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Financial Management

INTRODUCTION TO FINANCIAL MANAGEMENT:Corporate Financing & Capital Structure, Next >>>
 
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Financial Management ­ MGT201
VU
Lesson 01
INTRODUCTION TO FINANCIAL MANAGEMENT
Learning objectives:
The purpose of this lecture is to provide you with an overview of financial management. After
finishing this lecture, you would be able to have a better understanding of the following.
·  Definition of financial management
·  Significance of financial management for non-finance students and professionals
·  Important concepts and areas in financial management
·  The position of financial managers in organizational hierarchy and their respective work
domains.
·  Different business legal entities, their advantages and limitations.
·  The external and internal business environments and their relevance to financial management.
·  Different types of financial and real assets markets.
What is FM?
FM is the management of financial resources ­ how to best find and use investments and
financing opportunities in an ever-changing and increasingly complex environment.
Why should CS majors study FM?
First of all, financial management is a core life skill; almost every one needs to understand some
concepts of finance to manage his/her business & personal finances.
It is generally and quite rightfully said, "Money makes the world go round". Finance is like a
life-blood for a company. Even the best of the companies and CEOs go out of the business because of
poor financial management policies.
Management Information Systems (MIS) and Information Technology (IT) are just a part of the
overall corporate strategy which runs on finances, the major resource. So the computer sciences
professionals need to have an understanding of the financial concepts to understand and contribute to
the overall corporate strategy.
Financial Engineering is an upcoming field that requires people with CS, math/science, and
finance background. Financial engineering is the application of engineering methods to finance. One
important area of study is the design, analysis, and construction of financial contracts to meet the needs
of enterprises. This field is experiencing an increased demand for professionals, especially those who
are trained in both the underlying mathematics/computer technologies and finance.
Definitions
Finance:
Finance is the science of managing financial resources in an optimal pattern i.e. the best use of
available financial sources. Finance consists of three interrelated areas:
1) Money & Capital markets, which deals with securities markets & financial institutions.
2) Investments, which focuses on the decisions of both individual and institutional investors as
they choose assets for their investment portfolios.
3) Financial Management, or business finance which involves the actual management of firms.
Major Areas & Concepts of Financial Management
Following are some of the important areas and concepts of financial management, which would
be discussed in detail in the lectures to come.
Analysis of Financial Statements:
Analysis of financial statement is one of the most common techniques of financial analysis, in
which the financial performance and financial health of a company are analyzed based on its past
performance.`
The following financial statements are used in the analysis process.
·  Profit & Loss Statement or Income Statement
Income statement reflects the operating efficiency or profitability of a company as a result
of its operations along with the net profit available to the shareholders for a given year
(usually one accounting period). This statement provides the analyst with some insight into
the financial performance of the company.
·  Balance Sheet
Balance Sheet is a snap-shot of an organization's financial health at a particular time. It
shows what assets are owned by the business and the sources of acquiring these assets.
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Financial Management ­ MGT201
VU
·
Statement of Shareholders' equity
Statement of shareholders' equity provides the share of the owners in the business.
·  Statement of Cash Flows
Statement of cash flows explicitly reflects the cash movement (inflows and outflows)
during the operations in an accounting period.
Taken together, these statements give an accounting picture of the firm's operations and
financial position. Financial statements report what has actually happened to the assets, earnings,
and dividends over the years. The analysis of the information contained in these statements help
management of the organization to evaluate the performance and activities of the concern; it also
helps the investors and creditors to have an idea of the profitability potential and creditworthiness of
the business.
Investment Decisions & Capital Budgeting:
Investment decisions are the most critical as they usually involve huge sums of money and
these decisions are likely to bring prosperity or doom to a business. A company's future income
depends on how much investment is made, in what type of assets, and how these assets add to the
overall value of the company.
Capital budgeting is a term strictly related to investment in fixed assets; here, the term
capital refers to the fixed assets that are used in production, while budget is a plan which details
projected cash inflows and outflows over some future period. The following concepts and
techniques are employed while analyzing investment decisions.
Interest rate formulas
o
Time Value of Money
o
Discounted Cash Flows
o
Net Present Value
o
Internal Rate of Return
o
Risk & Return:
Investors, individual or institutional, invest their money with the expectations of earning a
return on their investment. While investors wish and attempt to earn maximum return, they are
constrained by risk. How the risks and returns are related and how do investors make a choice of
their portfolios is important for investment decision making. Following concepts and theories would
be discussed while discussing the risk-return choices of the investor:
Uncertainty
o
Risk
o
Portfolio Theory
o
Capital Asset Pricing Model
o
Corporate Financing & Capital Structure:
When a firm plans to expand, it needs capital or funds. Acquisition of funds is considered to
be a primary responsibility of a finance department in an organization. There are numerous ways to
acquire funds, i.e., finances can be raised in the form of debt or equity. The proportion of debt and
equity constitutes the capital structure of the firm. Financial experts attempt to find a combination of
debt and equity that could increase the overall value of the company, i.e., they try to find the
optimal capital structure. The following concepts would be used to understand how an optimal
capital structure could be attained.
Cost of Capital
o
Leverage
o
Dividend Policy
o
Debt Instruments
o
Valuation:
Asset or company valuation is important not only for financial managers, but also for
creditors and investors. It is important to know the value of the company or its assets to make
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Financial Management ­ MGT201
VU
important financing and investment choices. Different valuation techniques and factors that
influence the value of a company or its financial instruments would be discussed in this section.
Share
o
Bond
o
Option
o
Corporate
o
Working Capital & Inventory Management:
Working capital and inventory management pertains to the effective management of current
assets. As we will see, an optimal and effective utilization of working capital and inventory
increases the operating efficiency of the firm.
International Finance & Foreign Exchange:
With the increasing importance of international trade and global markets, the role of
international finance has increased manifold. In a global environment, the finance managers have
more choices pertaining to investing and financing than ever before. However, it is important to
understand the implications of working in a global environment, since fluctuations in the currency
rates can convert a good financing or investment decision into a bad one. This section of the course
would discuss the international financial environment and the financial implications of working in a
global environment.
Organizational Structure
(Who does the FM work?)
Chief Executive Officer (CEO)
Chief Financial Officer (CFO)
Treasurer
Controller
Accounts
Cash & Investment
Capital Budgeting
Audit
Capital Structure
Inventory
Business Legal Entities
·  Sole Proprietorship :
It is an unincorporated business owned by one individual. Going into a business as a sole
proprietor is simple ­ one merely has to begin business operations. Proprietorship consists of 80%of
the total number of businesses worldwide.
Advantages:
i.
It is easily & inexpensively formed.
ii.
It is subject to few government regulations.
iii.
The business pays no corporate income tax; only personal income tax is paid by the
proprietor.
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Financial Management ­ MGT201
VU
Limitations:
i.
It is difficult for a proprietorship to obtain large sums of capital.
ii.
The proprietor has unlimited personal liability for the business debts, which can
result in losses hat exceed the money invested by him in the business.
iii.
The life of the business organized as proprietorship is limited to the life of the
individual who created it.
Partnership:
A partnership exists whenever two or more persons associate to conduct a non-corporate
business. It could be registered or unregistered.
Advantages:
i.
Low cost involved
ii.
Ease of formation.
Limitations:
i.
Unlimited Liability.
ii.
Limited life of the organization.
iii.
Difficulty of transferring ownership.
iv.
Difficulty of raising large amounts of capital.
Corporation:
A corporation is a limited company and a separate legal entity registered by the government. It
is separate & distinct from its owners & managers. It Can be Private Limited (Pvt. Ltd.) or Public
Limited (which may be listed on Stock Exchange). The businesses in the form of corporations control
80% of global sales of products and services.
Advantages:
i- Unlimited life:
A corporation can continue even after the death of its original owners.
ii- Easy transferability of ownership interest:
Ownership interests can be divided into shares of stock, which in turn can be transferred far
more easily than can proprietorship & partnership interests.
iii- Limited Liability:
The liability of the shareholders is limited up to the extent of nominal value of shares held by
them. Creditors and banks cannot confiscate personal properties of director & shareholders in case of its
bankruptcy.
Limitations:
i.
Double Taxation:
Corporate earnings may be subject to double taxation ­ the earnings of the
corporation are taxed at corporate level, and then any earnings paid out as
dividends are taxed again as income to the stockholders.
ii.
Legal Formalities:
Setting up a corporation, and filing many official documents, is more complex
and time consuming than for a proprietor ship or a partnership
·
Hybrids (Mixed):
Hybrid organizations are specialized types of partnerships, which combine the
limited liability advantage of a corporation with the tax advantages of a
partnership.
S-Type Corporation:
S- Type corporations are Limited Liability Corporations without double
taxation. In a regular corporation, the company itself is taxed on business
profits. In addition, the owners pay individual income tax on money that they
draw from the corporation as salaries, bonuses, or dividends. In contrast, in an
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Financial Management ­ MGT201
VU
S corporation, all business profits "pass through" to the owners, who report
them on their personal tax returns (as in sole proprietorships, partnerships, and
Limited Liability Companies). The S corporation itself does not pay any
income tax, although a co-owned S corporation must file an informational tax
return like a partnership or Limited Liability Companies ­ to tell the tax
authorities what each shareholder's portion of the corporate income is.
LLP:
Limited Liability Partnership (LLP) is also a form of partnership with allows
limited liability to the owners and avoids double taxation. These organizations
are similar in many ways to the S Corporations; however, LLPs offer more
flexibility and benefits to the owners.
PC:
Personal Corporations (PC) or Professional Corporations are generally formed
by professionals to protect them against litigations. Professionals like doctors,
lawyers and accountants prefer to register their business as Professional
Corporations.
Balance Sheet ­ An FM Perspective
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Financial Management ­ MGT201
VU
Internal and External Business Environment
Internal Business Environment:
Internal environment of business normally consists of the following.
i.
Finance
ii.
Marketing
iii.
Human Resources
iv.
Operations (Production, Manufacturing)
v.
Technology
vi.
Other Functions (Logistics, Communications)
External Business Environment:
The following business environment factors outside an organization have a profound effect on
the functions and operations of an organization.
i.
Customers
ii.
Suppliers
iii.
Competitors
iv.
Government/Legal Agencies & Regulations
v.
Macro Economy/Markets:
vi.
Technological Revolution
An analysis which is used in a business is called SWOT Analysis. SWOT is an acronym where
S stands for Strengths
W stands for Weaknesses
O stands for Opportunities
T stands for Threats
Strengths and weaknesses are within an organization, i.e., they pertain to the internal
environment of the organization.
Opportunities and threats, on the other hand, pertain to the external environment, i.e., outside
the organization.
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Financial Management ­ MGT201
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Financial Markets
·
Capital Markets:
These are the markets for the long term debt & corporate stocks.
Stock Exchange:
A stock exchange is a place where the listed shares, Term finance certificates (TFC)
and national investment trust units (NIT) are exchanged and traded between buyers and
sellers.
Long term bonds:
Long term government & corporate bonds are also traded in capital markets.
·
Money Markets
Money market generally is a market where there is buying and selling of short term liquid
debt instruments. (Short term means one year or less). Liquid means something which is
easily en-cashable; an instrument that can be easily exchanged for cash. Following financial
instruments are traded in money markets.
Short term Bonds
Government of Pakistan: Federal Investment Bonds (FIB), Treasury-Bills (T-
o
Bills)
Private Sector: Corporate Bonds, Debentures
o
Call Money, Inter-bank short-term and overnight lending & borrowing
Loans, Leases, Insurance policies, Certificate of Deposits (CD's)
Badlah (money lending against shares), Road-side money lenders
·
Real Assets or Physical Asset Markets
Following are the active markets of real and physical assets in Pakistan
Cotton Exchange, Gold Market, Kapra Market
o
Property (land, house, apartment, warehouse)
o
Computer hardware, Used Cars, Wheat, Sugar, Vegetables, etc.
o
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Table of Contents:
  1. INTRODUCTION TO FINANCIAL MANAGEMENT:Corporate Financing & Capital Structure,
  2. OBJECTIVES OF FINANCIAL MANAGEMENT, FINANCIAL ASSETS AND FINANCIAL MARKETS:Real Assets, Bond
  3. ANALYSIS OF FINANCIAL STATEMENTS:Basic Financial Statements, Profit & Loss account or Income Statement
  4. TIME VALUE OF MONEY:Discounting & Net Present Value (NPV), Interest Theory
  5. FINANCIAL FORECASTING AND FINANCIAL PLANNING:Planning Documents, Drawback of Percent of Sales Method
  6. PRESENT VALUE AND DISCOUNTING:Interest Rates for Discounting Calculations
  7. DISCOUNTING CASH FLOW ANALYSIS, ANNUITIES AND PERPETUITIES:Multiple Compounding
  8. CAPITAL BUDGETING AND CAPITAL BUDGETING TECHNIQUES:Techniques of capital budgeting, Pay back period
  9. NET PRESENT VALUE (NPV) AND INTERNAL RATE OF RETURN (IRR):RANKING TWO DIFFERENT INVESTMENTS
  10. PROJECT CASH FLOWS, PROJECT TIMING, COMPARING PROJECTS, AND MODIFIED INTERNAL RATE OF RETURN (MIRR)
  11. SOME SPECIAL AREAS OF CAPITAL BUDGETING:SOME SPECIAL AREAS OF CAPITAL BUDGETING, SOME SPECIAL AREAS OF CAPITAL BUDGETING
  12. CAPITAL RATIONING AND INTERPRETATION OF IRR AND NPV WITH LIMITED CAPITAL.:Types of Problems in Capital Rationing
  13. BONDS AND CLASSIFICATION OF BONDS:Textile Weaving Factory Case Study, Characteristics of bonds, Convertible Bonds
  14. BONDS’ VALUATION:Long Bond - Risk Theory, Bond Portfolio Theory, Interest Rate Tradeoff
  15. BONDS VALUATION AND YIELD ON BONDS:Present Value formula for the bond
  16. INTRODUCTION TO STOCKS AND STOCK VALUATION:Share Concept, Finite Investment
  17. COMMON STOCK PRICING AND DIVIDEND GROWTH MODELS:Preferred Stock, Perpetual Investment
  18. COMMON STOCKS – RATE OF RETURN AND EPS PRICING MODEL:Earnings per Share (EPS) Pricing Model
  19. INTRODUCTION TO RISK, RISK AND RETURN FOR A SINGLE STOCK INVESTMENT:Diversifiable Risk, Diversification
  20. RISK FOR A SINGLE STOCK INVESTMENT, PROBABILITY GRAPHS AND COEFFICIENT OF VARIATION
  21. 2- STOCK PORTFOLIO THEORY, RISK AND EXPECTED RETURN:Diversification, Definition of Terms
  22. PORTFOLIO RISK ANALYSIS AND EFFICIENT PORTFOLIO MAPS
  23. EFFICIENT PORTFOLIOS, MARKET RISK AND CAPITAL MARKET LINE (CML):Market Risk & Portfolio Theory
  24. STOCK BETA, PORTFOLIO BETA AND INTRODUCTION TO SECURITY MARKET LINE:MARKET, Calculating Portfolio Beta
  25. STOCK BETAS &RISK, SML& RETURN AND STOCK PRICES IN EFFICIENT MARKS:Interpretation of Result
  26. SML GRAPH AND CAPITAL ASSET PRICING MODEL:NPV Calculations & Capital Budgeting
  27. RISK AND PORTFOLIO THEORY, CAPM, CRITICISM OF CAPM AND APPLICATION OF RISK THEORY:Think Out of the Box
  28. INTRODUCTION TO DEBT, EFFICIENT MARKETS AND COST OF CAPITAL:Real Assets Markets, Debt vs. Equity
  29. WEIGHTED AVERAGE COST OF CAPITAL (WACC):Summary of Formulas
  30. BUSINESS RISK FACED BY FIRM, OPERATING LEVERAGE, BREAK EVEN POINT& RETURN ON EQUITY
  31. OPERATING LEVERAGE, FINANCIAL LEVERAGE, ROE, BREAK EVEN POINT AND BUSINESS RISK
  32. FINANCIAL LEVERAGE AND CAPITAL STRUCTURE:Capital Structure Theory
  33. MODIFICATIONS IN MILLAR MODIGLIANI CAPITAL STRUCTURE THEORY:Modified MM - With Bankruptcy Cost
  34. APPLICATION OF MILLER MODIGLIANI AND OTHER CAPITAL STRUCTURE THEORIES:Problem of the theory
  35. NET INCOME AND TAX SHIELD APPROACHES TO WACC:Traditionalists -Real Markets Example
  36. MANAGEMENT OF CAPITAL STRUCTURE:Practical Capital Structure Management
  37. DIVIDEND PAYOUT:Other Factors Affecting Dividend Policy, Residual Dividend Model
  38. APPLICATION OF RESIDUAL DIVIDEND MODEL:Dividend Payout Procedure, Dividend Schemes for Optimizing Share Price
  39. WORKING CAPITAL MANAGEMENT:Impact of working capital on Firm Value, Monthly Cash Budget
  40. CASH MANAGEMENT AND WORKING CAPITAL FINANCING:Inventory Management, Accounts Receivables Management:
  41. SHORT TERM FINANCING, LONG TERM FINANCING AND LEASE FINANCING:
  42. LEASE FINANCING AND TYPES OF LEASE FINANCING:Sale & Lease-Back, Lease Analyses & Calculations
  43. MERGERS AND ACQUISITIONS:Leveraged Buy-Outs (LBO’s), Mergers - Good or Bad?
  44. INTERNATIONAL FINANCE (MULTINATIONAL FINANCE):Major Issues Faced by Multinationals
  45. FINAL REVIEW OF ENTIRE COURSE ON FINANCIAL MANAGEMENT:Financial Statements and Ratios