Fundamentals of Finance and Financial

Management

Session – 01 Introduction

1
 Learning Outcomes
• To introduce basic types of financial
management decisions and the role of the
financial manager
• To understand the financial implications of
the different forms of business organization
• To recognize the goal of financial
management
• To understand the conflicts of interest that
can arise between owners and managers

2
 Basic Areas Of Finance
• Corporate finance
• Investments
• Financial institutions
• International finance

3
 Investments
• Work with financial assets such as stocks
and bonds
• Value of financial assets, risk versus return,
and asset allocation
• Job opportunities
– Stockbroker or financial advisor
– Portfolio manager
– Security analyst

4
 Financial Institutions
• Companies that specialize in financial
matters
– Banks – commercial and investment, credit
unions, savings and loans
– Insurance companies
– Brokerage firms

5
 International Finance
• This is an area of specialization within each of the
areas discussed so far
• It may allow you to work in other countries or at
least travel on a regular basis
• Need to be familiar with exchange rates and
political risk
• Need to understand the customs of other
countries; speaking a foreign language fluently is
also helpful

6
 Why Financial Managment?
• Marketing
– Budgets, marketing research, marketing financial
products
• Accounting
– Dual accounting and finance function, preparation of
financial statements
• Management
– Strategic thinking, job performance, profitability
• Personal finance
– Budgeting, retirement planning, college planning, day-
to-day cash flow issues

7
 Business Finance
• Some important questions that are
answered using finance
– What long-term investments should the firm
take on?
– Where will we get the long-term financing to
pay for the investments?
– How will we manage the everyday financial
activities of the firm?

8
 Financial Manager
• Financial managers try to answer some, or all, of
these questions
• The top financial manager within a firm is usually
the Chief Financial Officer (CFO)
– Treasurer – oversees cash management, credit
management, capital expenditures, and financial
planning
– Controller – oversees taxes, cost accounting, financial
accounting, and data processing

9
Financial Management Decisions
• Capital budgeting
– What long-term investments or projects should
the business take on?
• Capital structure
– How should we pay for our assets?
– Should we use debt or equity?
• Working capital management
– How do we manage the day-to-day finances of
the firm?

10
 Forms of Business Organization
• Three major forms in the United States
– Sole proprietorship
– Partnership
• General
• Limited
– Corporation
• Limited liability company

11
 Sole Proprietorship

• Advantages • Disadvantages
– Easiest to start – Limited to life of owner
– Least regulated – Equity capital limited to
– Single owner keeps all owner’s personal wealth
of the profits – Unlimited liability
– Taxed once as personal – Difficult to sell
income ownership interest

12
 Partnership
• Advantages • Disadvantages
– Two or more owners
– More capital available
– Relatively easy to start
– Income taxed once as
personal income
– Unlimited liability
• General partnership
• Limited partnership
– Partnership dissolves
when one partner dies
or wishes to sell
– Difficult to transfer
ownership
13
 Corporation
• Advantages • Disadvantages
– Limited liability
– Unlimited life
– Separation of ownership
and management
– Transfer of ownership is
easy
– Easier to raise capital
– Separation of ownership
and management
(agency problem)
– Double taxation (income
taxed at the corporate
rate and then dividends
taxed at personal rate,
while dividends paid are
not tax deductible)
14
 Goal Of Financial Management
• What should be the goal of a corporation?
– Maximize profit?
– Minimize costs?
– Maximize market share?
– Maximize the current value of the company’s
stock?
• Does this mean we should do anything and
everything to maximize owner wealth?

15
 The Agency Problem
• Agency relationship
– Principal hires an agent to represent its
interests
– Stockholders (principals) hire managers
(agents) to run the company
• Agency problem
– Conflict of interest between principal and
agent
• Management goals and agency costs

16
 Managing Managers
• Managerial compensation
– Incentives can be used to align management and
stockholder interests
– The incentives need to be structured carefully to make
sure that they achieve their goal
• Corporate control
– The threat of a takeover may result in better
management
• Other stakeholders

17
18
 Financial Markets
• Cash flows to the firm
• Primary vs. secondary markets
– Dealer vs. auction markets
– Listed vs. over-the-counter securities
• NYSE
• NASDAQ

19
Financial markets and financial system
Financial system
Return on
Return on
investments
Financial investments
markets
money money

Saving surplus Saving deficit

units (savers) units (investors)

money money
Ф Financial
intermediaries
Return on Return on
investments investments
 Financing decisions
Financing
decisions

Internal corporate External sources

financing of funds

Direct financing Indirect financing

Retained earnings (financial markets (financial
Instruments) Intermediaries)

Stocks Loans

Debt instruments
(bonds, CPs etc.)
 Financial markets

Financial markets

Organized exchanges
Primary markets Money market
Over-the-counter
Secondary markets Capital market
 Primary and secondary markets
• Primary market – primary issues of securities
are sold, allows governments, banks,
corporations to raise money by directly selling
financial instruments to the public.
• Secondary market – allows investors to trade
financial instruments between themselves.
Secondary transactions take place.
 Money and capital markets
Money markets – short-term assets (maturity less than 1
year) are traded:
Certificates of deposits (CDs)
Commercial papers (CPs)
Treasury bills
Capital markets – long-term assets (maturity longer than 1
year) are traded:
Stocks
Corporate bonds
Long-term government bonds
 Organized exchanges and over-the-
counter
• Organized exchange – most of stocks, bonds and
derivatives are traded. Has a trading floor where floor
traders execute transactions in the secondary market for
their clients.
• Stocks not listed on the organized exchanges are traded
in the over-the-counter (OTC) market. Facilitates
secondary market transactions. Unlike the organized
exchanges, the OTC market doesn’t have a trading floor.
The buy and sell orders are completed through a
telecommunications network.
Organized exchanges and over-the-
counter
• Prices of financial instruments are determined
in equilibrium by demand and supply forces
• They reflect market expectations regarding
the future as inferred from currently available
information
Types of financial instruments
Type of issuer

Government, government
agencies

States (regions,
provinces), municipalities

Corporations

Financial
institutions

Others
Types of financial instruments

Maturity

Short-term instruments

Long-term instruments
Types of financial instruments
Type of yield

Dividend bearing
(stocks)

Discount debt
Instruments
(treasury bills)

Interest income instruments (bonds)

Types of financial instruments
By level of risk

Risk-free instruments (treasury bills)

Low-risky securities (treasury notes and bonds),

investment grade corporate bonds,
blue-chip stocks)

High-risky securities (junk bonds,

stocks), derivatives
 Financial instruments issued by
government: goals
• To finance any shortfall between expenditures
and taxes (deficit)
• To refinance maturing debt
• To finance investment projects, social
programs etc.
 Financial instruments issued by
government
• Treasury bills (T-bills)
T-Bills are the largest component of the money market, Short Maturities,
Sold at a discount from face value, Considered as a risk-free investment,
No chance of default, Very little interest rate risk.

• Treasury coupon issues:

- Treasury notes (T-notes): maturity of 1-10 years
- Treasury bonds (T-bonds): maturity of 10-30 years
Considered free of default risk
• Subject to interest rate risk
• Interest is subject to federal tax (but exempted from state and
local taxes)
 Financial instruments issued by
government
Treasury inflation-protected securities (TIPs):
• Treasury inflation-indexed securities
• Offer a fixed (real) coupon rate plus linkage to the
consumer price index (inflation)
• Interest is subject to federal tax (but exempted from
state and local taxes)
• TIPs are available in 5,10,30-year maturities
 Yields on debt securities
• Are affected by the following characteristics:
- Credit (default) risk
- Liquidity
- Tax status
- Term to maturity
 Credit (default) risk
• Investors have to consider the
creditworthiness of the security issuer, as
most securities are subject to the risk of
default
• Securities with higher degree of risk would
have to offer higher yields
• Is especially relevant for longer-term
securities
 Liquidity
• Liquid securities could be easily converted to
cash without a loss in value
• Securities with less liquidity will have to offer
a higher yield
• Securities with a short-term maturity or an
active secondary market have greater liquidity
 Tax status
• Investors are concerned with after-tax income earned on
securities
• Taxable securities will have to offer a higher before-tax
yield to investors than tax-exempt securities
• Investors in high tax brackets benefit most from tax-
exempt securities

Yat  Ybt (1  T ) , where

Yat  after  tax yield

Ybt  before tax yield

T  investor' s m arg inal tax rate
 Yield Curve
• Yield curve describes YTM (yield to maturity) for
different maturities of debt instruments. It reflects risk
and expectations regarding future interest rates.
• Also called “term structure of interest rates”

Bond price reaction to interest rate changes:

• As interest rates increase bond prices decrease
• As interest rates decrease bond prices increase
 Financial instruments issued by
corporations: goals
• To finance operations
• To invest in new projects
• To expand their business
• To repay debt or repurchase shares
 Financial instruments issued by
corporations: CPs
Commercial paper – short-term debt with
maturity of not more than one year.
• Issued at discount
• Higher rates than comparable Treasury bills
because of smaller default risk and less
liquidity than government securities
 Financial instruments issued by
corporations: bonds
Corporate bond – long-term debt security, promising a
bondholder interest payments on a regular basis and
payback of a par (face) value at maturity.
Maturities
Short-term: 1-5 years
Intermediate-term: 5-10 years
Long-term: 10-20 years
Interest is quoted as a percentage from face value
 Financial instruments issued by
corporations: bonds ratings
• Junk bonds – bonds with below investment
grade rating
• High yield (high risk) bonds
 Corporate bonds
• Debentures-unsecured debt. Backed only by the general
assets of the issuing corporation
• Secured debt (mortgage debt) – secured by specific
assets
• Subordinated debt – in default, holders get payments
only after other debtholders get their full payment
• Senior debt – in default holders get payment before
other debtholders get.
 Corporate bonds – Zero Coupon
Bond
Bonds that pay face value at maturity and no
payment until then
Sell today at a discount from face value
Taxed based on accrued interest
No reinvestment risk or reinvestment cost
 Financial instruments issued by
corporations: common stocks
• The common stockholders are the owners of the
corporation’s equity
• Do not have a specified maturity date and the firm is
not obliged to pay dividends to shareholders
• Returns come from dividends and capital gains
• Common stockholders are called the residual
claimants of the firm
• Stockholders have only limited liabilities
 Financial instruments issued by
corporations: preferred stocks
• Hybrid securities: has characteristics of debt
and equity
• Have face value, predetermined periodical
(dividend) payments with priority over
common stockholders
• If dividend payment is not paid, preferred
stockholders may get voting rights
 Derivative securities
• Securities whose value is derived from the
value of some underlying asset
• Most important derivatives are options and
futures
Stock options. Is not a tool of fundraising, it is a
method of compensation
International Financial Markets
The basic borrowing interest rate for
Eurodollar loans has long been tied to the
London Interbank Offered Rate (LIBOR) – the
average of Interbank offered rates for
Eurocurrency deposits in London market