OVERVIEW OF FINANCIAL MANAGEMENT

Finance has three areas:

A. Financial Management
B. Capital Markets
C. Investments
Financial Management Activities:
 What assets to acquire (Investment question) –
NCA
 How to raise the capital needed for the
purchase (Finance question) – L&E
 How to run the business (Operating question) –
Current items
Shareholder Wealth Maximization
- The primary goal of the corporation.
- This is not same as maximizing profits.
- Should be accomplished within the bounds of
ethical behavior
How is wealth determined?
- The value of an asset is the present value of the
stream of cash flows that the asset provides to
its owners over time.
EFFICIENT MARKET HYPOTHESIS
Market Efficiency
 The extent to which the market prices reflect all
relevant information available.
 In this situation, traders cannot profit from
over- or undervaluation as all stocks are traded
at equilibrium.
 There is information symmetry (both buyer and
seller have the same information on the asset).
From the social pov, this is desirable.
Are markets efficient? NO
 Weak form efficiency
o A condition where stocks traded in the
exchange are priced to reflect all
relevant past information.
o Historical information cannot be
studied to beat the market and there is
no correlation between stock price
movements in successive periods.
o Stock prices appears to be following a
random walk.
o Technical analysis is deemed useless.
 Semi-strong form efficiency
o A condition where a stock trading on an
exchange are priced to reflect all public
information.
o If true, information which is already
known to the public, both new and
 historical, cannot be studied to beat the Technology
market. Globalization
o This is because in this form, prices of Derivatives
stocks react quickly and accurately to
reflect new information as it becomes Financial Institutions
known.  Commercial banks
 Strong form efficiency  Investments bank
o The stock prices trading on the market  Financial Services Corporation
reflect all information, whether past,  Credit unions
public, and especially private  Pension funds
information.  Life Insurance Companies
o This is impossible in the real world as it  Mutual Funds Companies
is always possible for an individual,  Exchange Traded Funds
especially someone in power, to have  Hedge Funds
access to information not available to  Private Equity Companies
the public.
o E.g. the potential for insider trading The Stock Market
The most active secondary market, and the most
important for financial managers.
FINANCIAL MARKETS
The Capital Allocation Process

Capital flows from those who have excess of it to those

who need it.

Stock Transactions
Primary Market
Secondary Market
Initial Public Offering

Types of Markets:
Physical Asset Market
Financial Market

Spot Market
Futures Market

Money Market
Capital Market

Primary Market
Secondary Market

Private Market
Public Market

Recent Trends in Financial Markets:

MEASURING STAND ALON RISK – STANDARD DEVIATION
AND COEFFICIENT OF VARIATION

Risk
– The likelihood of an outcome to deviate from
expectation.
– Maybe an upward or downward deviation.

How do we measure risk?

Standard Deviation
- A statistical measure of how scattered the
possible outcomes are from the expectation
- Mathematically, it is the square root of the
variance
Sample Case:

Coefficient of variation
- A statistical measure of risk per rate of return
- This can be arrived at by dividing the standard
deviation by the expected rate of return.
- Used for comparing the risk of two investments
with different expected return.

CoV = 17.04%/8%
CAPITAL ASSET PRICING MODEL (CAPM)

Risk and Return Relationship

- The higher the risk, the higher the return.
- For an investor to take more risks, he should be
compensated with more returns.
Capital Asset Pricing Model
- Describe the relationship between systematic
risk and expected return for assets, particularly
stocks.
- Important assumption: The investor is
diversified, i.e. invested in a “basket” or
portfolio of securities.
Diversified Risk (Nonsystematic Risk)
- Risk that can be eliminated by diversification.
Market Risk (Systematic Risk)
- Risk that is inherent in the market, cannot be
eliminated by diversification.
How to measure market risk?
Beta (β) a measure of stocks volatility in relation to the
overall market.