firm
Current Assets
Fixed Assets
1 Tangible
2 Intangible
Total Value
of Assets:
Shareholders
Equity
Current
Liabilities
Long-Term
Debt
Total Firm Value
to Investors:
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Current
Assets
Fixed Assets
1 Tangible
2 Intangible
Shareholders
Equity
Current
Liabilities
Long-Term
Debt
What LT
investments
should the
firm engage
in?
The Capital Budgeting Decision
The Balance-Sheet Model of the Firm
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How can the
firm raise the
money for the
required
investments?
The Capital Structure Decision
Current
Assets
Fixed Assets
1 Tangible
2 Intangible
Shareholders
Equity
Current
Liabilities
Long-Term
Debt
The Balance-Sheet Model of the Firm
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How much ST
CF does a firm
need to pay its
bills?
The Net Working Capital Investment Decision
Net
Working
Capital
Shareholders
Equity
Current
Liabilities
Current
Assets
Fixed Assets
1 Tangible
2 Intangible
Long-Term
Debt
The Balance-Sheet Model of the Firm
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Types of Markets
Financial Market--market for financial assets
(securities) such as stocks, bonds, currencies,
and derivatives
Capital Market--financial market for stocks
and intermediate & LT debt
Money Market--financial market for ST debt
securities (B/A, commercial paper, T-bills with
a maturity of less than 1 year
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Primary market--a part of capital market in
which security is directly sold to the public by
the issuer
Secondary market--market in which
securities are traded after they have been
initially offered
Spot market--market for assets which are
bought or sold for on-the-spot delivery
Future market--market for commodity, and
future contracts for delivery at a specified
future date
Types of Markets
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Basic Forms of Business
Organization
Sole Proprietorship
Owned by one person
Operated for personal profit
Unlimited liability
Partnerships (general and limited)
Owned by two or more people
Operated for joint profit
Liable personally and collectively
Run by partnership deed
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Basic Forms of Business
Organization
Corporations
Legal entity created by law
Mandatory registration
Legally functions separate and apart from its
owners.
Owners liability is limited to the amount of their
investment
Owners hold common stock, and ownership can
be transferred
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Partnership Vs. Corporations
Corporation Partnership
Liquidity Shares can easily be
exchanged.
Subject to substantial
restrictions.
Voting Rights Usually each share
gets one vote
General Partner is in
charge; limited
partners may have
some voting rights.
Taxation Double Partners pay taxes
on distributions.
Reinvestment and
dividend payout
Broad latitude All NCF is distributed
to partners.
Liability Limited liability
General partners may
have unlimited liability.
Limited partners enjoy
limited liability.
Continuity Perpetual life Limited life
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Sole Proprietorships & Partnerships
Advantages
Ease of formation
Subject to few regulations
No corporate income taxes
Disadvantages
Difficult to raise capital
Unlimited liability
Limited life
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Corporation
Advantages
Limited Liability
Permanency
Transferability of
ownership
Better access to
capital markets
Disadvantages
Difficult to set up and
report filing
Separation of owners
from management
Less control
Double taxation
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Separation of Ownership and
Control
Board of Directors
Management
Assets
Debt
Equity
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Characteristics of Corporation
Ownership
Stock holders are the owners of the corporation
Control
Ultimate control rests with the stock holders, but
managers control day-to-day operations
Risk Bearing
Shareholders bear all residual risk
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Rights of Ownership
Dividend Rights
Voting Rights
Majority voting--one vote per share per director
Cumulative voting--one can cast all votes for a
single candidate
Liquidation Rights
The right of a firms residual value in the event of
liquidation
Preemptive Rights
The right to subscribe proportionally to any new
shares issued by the firm
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The Goal of the Corporation
What should be the goal of a corporation?
To survive?
To avoid financial distress and bankruptcy?
To beat the competition?
To maximize sales or market share?
To maintain steady earnings growth?
To minimize costs?
To maximize profit???
Does this mean we should do anything and
everything to maximize profit?
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The Goal of the Corporation
Investment Year 1 Year 2 Year 3 Total (years 1-3)
Rotor 1.40 $ 1.00 $ 0.40 $ 2.80 $
Valve 0.60 $ 1.00 $ 1.40 $ 3.00 $
Earnings per share (EPS)
Which Investment i s Preferred?
Profit maximization
Fails to account for differences in the level of CFs
Does not consider the timing of these CFs
Does not consider the risk of these CFs.
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The Goal of the Corporation
To maximize shareholder wealth
market price of stock value of firm
Why best goal?
A comprehensive goal for the firm, its managers,
and employees
This goal can be explored through economic
valued added (EVA)
This goal focuses on stakeholders
This goal meets triple bottom line (economic,
social and environmental)
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The Goal of the Corporation
This can be illustrated using the following
simple stock valuation equation:
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The process of shareholder wealth
maximization can be described using the
following flow chart:
The Goal of the Corporation
Financial
Manager
Financial
Decision
Alternative
or Actions
Return?
Risk?
I ncrease
Share
Price?
Yes Accept
No
Reject
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Is Stock Price Maximization the Same
as Profit Maximization?
No, despite a generally high correlation
amongst stock price, EPS, and CFs
Current stock price depends on current as well as
future earnings and CFs
Some actions may cause earnings to increase,
yet cause the stock price to decrease (vice-versa)
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The Goal of Non-Business Firm
To maximize the interests (benefits) of
stakeholders given a set of resources.
Example: The goals of a university:
Quality education for the students
Good management for the university
Right contribution to the society and to the
country
Financially healthy condition
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What about Stakeholders?
Stakeholders include groups that have
direct economic links to the firm
Owners, employees, customers, suppliers, and
creditors
Maintaining positive relationships with
stakeholders helps maximize LT benefits to
shareholders
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Three Basic Questions
Do firms have any responsibilities to society
at large?
Is stock price maximization good or bad for
the society?
Should firms behave ethically?
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Stock Price Maximization Increases
Social Welfare
Society receives benefits as owners of stocks
Increased stock price give society benefits
Consumers receive benefits
Increased stock price requires being efficient i.e.
producing high-quality goods at the lowest cost
Employees receive benefits
Increased stock price helps company grow fast
because company can easily raise capital
Thus, employment opportunity is created
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Factors That Affect Stock Price
Projected CFs to
shareholders
Timing of CF stream
Riskiness of the CFs
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Determinants of a Firms Value
Sales
Rev.
I nterest
rates
Financing
decisions
Required
invest in
operations
Opera
costs &
taxes
Firm
risk
Market
Risk
FCF WACC
Value of the Firm
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Free Cash Flow (FCF)
Cash available for distribution to all investors after
meeting all expenses and making required
investment in operations to support growth
Weighted Average Cost of Capital (WACC)
A firm's cost of capital in which each category of
capital is proportionately weighted
The average return required by all investors
Determined by the capital structure, interest
rates, the firms risk, and attitude toward risk
Determinants of a Firms Value
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What is WACC, if a firm raises the following funds?
Equity $30,000 and required rate of return 12%
Bank loan (Notes payable) $10,000 @ 15% interest
rate and tax rate is 40%
Bonds $10,000 @ 10% interest rate
Calculation of WACC
Funds
(1)
Amount
(2)
Weight
(3)
Rate
(4)
WACC
(5)=(1-t) (3)(4)
Equity $30,000 0.6 0.12 0.60.12=0.072
Bank Loan $10,000 0.2 0.15 (1-0.4) 0.2 .15=0.018
Bonds $10,000 0.2 0.10 (1-0.4) 0.2.10)=0.012
Total $50,000 1.0 0.102
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The Cost of Money or Fund
The interest rate paid as price to borrow
debt capital
The cost of equity is the required return an
investor expects in form of dividends and
capital gains
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Factors Affecting the Cost of Money
Production opportunities (returns available
within an economy)
Time preferences for consumption (as
opposed to saving for future consumption)
Risk of return
Expected inflation
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Determinants of Market Interest Rate
r = r* + IP + DRP + LP + MRP
r = required return on a debt security
r*= real risk-free rate of interest
IP= inflation premium
DRP =default risk premium
LP =liquidity premium
MRP =maturity risk premium (interest rate)
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Risks Associated with Investing
Overseas
Exchange rate risk--therisk to which
investors are exposed because changes
in exchange rates may have an effect on
investments
Country risk--the risk arises in a
particular country and depends on the
countrys economic, political, and social
environment.
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Economic Factors Influencing
Interest Rate (r)
Policy of Central Bank
To support growth, increased money supply forces
r to go down, but larger money supply increases
inflation rate which again drives up r
Budget Deficit or Surplus
If government runs trade deficit, then financed
from borrowing will drive up r and vice-versa
International Trade Deficits or Surplus
International trade deficit is financed by borrowing
from foreign sources which drives up r
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Four Golden Rules of Finance
If it dont jingle it dont count
Risk is the possibility that bad or good things
may happen
The greater the risk the greater the expected
reward
A $1 today is worth more than a $1 tomorrow
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Agency Relationships
An agency relationship exists whenever
stockholders (principals) hire managers
(agents) to act on their behalf
Within corporations, agency relationships
exist between:
Stockholders and managers, and
Stockholders and creditors
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Agency Problems and Costs
Agency problems arise when managers
place personal goals ahead of the goals of
shareholders
Agency costs arise from agency problems
Borne by shareholders and represent a loss of
shareholder wealth
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Stockholders Vs. Managers
Managers are naturally inclined to act in their
own best interests
How to increase personal wealth, job security,
fringe benefits, and lifestyle
But the following factors affect managerial
behavior:
The threat of firing
The threat of hostile takeover
Structuring managerial incentives
Legal forces--fraud and fiduciary misconduct laws
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Stockholders through managers could
take actions to maximize stock price that
are detrimental to creditors
In the long run, such actions will raise the cost of
debt and ultimately lower stock price
Stockholders Vs. Creditors
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Set of Contracts Model of the Firm
Preferred
Stockholders
Managers
The Firm
Common
Stockholders
Communities
Creditors
Governments
Customers
Suppliers
Society
Banks
Environment
Bondholders
Employees