Introduction to CB3410

Financial Management

Spring 2023
Lecture 1

Prof. Chiyoung Cheong

 Introduction to Financial Management
(Chapter 1)

Objectives:
• Know the basic types of financial management decisions
and the role of the financial manager
• Know the financial implications of the different forms of
business organization
• Know the goal of financial management
• Understand the conflicts of interest that can arise between
owners and managers
 Why Study Finance?
• 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
 Four Areas of Finance
• Corporate Finance = Business Finance
• Investment
• Financial Intermediaries
• International Finance
 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?
 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
 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?
 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
 Financial Institutions
• Companies that specialize in financial matters
– Banks – commercial and investment, credit unions,
savings and loans
– Insurance companies
– Brokerage firms
• Job opportunities
 International Finance
• An area of specialization within each of the
areas discussed so far
• 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
Basic Areas Of Finance

INTERNATIONAL

DOMESTIC
Corporate Financial
Investments
Finance Institutions
 Forms and Ownership
of Business Organization
Assume you start a company as a sole owner. Your product (service)
is an immediate hit and you grow fast in Hong Kong
• You need to expand and you need a lot of capital
• A year later, you invite two of your close friends to invest in your
company.
– What do they get in exchange for their money?
– What determines a return that investors require in
exchange for their capital?
• May be more friends, family or unrelated people can invest later
• Questions for consideration:
• What is the ownership structure of the firm? Will a founder or outside
investors have majority?
 Forms and Ownership
of Business Organization cont’d
• Two years, your company successfully obtains a bank loan
• What does a bank get in exchange for its money?
• Difference between debt and equity
• Six year, your company need more capital to invest. In addition,
You want to sell some of your ownership in the company to, say,
buy a house.
• What should you do then?
– IPO: Many companies go public to raise money to expand
the business
• Question for consideration:
• How is the value of the firm and each individual share determined?
 Financial Markets
• Initial Public Offering (IPO): A company sells some of its
equity to the public.
– Founders lose control because ownership is transferred to
outside investors
– However, publicly traded firms have greater and easier
access to debt and equity capital markets in the future
• Financial markets provide cash flows to the firm
– Hong Kong Stock Exchange
– Primary vs. secondary markets

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

1-15
 Partnership
Business owned by two or more persons
• Advantages • Disadvantages
– Two or more owners – Unlimited liability
– More capital available • General partnership
– Relatively easy to start • Limited partnership
– Income taxed once as – Partnership dissolves
personal income when one partner dies or
wishes to sell
– Difficult to transfer
ownership

1-16
 Corporation
A legal “person” distinct from owners and a
resident of a state
• Advantages • Disadvantages
– Limited liability – Separation of ownership and
– Unlimited life management (agency
– Separation of ownership problem)
and management – Double taxation (income
– Transfer of ownership is taxed at the corporate rate
easy and then dividends taxed at
personal rate, while
– Easier to raise capital
dividends paid are not tax
deductible)
1-17
 International Corporate Forms
• All of these forms feature public ownership and
limited liability
 Goal Of Financial Management
• What should be the goal of a corporation?
– Maximize profit?
– Minimize costs?
– Maximize market share?
– Maximize the current value per share of the
company’s existing stock
– Maximize the market value of the existing
owners’ equity
 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

1-20
Do Managers Act in the Shareholders’
Interests?
• Managerial compensation
– Incentives can be used to align management and
stockholder interests
– Incentives need to be carefully structured to
ensure that they achieve their goal
• Corporate control
– Threat of a takeover may result in better
management
• Other stakeholders
1-21
 Sarbanes-Oxley Act
(SarBox, 2002)
• Driven by corporate scandals
– Enron, Tyco, WorldCom, Adelphia
• Intended to strengthen protection against
accounting fraud and financial malpractice
• Compliance very costly
– Firms driven to:
• Go public outside the U.S.
• Go private (“go dark”)
 The Role of the Financial Manager (1)
• Caretaker of the shareholder’s money
• Determines which projects the firm should invest in
– Should Park’n’Shop open an organic food store?
• Decides how to pay for these projects (debt vs. equity) and
what firm’s mix of debt and equity should be
– Debt is tax advantaged but introduces possibility of bankruptcy
and may distort investment decisions
• Ensures that the firm has enough cash to meet its obligations
and invest in profitable projects
– We spend much of this course developing the tools used to
identify profitable projects
 The Role of the Financial Manager (2)
Principal Decisions in Financial Management
1. Capital Budgeting Decisions (real assets)
• Which projects should we invest in?
• Should we expand, shutdown or diversify?
2. Financing Decisions (financial assets)
• How much cash should we raise?
• How should we raise cash?
• What types of financial claims should we issue?
– Common stock? Preferred stock? Convertible
bonds?
• How much cash should we return to investors?
 Goal Of Financial Management
• The goal is to maximize the current value of the company’s
stock or shareholder wealth

Shareholder wealth (market capitalization)

=Current Stock price x number of shares outstanding

• This goal avoids problems associated with goals such as

–Maximize profit
–Minimize costs
–Maximize market share

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 Financial Markets
• Cash flows to the firm
• Primary vs. secondary markets
– Dealer vs. auction markets
– Listed vs. over-the-counter securities
• NYSE
• NASDAQ
Cash Flows Between the Firm and the Financial
Markets
Figure 1.2
 Financial Statements and Cash Flow
(Chapter 2)

Our emphasis is on determining a firm’s cash flow from its

financial statements (not on preparing financial statements)
Keep in mind: Cash flow is a company’s lifeblood .

Other objectives:
Know the difference between book value and market value
Know the difference between accounting income and cash flow
Why care about financial statements?
• To have intelligent business conversations:
– Profit margins, net income
– Earnings and cash flows
• To understand financials of your own company.
• All investors use them to estimate the value of
companies.
• The government uses them to assess income tax.
• Managers’ compensation is linked to financial reports.
Who uses Financial Statement Analysis?
• Almost Everyone in the Business World
– Bankers – analyze loans and cash flow
– Portfolio Managers – projections of stock prices
– Marketing Managers – market penetration and
impacts to profitability
– Human Resources – compensation analysis
– Senior Management – corporate strategy
– Sales Managers – commission rates on sales
– Internal Financial Analysts – profitability analysis
– Customer Service Managers – efficiency ratios

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 Financial Statements

• There are four main financial reports:

– Balance Sheet
– Income Statement
– Cash Flow Statement
– Owners’ Equity (Ignored by us)

We use information in these statements to estimate

Operating and Free Cash Flows

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 Difference between
Accounting and finance perspectives
• Accounting is transactions based, not cash flow based.

• Very simple example: You invest $1,000 today in some safe investment. You know for sure
that you will receive $3,000 in one year.
Accounting Perspective: You have earned $2,000 today. You are earning nothing next
year.
Accounting entry: +$2,000 today.
Finance Perspective: You are losing $1,000 today. You are gaining $3,000 tomorrow.
Finance entry: –$1,000 today
+$3,000 next year.
(Note: future payments will be reduced for possible non-payment risk, time value of money,
etc.)
 Income Statement
• The income statement measures performance
over a specified period of time (period,
quarter, year).
• Report revenues first and then deduct any
expenses for the period
• End result = Net Income = “Bottom Line”
– Dividends paid to shareholders
– Addition to retained earnings
• Income Statement Equation:
• Net Income = Revenue - Expenses
U.S. Corporation Income Statement
 The Balance Sheet
• A snapshot of the firm’s assets and
liabilities at a given point in time (“as of …”)
• Assets
− Left-hand side (or upper portion)
− In order of decreasing liquidity
• Liabilities and Owners’ Equity
– Right-hand side (or lower portion)
– In ascending order of when due to be paid
• Balance Sheet Identity
▪ Assets = Liabilities + Stockholders’ Equity
Balance Sheet

36
 Market vs. Book Value
• Book value = the balance sheet value of the
assets, liabilities, and equity.
• Market value = true value; the price at
which the assets, liabilities, or equity can
actually be bought or sold.
– Market value and book value are often very
different. Why?
– Which is more important to the decision-making
process?
Klingon Corporation
Example 2.2
 The Concept of Cash Flow
• Cash flow = one of the most important
pieces of information that can be derived
from financial statements
• The accounting Statement of Cash Flows
does not provide the same information that
we are interested in here
• Our focus: how cash is generated from
utilizing assets and how it is paid to those
who finance the asset purchase.
 Cash Flow From Assets

• Cash Flow From Assets (CFFA)

= Operating Cash Flow (OCF)
– Net Capital Spending (NCS)
– Changes in NWC (ΔNWC)

• Cash Flow From Assets (CFFA)

= Cash Flow to Creditors (CF/CR)
+ Cash Flow to Stockholders (CF/SH)
 Example: U.S. Corporation
Balance Sheet U.S. Corporation
Assets Liabiities & Owners' Equity
2009 2010 2009 2010 Income Statement
Current Assets Current Liabilities Net sales $1,509
Cash $104 $160 Accounts Payable $232 $266
Accounts Receivable 455 688 Notes Payable 196 123
Cost of goods sold 750
Inventory 553 555 Total $428 $389 Depreciation 65
Total $1,112 $1,403 Earnings before interest and taxes $694
Fixed Assets
Net Fixed assets $1,644 $1,709 Long-term debt $408 $454 Interest Paid 70
Owners' equity Taxable income $624
Common stock and
paid-in surplus 600 640
Taxes 212
Retained earnings 1,320 1,629 Net Income $412
Total $1,920 $2,269 Dividends $103
Total Liabilties &
Total assets $2,756 $3,112 Owners Equity $2,756 $3,112 Addition to retained earnings $309

• CFFA = OCF – NCS - ΔNWC

OCF = EBIT + depreciation – taxes

NCS = ending net FA– beginning net FA + depreciation

ΔNWC = ending NWC – beginning NWC

• CFFA =
 Example: U.S. Corporation
Balance Sheet U.S. Corporation
Assets Liabiities & Owners' Equity
2009 2010 2009 2010 Income Statement
Current Assets Current Liabilities Net sales $1,509
Cash $104 $160 Accounts Payable $232 $266
Accounts Receivable 455 688 Notes Payable 196 123
Cost of goods sold 750
Inventory 553 555 Total $428 $389 Depreciation 65
Total $1,112 $1,403 Earnings before interest and taxes $694
Fixed Assets
Net Fixed assets $1,644 $1,709 Long-term debt $408 $454 Interest Paid 70
Owners' equity Taxable income $624
Common stock and
paid-in surplus 600 640
Taxes 212
Retained earnings 1,320 1,629 Net Income $412
Total $1,920 $2,269 Dividends $103
Total Liabilties &
Total assets $2,756 $3,112 Owners Equity $2,756 $3,112 Addition to retained earnings $309

• CFFA = CF/CR + CF/SH

CF/CR = interest paid – net new borrowing

CF/SH = dividends paid – net new equity

• CFFA =