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Introduction to Financial Management

BM40002
Course Instructor Dr. Devlina Chatterjee

Why are you taking this course?


Need a breadth course that will not clash with other courses? Looks good on the resume? Want a job in a bank or a consulting firm? Understand how the business world works? Learning to manage your own personal finances? Understand current financial and economic news? Because your friends are taking it?

Why study finance?


To manage your personal resources To deal with the world of business To pursue interesting and rewarding career opportunities To be able to understand the financial news and make sense of the way the world economy is evolving For the intellectual challenge

Course Description
Aim: Provide an introduction to financial management to nonbusiness students

Learning Objectives: What is finance and why is it important? Understand the financial system and how it operates Learn the language of finance and business Be able to read and analyze financial statements Be able to understand the principles guiding financial decisions of the three main areas of finance viz.
Capital budgeting Capital Structure and Cost of Capital Working Capital Management

Course Syllabus
Sl No 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 Topic Financial Management an Overview The financial system Understanding Financial Statements Capitaline Database - Tutorial Analyzing Financial Statements Break-even analysis and leverages Time value of money & calculation of present values. Sources of long term finance, Securities Market Valuation of Securities Midterm Risk, Return & Portfolio Cost of Capital Concepts Basics of Capital Budgeting Working Capital Estimation Introduction to Mergers & Acquisition International Financial Management Suggested Readings, References Chapter 1 Chapter 2 Chapter 3 Handout Chapter 4, 6 Chapter 6 Chapter 8 Chapter 19, 21 Chapter 9 Chapter 10 Chapter 14 Chapter 11, 12, 13 Chapter 22,23,24,25 Chapter 28 Chapter 29

Some things to remember


Grading Policy: Final exam 50% (mandatory) Mid-semester exam 30% Quizzes and assignments 15% Attendance 5% Academic honesty and integrity is an absolute must. Cheating in any form will result in serious action. Text Book: Fundamentals of Financial Management 5th Edition, Prasanna Chandra, TATA McGraw Hill Publication, 2005

Introduction
What is finance? Finance is the study of the behavior of individuals in the intertemporal allocation (over time) of their resources in an uncertain environment, and the study of the function of economic institutions and markets in making these allocations possible.

What does this mean?


Some people have more cash than they need right now (Cash Surplus) savers, lenders, investors Some people have less cash than they need right now (Cash Deficit) - entrepreneurs, existing firms How can those who need cash get it from those who dont need it? How will the lenders or investors be rewarded for forgoing their present consumption? How can society ensure that the borrowers will pay back the money to the lenders (financial markets, institutions, regulatory bodies)

Three areas within finance


Financial management (Corporate finance)
how firms raise and use funds to make short-term and

long-term investments

Investment
how the securities markets work how to evaluate and manage investments in stocks and

bonds

Financial Markets and Institutions


study of the banking system and markets

Financial Management
Financial Management deals with how the finances of a company Three primary decisions: Capital Budgeting what businesses should one invest in?

Capital Structure how should one finance these investments?


Working Capital Management how should one manage the day to day financial transactions?

Possible goals of a firm


Maximization of profits Maximization of market share Minimizing risk Maximizing the value for different stakeholders customers, employees, suppliers

How does one balance these divergent interests and points of view?

Pitfalls of some of these goals


Alternative Goals Pitfalls Maximization of absolute profit Should not compare absolute profit for different size firms Short term profits may be misleading about the long term viability of a firm Riskiness of profits is not taken into account Maximization of earnings per share Accounting earnings may be manipulated showing higher earnings per share Short term earnings may be misleading Riskiness of the projects is not accounted for Maximization of market share Minimization of risk Market share may be gained by high expenditure on advertisement which may lead to lower profits Firm may be too cautious and hence miss some good opportunities

Accepted goal of financial management


Maximization of the value of the firm Maximization of shareholder wealth Assuming the existence of free and efficient financial markets, the share price of a publicly listed firm may be taken to be a good proxy of the perceived value of the firm

Fundamental principle of finance


A business proposal raises the value of the firm only if its net present value if positive

Kinds of Business Organizations


# of owners Sole Proprietorship Partnership 1 2-20 Act under which incorporated Liability Legal Entity Taxation No registration Unlimited required liability Indian Partnership Act, 1932 Unlimited Liability Limited liability Companies Act, 1956 Limited liability No separate legal entity Profit taxed as income

Distinct legal Double entity taxation Distinct legal Double entity taxation Separate Legal Entity Separate Legal Entity Double taxation Double taxation

Limited Liability Partnership Private Limited 2-50 Company Public limited company 7-no limit

Companies Limited Act, 1956; SEBI liability Act, 1992

Organization of the finance function


Chief Finance Officer

Treasurer

Controller

Cash Manager

Credit Manager

Financial Accounting Manager

Cost Accounting Manager

Capital Budgeting Manager

Fund Raising Manager

Tax Manager

Data Processing Manager

Portfolio Manager

Internal Auditor

Finance and Accounting


Accounting Time-line Nature of the job Concerned with past Accurate reporting and keeping track (score-keeping) Accrual method Finance Concerned with future Making decisions for running the company (value-maximizing) Cash flow method

Recognizing income and expenditure Level of certainty in the figures used Regulatory pressure

More certain since it Less certain since it has to do with reporting deals with future which past history is uncertain Highly regulated and can Decisions can be held up be held up to scrutiny by to scrutiny by outsiders shareholders, but not so much by outsiders

The Financial System

THE FINANCIAL SYSTEM


Funds Deposits/Shares
Financial Institutions Commercial Banks Insurance Companies Mutual Funds Provident Funds Non-Banking Financial Companies

Funds Loans

Suppliers of Funds Individuals Businesses Governments

Demanders of Funds

Individuals Businesses Governments

Financial Markets

Funds Securities

Money Market Capital Market

Funds Securities

Centre for Financial Management , Bangalore

Functions of the Financial System


Payment system banks, credit card companies Pooling of funds Transfer of resources Risk management pool, price and exchange risk
(hedging, diversification, insurance)

Price information for decentralized decision making


(interest rates, security prices help households in making consumption/saving decisions, firms in making investment/financing decisions)

Dealing with incentive problem Information asymmetry leads to agency problems


Moral hazard Adverse selection

Financial Assets
Financial assets are intangible assets that represent claims to future cash flows. The terms financial asset, instrument, or security are used interchangeably

Examples : A 10-year bond issued by the GOI carrying an interest rate of 7 percent. Equity shares issued by TCS to the general investing public through an initial public offering. Call options granted by WIPRO to its employees.

Financial Markets
A financial market is a market for creation and exchange of financial assets. Play a pivotal role in allocating resources in the economy Performs three important functions:
Facilitate price discovery. Provide liquidity. Reduce the cost of transacting
Search cost Information costs

Classification of financial markets


DEBT MARKET NATURE OF CLAIM

EQUITY MARKET MONEY MARKET


MATURITY OF CLAIM CAPITAL MARKET PRIMARY MARKET

SEASONING OF CLAIM
SECONDARY MARKET CASH OR SPOT MARKET TIMING OF DELIVERY FORWARD OR FUTURES MARKET EXCHANGE-TRADED MARKET ORGANISATIONAL STRUCTURE OVER-THE-COUNTER MARKET

Financial Market Returns

Interest Rate
Function of the unit of account, maturity, and default risk

Rate of Return on Risky Assets


Cash dividend
r= Beginning price Dividend yield + Beginning price Capital yield

Ending price Beginning price

Inflation and Real Interest Rate


1 + Nominal rate 1 + Real rate = 1 + Inflation rate

Determinants of rates of return


Expected productivity of capital Degree of uncertainty about the productivity of capital Time preferences of people Degree of risk aversion

EQUILIBRIUM IN FINANCIAL MARKETS


(a) Supply and demand for loanable funds and determination of interest rate Interest rate

Sf (lending)
ie ie Df (borrowing) Sf

A B Amount of loanable funds

Centre for Financial Management , Bangalore

(b) Supply and demand for securities and determination of prices

Price Pe Pe

SS (borrowing)

Ds Ds (lending)

A B Amount of securities
Centre for Financial Management , Bangalore

Financial Intermediaries
Reserve Bank of India

Commercial banks

Developmental financial institutions

Insurance companies

Other public sector financial institutions

Mutual funds

Non-banking financial corporations

Public sector banks

All India institutions

Life Insurance Corporation of India

POSB

Unit Trust of India

Public sector firms

Private sector insurance companies

NABARD

Private sector banks

State level institutions

General Insurance Corporation of India

NHB

Other mutual funds

Private sector firms

Rationale for Financial Intermediaries


Diversification Lower transaction cost Economies of scale Confidentiality Signalling

Regulatory Infrastructure
RESERVE BANK OF INDIA

SEBI

Financial Sector Reforms in India


The financial sector reforms initiated from the early 1990s have focused on the following objectives: Removal of financial repression. Creation of an efficient, productive, and profitable financial sector. Evolution of market-determined interest rates. Granting of operational and functional autonomy to institutions. Opening of operational and functional autonomy to institutions. Opening up of the external sector in a calibrated fashion. Maintenance of financial stability in face of domestic and external disturbances.

Key Trends in Indian Financial Sector


Market-determined interest rates and greater volatility

of interest rates
Emergence of universal banks Emphasis on prudential regulation and supervision Gradual integration with the global financial system Increase in financial innovation