Finance Management

An Overview of Financial
Management
 What is Finance
• According to Webster’s Dictionary;
«Finance is the system that includes
- the circulation of money,
- granting of credits,
- the making of investments, and
- the provision of banking facilities.»
 What is Finance
• Finance has many facets,
• it is difficult to provide a concise definition.
• This lesson will give you an idea of
- what finance professionals do and
- what you might do if you enter the finance
field after you graduate.
 Areas of Finance
• 1) Financial Management
• 2) Capital Markets
• 3) Investments
 Financial Management
• Financial management also called as
‘corporate finance’.
• Focuses on decisions relating to;
- how much and what type of assets to acquire,
- how to raise capital needed to purchase assets,
and
- how to run the firm so as to maximize its value.
 Financial Management
• The same principles apply to both for-profit
and not-for-profit organizations.
• But our lesson much focuses to financial
management in for-profit corporations.
 Capital Markets
• Capital markets are places where
- the interest rates,
- stock and bond prices are determined.
• Also studies here are the financial institutions
that supply capital to businesses.
 Capital Markets
- Banks,
- investment banks,
- stockbrokers,
- mutual funds,
- insurance companies, and etc.
bring together ‘savers’ who have money to invest and
- businesses,
- individuals, and
- other entities that need capital for various purposes.
 Capital Markets
• Governmental organizations such as
- FED, CBTR(TCMB), BRSA(BDDK), SDIF(TMSF),
which regulate banks and control the supply of
money, and
- SEC, CMB(SPK), which regulate the trading of
stocks and bonds in public markets,
are also studied as part of capital markets.
 Investments
• Investment related to decisions concerning
stocks and bonds and include a number of
activities about:
1) Security analysis
2) Portfolio theory
3) Market analysis
 Security analysis
1) Security analysis deals with finding the
proper values of securities (i.e., stocks and
bonds)
 Portfolio theory
2) Portfolio theory deals with the best way to
structure portfolios, or ‘baskets’, of stocks and
bonds.
Rational investors want to hold diversified
portfolios in order to limit risks,
so choosing a properly balanced portfolio is an
important issue for any investor.
 Market analysis
3) Market analysis deals with the issue of whether
stock and bond markets at any given time are ‘too
high’, ‘too low’ or ‘about right’.
• Include market analysis is ‘behavioral finance’
where investor psychology is examined in effort
to determine if stock prices have been bid up to
unreasonable heights in a speculative bubble or
driven down to unreasonable lows in a fit of
irrational pessimism.
 Areas of Finance
• Although separated these three areas, they closely
interconnected.
• Banking is studied under financial markets, but a bank
lending officer evaluating a business’ loan request must
understand corporate finance to make a sound decision.
• Similarly a corporate treasurer negotiating with a banker
must understand banking if the treasurer is to borrow on
reasonable terms.
• A security analyst trying to determine a stock’s true value
must understand corporate finance and capital markets to
do his/her job.
 Interest rates
• Financial decisions of all types depend on the
interest rates;
• so all people in corporate finance, investments,
and banking must know something about interest
rates and
• the way how interest rates are determined.
 Finance within an Organization
• Most business and not-for-profit organizations have an organization
chart.
• The board of directors is the top governing body, and the chairperson
of the board is generally the highest-ranking individual.
• The CEO comes next.
• The chair-person of the board often also serves as the CEO.
• Below the CEO comes the chief operating officer (COO).
• The COO is often also designated as a firm’s president.
• The COO directs the firm’s operations, which include marketing,
manufacturing, sales, and other operating departments.
• The chief financial officer (CFO), who is generally a senior vice
president and the third-ranking officer, is in charge of accounting,
finance, credit policy, decisions regarding asset acquisitions, and
investor relations, which involves communications with stockholders
and the press.
Figure 1 Finance within the Organization
 Finance Versus
Economics and Accounting
• Finance as we know today, grew out of
economics and accounting.
• Economists developed the notion that an
asset’s value is based on the future cash flows
the asset will provide, and
• Accountants provide information regarding
the likely size of those cash flows.
• People who work in finance need knowledge
of both economics and accounting.
 Finance Versus
Economics and Accounting
• Figure 1 above illustrates that in a modern
corporation, the accounting department typically
works under the control of the CFO.
• This further illustrates the link among finance,
economics, and accounting.
 Jobs in Finance
• Finance prepare students for jobs in
- banking,
- investment,
- insurance,
- corporations, and
- government sectors.
 Jobs in finance
• Accounting students need to know marketing, management, and
human resources.
• They also need to understand finance for it affects decisions in all
those areas.
• For example marketing people propose advertising programs, but
those programs are examined by finance people to judge the
effects of the advertising on the firm’s profitability.
• So to be effective in the marketing, one needs to have basic finance
knowledge.
• The same holds for management.
• Most important management decisions are evaluated in terms of
their effects on the firm value.
• So, finance is important to individuals regardless of their jobs.
 Determinants of Value
Figure 2 below illustrates the situation.
The top box illustrates managerial actions combined with
the economy, taxes, and the political conditions,
influence the level and riskiness of the company’s future
cash flows.
Which they are ultimately determine the company’s stock
price.
Investors like the higher expected cash flows.
But they dislike risks.
So the larger the expected cash flows and the lower the
perceived risk, and the higher the stock price.
Figure 2 Determinants of Intrinsic Value and Stock Price
 Determinants of Value
• The second row of the box differentiates what
we call ‘true’ expected cash flows and ‘true’ risk
from ‘perceived’ cash flows and ‘perceived’ risk.
• By ‘true’ we mean the cash flows and risk that
investors would expect if they had all the
information that existed about company.
• ‘Perceived’ means what investors expect, given
the limited information they have.
 Determinants of Value
• The third row of the boxes show that each stock
has an ‘intrinsic’ value.
• Which is an estimate of stock’s true value as
calculated by a component analyst who has the
available data,
• And a market price, which is the actual market
price based on perceived but possible incorrect
information as seen by the marginal investor.
• Not all the investors agree, so it is the ‘marginal’
investor who determines the actual price.
 Equilibrium
• When a stock’s actual market price is equal its
intrinsic value, the stock price is in
equilibrium,
• which is shown in the bottom box.
• When equilibrium exists, there is no pressure
for a change in the stock’s price.
• Market prices can differ from intrinsic values,
but eventually, as the future unfolds, the two
values tend to converge.
 Intrinsic Value
• Actual stock prices are easy to determine.
• They can be found on the internet or
published in newspapers every day.
• However, intrinsic values are estimates;
• And different analysis with different data and
different views about the future from different
estimates of a stock’s intrinsic value.
 Intrinsic Value
• Investing would be easier, more profitable and
riskless if we knew all stock’s intrinsic values.
• We can estimate intrinsic values of stocks.
• But we can’t be sure that we are right.
• A firm manager has the best information
about the firm’s future prospects.
• So the managers’ estimates of intrinsic values
are generally better than those of outside
investors.
 Intrinsic Value
• However even managers can be wrong.
• Figure 3 shows a hypothetical company’s
actual price and intrinsic value as estimated by
its management over time.
• The intrinsic value rises because the firm
retains and reinvests each year.
• Which the firm tends to increase the profits
every year.
Figure 3 Intrinsic Value
 Intrinsic Value
• The value jumped dramatically in 2008.
• Because a research and development (R&D)
break-through raised management’s estimate of
future profit estimates before outside investors
had this information.
• The actual stock price tended to move up and
down with the estimated intrinsic value.
• But the investor optimism and pessimism, along
with imperfect knowledge about the intrinsic
value, led to deviations between the actual prices
and intrinsic values.
 Intrinsic Value
• Intrinsic value is an long-run concept.
• Management’s goal should be to take actions
to maximize the firm’s intrinsic value.
• Not its current market price.
• That maximizing the intrinsic value will
maximize the average price over the long-run.
• But no necessarily the current price at each
point in time.
 Intrinsic Value
• For example, management might make an
investment that lower profits for the current
year but raising expected profits for the
future.
• If investors are not aware of this situation, the
stock price will be held down by the low
current profit.
• Even though the intrinsic value was actually
raised.
 Intrinsic Value
• Management should provide information that
helps investors make better estimates of the
firm’s intrinsic value.
• Which will keep the stock price close to its
equilibrium level.
• However sometimes management may not
want to share the situation because of the
competition circumstances.
 Stockholder-Manager Conflicts
• Managers’ personal goals may compete with
shareholder wealth maximization.
• Managers might be more interested in
maximizing their own wealth then their
stockholders’ wealth.
• Therefore managers might pay themselves
excessive salaries.
 Stockholder-Manager Conflicts
• Effective executive compensation plans can be
motivate the managers to act in their
stockholders’ best interests.
• Useful motivational tools are:
- Reasonable compensation packages,
- Firing of managers who don’t perform well,
and
- The threat of hostile takeovers.
 Stockholder-Debtholder Conflicts
• Debtholders, which includes the company’s
banker and bondholders, generally receive fixed
payments regardless of how well the company
does.
• While stockholders do better when the company
better.
• This situation leads to conflicts between these
two groups.
• To the extent that stockholders are more willing
to take on risky projects.
 Table 1 Stockholder-Debtholder Conflicts

Market Conditions One Year from Now

Project L Money Good Bad Expected Expected
İnvested Cash Flow Return
Cash flow to firm 2,400 2,000 2,200
Bondholders’ portion 1,000 1,080 1,080 1,080 8%
Stockholders’ portion 1,000 1,320 920 1,120 12%

Market Conditions One Year from Now

Project H Money Good Bad Expected Expected
İnvested Cash Flow Return
Cash flow to firm 4,400 0 2,200
Bondholders’ portion 1,000 1,080 0 540 -46%
Stockholders’ portion 1,000 3,320 0 1,660 66%
 Table 2 Stockholder-Debtholder Conflicts

Market Conditions One Year from Now

Project L Money Good Bad Expected Expected
İnvested Cash Flow Return
Cash flow to firm 2,400 2,000 2,200
Bondholders’ portion 1,000 1,080 1,080 1,080 8%
Stockholders’ portion 1,000 1,320 920 1,120 12%

Market Conditions One Year from Now

Project H Money Good Bad Expected Expected
İnvested Cash Flow Return
Cash flow to firm 4,400 0 2,200
Bondholders’ portion 1,000 1,080 0 1,000 8%
Stockholders’ portion 1,000 3,320 0 1,200 20%
 Stockholder-Debtholder Conflicts
• Consider a company has raised $2,000 in capital, $
1,000 from bondholders and $ 1,000 from
stockholders.
• Assume that the bonds have one-year maturity
and pay an %8 annual interest rate.
• The company will invest its $ 2,000 to project L.
• This is relatively a low-risk project that is expected
to be worth $ 2,400 one year from now if the
market is good and $ 2,000 if the market is bad.
• There is 50% chance that the market will be good
and a 50% chance the market will be bad.
 Stockholder-Debtholder Conflicts
• In either case, there will be enough cash to
pay the bondholders their money back plus
8% annual interest rate that promised.
• The stockholders will receive whatever is left
over after the bondholders have been paid.
• As expected, because they are paid last, the
stockholders are bearing more risk, but they
are also earning a higher expected return.
 Stockholder-Debtholder Conflicts
• Assume that the company discovers another project
(Project H).
• That has considerable more risk.
• Project H has the same expected cash flows as Project
L.
• But it will produce cash flows of $4,400 if the market is
good but $ 0 if the market is bad.
• Clearly the bondholders would not be interested in
Project H.
• Because they would not receive any additional benefits
if the market is good and they would loose everything
if the market is bad.
 Stockholder-Debtholder Conflicts
• However, Project H provides a higher rate of return
for stockholders than Project L, because they
capture all of the extra benefits if the market turns
to be good.
• While project H is clearly riskier, in some
circumstances managers acting on behalf of the
stockholders may decide that the higher expected
return is enough the justify the additional risk, and
they would proceed with Project H, despite the
strong objections of the bondholders.
 Stockholder-Debtholder Conflicts
• Another type of stockholder-debtholder conflict arises over the use of
additional debt.
• The more debt a firm uses to finance a given amount of asset, the
riskier the firm becomes.
• For example if a firm has $ 100 million of assets and finance them with
$ 5 million of bonds and $95 million of common stock, things have to go
terribly bad before the bondholders suffer a loss.
• On the other hand, if the firm uses $ 95 million of bonds and $ 5 million
of stock, the bondholders suffer a loss even if the value of the assets
declines only slightly.
• Bondholders want to protect themselves by including covenants in the
bond agreement that limit firms’ use of additional debt and constrain
managers’ action in other ways.