Fiinancial Management

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Financial ManagementFinancial Management

An IntroductionAn Introduction


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Basic Forms of Business OrganizationBasic Forms of Business Organization


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An Overview of the FinancialAn Overview of the FinancialSystemSystem


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Financial System Composed of:Financial System Composed of:

Financial MarketFinancial Market

Financial Institutions/IntermediariesFinancial Institutions/Intermediaries Financial InstrumentsFinancial Instruments

Financial ServicesFinancial Services


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Function of the Financial Markets

Lender-SaversHouseholds

Business firms

Governments

Foreigners

Financial

Intermediaries

Borrower SpendersBusiness Firms

Governments

HouseholdsForeigners

Financial

Markets

Funds Funds

Funds

Funds Funds


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Functions of the FinancialFunctions of the Financial

MarketsMarkets

Person A is having a powerful idea andPerson A is having a powerful idea andPerson B is having surplus funds.Person B is having surplus funds.

The Role or function of the financialThe Role or function of the financialmarkets (bonds and Stock markets) is getmarkets (bonds and Stock markets) is getpeople like A and B together.people like A and B together.

This requires flow of funds from savers toThis requires flow of funds from savers toborrowers.borrowers.

This flow can occur in two ways; DirectThis flow can occur in two ways; DirectFinance and Indirect finance route.Finance and Indirect finance route.


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Direct and Indirect FinanceDirect and Indirect Finance

Direct Finance: Borrowers borrow fundsDirect Finance: Borrowers borrow funds

directly from the lenders in the financialdirectly from the lenders in the financial

markets by selling them securities (financialmarkets by selling them securities (financial

instruments), which are claims on theinstruments), which are claims on the

borrowers future income or assets.borrowers future income or assets.

Securities are assets for the person whoSecurities are assets for the person who

buys them but liabilities to the person orbuys them but liabilities to the person or

firms that sells or issue them.firms that sells or issue them.


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Direct and Indirect FinanceDirect and Indirect Finance

Indirect Finance: Borrowers borrow fundsIndirect Finance: Borrowers borrow fundsthrough financial intermediaries(banks,through financial intermediaries(banks,

insurance companies, pension funds) in theinsurance companies, pension funds) in theform of loans and deposits.form of loans and deposits.

Banks issue a liability(saving deposits, timeBanks issue a liability(saving deposits, timedeposits etc) use these funds to acquire andeposits etc) use these funds to acquire anasset by a loan to Honda motors or byasset by a loan to Honda motors or bybuying Honda motors bonds in the financialbuying Honda motors bonds in the financialmarkets.markets.


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Function of the Financial Markets

Lender-SaversHouseholds

Business firms

Governments

Foreigners

Financial

Intermediaries

Borrower SpendersBusiness Firms

Governments

Households

Foreigners

Financial

Markets

Funds Funds

Funds

Funds Funds

INDIRECT FINANCE

DIRECT FINANCE


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Why this channeling of Funds soWhy this channeling of Funds so

important for the economy?important for the economy? Financial markets are essential to promoteFinancial markets are essential to promote

economic efficiency.economic efficiency.

Financial markets are essential to increaseFinancial markets are essential to increase

productionproduction Financial markets are helpful to fulfill youFinancial markets are helpful to fulfill you

dreams.dreams.

Financial markets enhance entrepreneurialFinancial markets enhance entrepreneurialdevelopment and national welfaredevelopment and national welfare


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Functions of FinancialFunctions of Financial

IntermediariesIntermediaries Financial intermediaries also do theFinancial intermediaries also do the

function of connecting people forfunction of connecting people forinvestments.investments.

Financial intermediaries are important as it;Financial intermediaries are important as it; Reduces transaction costsReduces transaction costs

Enables risk sharingEnables risk sharing

Removes information costs and moralRemoves information costs and moralhazards.hazards.


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Structure of Financial MarketsStructure of Financial Markets

Several categorization of financial marketsSeveral categorization of financial marketsillustrate essential features of Financialillustrate essential features of FinancialMarkets.Markets.

Debt and Equity markets.Debt and Equity markets. Primary and Secondary MarketsPrimary and Secondary Markets

Exchange and Over the counter MarketsExchange and Over the counter Markets

Money and Capital MarketsMoney and Capital Markets Internationalization of the FinancialInternationalization of the Financial

Markets.Markets.


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Debt and Equity MarketsDebt and Equity Markets

A firm or individual can obtain funds in aA firm or individual can obtain funds in a

financial markets in two ways; issue offinancial markets in two ways; issue of

bonds or issue of equities.bonds or issue of equities.

Bonds: A contractual agreement by theBonds: A contractual agreement by the

borrower of the fund to pay the holder ofborrower of the fund to pay the holder of

the instrument fixed amount at regularthe instrument fixed amount at regular

interval (int. payments and principal) until ainterval (int. payments and principal) until a

specified time (maturity period).specified time (maturity period).


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Equity: Claims to the share in the net incomeEquity: Claims to the share in the net income

(income after expenses and taxes) and the assets of(income after expenses and taxes) and the assets of

a business.a business.

If you hold one share in a company who hasIf you hold one share in a company who hasissued 100 shares, you are entitled to get 1% of theissued 100 shares, you are entitled to get 1% of the

firms net income and 1% of the firms assets.firms net income and 1% of the firms assets.

You are also entitled for periodic payments ofYou are also entitled for periodic payments of

dividends. You have right to vote in electing thedividends. You have right to vote in electing the

board members.board members.


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The equity holders are the residualThe equity holders are the residual

claimants; the corporation must pay theclaimants; the corporation must pay the

bond holders first before paying to thebond holders first before paying to the

equity holders.equity holders.

The equity holders directly get advantagesThe equity holders directly get advantages

from any increase in the corporationsfrom any increase in the corporations

profitability or asset values.profitability or asset values.


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Primary and Secondary MarketsPrimary and Secondary Markets

A primary market is a financial market inA primary market is a financial market in

which new issues of a security such as bondwhich new issues of a security such as bond

or stocks are sold to initial buyers by theor stocks are sold to initial buyers by the

corporations or Government.corporations or Government.

Secondary markets deals with securities thatSecondary markets deals with securities that

previously issued. These securities arepreviously issued. These securities are

resold in these markets.resold in these markets.


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The public does not know the primaryThe public does not know the primarymarkets for securities as the transactions aremarkets for securities as the transactions aredone behind closed doors.done behind closed doors.

The Investment Banks assist an initial saleThe Investment Banks assist an initial saleof securities in the primary markets.of securities in the primary markets.

It does this by underwriting securities.It does this by underwriting securities.

It guarantees a price for a corporationsIt guarantees a price for a corporationssecurity and then sale them to the public.security and then sale them to the public.


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When an individual buys securities in theWhen an individual buys securities in thesecondary market, the corporation acquiressecondary market, the corporation acquiresno new funds.no new funds.

A corporation gets new funds when itsA corporation gets new funds when itssecurities are first sold in the primarysecurities are first sold in the primarymarkets.markets.

Nonetheless, the functioning of theNonetheless, the functioning of thesecondary market is very importantsecondary market is very important


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Functioning of the SecondaryFunctioning of the Secondary

MarketsMarkets

Secondary markets make the financialSecondary markets make the financial

instruments more liquid.instruments more liquid.

They determine the price of the securitiesThey determine the price of the securities

those are issuing firms sale in the primarythose are issuing firms sale in the primary

markets.markets.

So, condition in the secondary marketSo, condition in the secondary marketenhances the credibility of the corporations.enhances the credibility of the corporations.

Hence, we will focus more on theHence, we will focus more on the

functioning of the secondary markets.functioning of the secondary markets.


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Structure of the FinancialStructure of the Financial

MarketsMarkets Debt and Equity MarketDebt and Equity Market

Primary and Secondary MarketPrimary and Secondary Market

Exchanges and Over-the-Counter MarketsExchanges and Over-the-Counter Markets

Secondary markets can be organized in twoSecondary markets can be organized in twoways; one is to organize exchanges, whereways; one is to organize exchanges, wherethe buyers and sellers or their agents orthe buyers and sellers or their agents or

brokers meet at central location to conductbrokers meet at central location to conducttrades. - BSEtrades. - BSE


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MarketsMarkets The other method of organizing a secondaryThe other method of organizing a secondary

market is to have an over-the-counter(OTC)market is to have an over-the-counter(OTC)

market, in which dealers at differentmarket, in which dealers at different

locations who have inventory of securitieslocations who have inventory of securities

stand ready to buy and sale securities overstand ready to buy and sale securities over

the counter local stock exchanges.the counter local stock exchanges.


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MarketsMarkets Money and Capital Markets:Money and Capital Markets:

MM: Money market is a financial market inMM: Money market is a financial market inwhich only short-term debt instruments arewhich only short-term debt instruments are

traded. Generally, those instruments aretraded. Generally, those instruments arematurity less than one year.maturity less than one year.

CM: Capital market is the market in whichCM: Capital market is the market in which

longer term debt and equity instruments arelonger term debt and equity instruments aretraded. (maturity greater than one year).traded. (maturity greater than one year).


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Money and Capital MarketMoney and Capital Market

Money market securities are usually lessMoney market securities are usually lessfluctuating. Corporations use money marketfluctuating. Corporations use money marketinstruments to earn money.instruments to earn money.

Capital market instruments are generallyCapital market instruments are generallyheld by financial intermediaries, insuranceheld by financial intermediaries, insurancecompanies and pension funds.companies and pension funds.

Money market is a market for very shortMoney market is a market for very shorttermterm


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Money MarketMoney Market

Crowther defines, money market is the market thatCrowther defines, money market is the market thatdeals in various grades of near monies.deals in various grades of near monies.

WR Wegess defines, what a bank balance is to anWR Wegess defines, what a bank balance is to an

individual the money market is to the countrysindividual the money market is to the countryscredit system.credit system.

Segments of Money Market:Segments of Money Market:

Call Money MarketCall Money Market

Acceptance MarketAcceptance MarketBill discount MarketBill discount Market

Collateral loan market.Collateral loan market.


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Call money market deals in loans at call and shortCall money market deals in loans at call and shortnotices.notices.

Deals with extreme form of short term loans; 24Deals with extreme form of short term loans; 24

hours, 7-15 days maturity.hours, 7-15 days maturity. They can be recalled on demand or shortestThey can be recalled on demand or shortest

possible notice.possible notice.

Normally, collaterals are not insisted upon.Normally, collaterals are not insisted upon.

In India, CMM provides facilities for inter-bankIn India, CMM provides facilities for inter-banktending.tending.

Surplus suppliers of funds: UTI, SBI, LICSurplus suppliers of funds: UTI, SBI, LIC


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Call Money Rate is the interest rate at whichCall Money Rate is the interest rate at whichmoney is lended in the market.money is lended in the market.

The market experiences some regular seasonalThe market experiences some regular seasonalchanges; it is normally tighter during the busychanges; it is normally tighter during the busyseason (October April) than during the slackseason (October April) than during the slackseason (May September). It is much tighter inseason (May September). It is much tighter inApril.April.

By its nature, the call money rate is highlyBy its nature, the call money rate is highlyvolatile, in 1990-91was 70 and 85 in 1991-92,volatile, in 1990-91was 70 and 85 in 1991-92,1995-961995-96


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Internationalization of FinancialInternationalization of Financial

MarketsMarkets

With the ongoing financial liberalization,With the ongoing financial liberalization,each country now have a wider source ofeach country now have a wider source of

funds.funds. The traditional instruments in theThe traditional instruments in the

international bond market are known asinternational bond market are known asForeign bonds.Foreign bonds.

Foreign bonds are sold in the foreignForeign bonds are sold in the foreigncountries and are denominated in thatcountries and are denominated in thatcountrys currency.countrys currency.


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MarketsMarkets Foreign bonds: German auto maker sales aForeign bonds: German auto maker sales a

foreign bond in US denominated in USforeign bond in US denominated in USdollar.dollar.

Euro Bond: Bonds denominated in in aEuro Bond: Bonds denominated in in acurrency other than that of the country incurrency other than that of the country inwhich it is sold.which it is sold.

Euro bond: A bond denominated in USEuro bond: A bond denominated in USdollar and sold in London.dollar and sold in London.


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MarketsMarkets

However, A bond denominated in euro isHowever, A bond denominated in euro iscalled Euro Bond if it is sold outside thecalled Euro Bond if it is sold outside the

countries that adopted Euro as theircountries that adopted Euro as theircurrencies.currencies.

Euro Currencies: A variant of euro bond isEuro Currencies: A variant of euro bond iseuro currencies. Foreign currencieseuro currencies. Foreign currencies

deposited in banks outside the homedeposited in banks outside the homecountry. US dollar deposited in Bankscountry. US dollar deposited in Banksoutside US.outside US.

Financial Intermediaries: RiskFinancial Intermediaries: Risk


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Financial Intermediaries: RiskFinancial Intermediaries: Risk

sharing and reducing informationsharing and reducing information

costs.costs.

Financial intermediaries do help theFinancial intermediaries do help the

investors reducing risks they are exposed toinvestors reducing risks they are exposed to They do this through the process called riskThey do this through the process called risk

sharing.sharing.

They create and sale assets with riskThey create and sale assets with riskcharacteristics that people are comfortablecharacteristics that people are comfortablewith.with.


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Risk SharingRisk Sharing

However, the intermediaries do use these fundsHowever, the intermediaries do use these fundsacquired by selling to purchase other assets thatacquired by selling to purchase other assets thatmay have far more risk.may have far more risk.

The process of risk sharing is also called assetThe process of risk sharing is also called assettransformation process.transformation process.

The asset transformation process turned the riskyThe asset transformation process turned the riskyassets into safer assets for investors.assets into safer assets for investors.

Te risk sharing process also calls forTe risk sharing process also calls fordiversification.diversification.

Diversification: investing in the collection ofDiversification: investing in the collection ofassets (portfolio)assets (portfolio)

Asymmetric Information:Asymmetric Information:


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Asymmetric Information:Asymmetric Information:Adverse Selection and MoralAdverse Selection and Moral

HazardHazard In financial markets one party does not knowIn financial markets one party does not know

enough about the other party to make accurateenough about the other party to make accurate

decisions.decisions. This inequality is called Asymmetric Information.This inequality is called Asymmetric Information.

A borrower has better information about theA borrower has better information about thepotential return and risk associated with thepotential return and risk associated with theproject for which the fund borrowed that theproject for which the fund borrowed that thelender.lender.


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Asymmetric InformationAsymmetric Information

Lack of information creates problems in theLack of information creates problems in thefinancial systems on two grounds: beforefinancial systems on two grounds: beforetransaction is entered and after.transaction is entered and after.

Adverse Selection: is the problem created byAdverse Selection: is the problem created byasymmetric information before the transactionasymmetric information before the transactionoccurs.occurs.

Adverse selection in the financial markets occursAdverse selection in the financial markets occurs

when the potential borrowers who are the mostwhen the potential borrowers who are the mostlikely to produce an adverse outcome bad creditlikely to produce an adverse outcome bad creditrisk.risk.


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Because adverse selection makes it more likelyBecause adverse selection makes it more likelythat loans might be made to bad credit risks,that loans might be made to bad credit risks,lender may decide not to make any loans evenlender may decide not to make any loans eventhough there are good credit risk in thethough there are good credit risk in themarketplace.marketplace.

Example:Example:

Person X conservative: only when he is sure ofPerson X conservative: only when he is sure of

returning back, he come for borrowing.returning back, he come for borrowing.Person Y aggressive investor with an idea ofPerson Y aggressive investor with an idea of

investment of get-rich-quick scheme.investment of get-rich-quick scheme.


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If you know both the persons, you will lendIf you know both the persons, you will lend

only person X.only person X.

If you do not know, you may not lendIf you do not know, you may not lend

anybody because of the possibilities ofanybody because of the possibilities of

adverse selection.adverse selection.

Though person X has excellent credit riskThough person X has excellent credit risk

might need loan for worthwhile investment.might need loan for worthwhile investment.


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Moral HazardMoral Hazard

Moral hazard is the problem created byMoral hazard is the problem created byasymmetric information after the transactionasymmetric information after the transactionoccurs.occurs.

Moral hazard in the financial markets is theMoral hazard in the financial markets is therisk(hazard) that the borrower might engage inrisk(hazard) that the borrower might engage inactivities that are undesirable (immoral) from theactivities that are undesirable (immoral) from thelenders point of view.lenders point of view.

The existence of moral hazard lowers theThe existence of moral hazard lowers theprobability that loans will be repaid.probability that loans will be repaid.

So, Lender will decide not to make a loan.So, Lender will decide not to make a loan.


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Moral HazardMoral Hazard

Suppose that you have made 1 lakh loan to personSuppose that you have made 1 lakh loan to personA, who promised to make a cyber caf and wordA, who promised to make a cyber caf and word

processing job to help students process theirprocessing job to help students process theirassignments and term papers.assignments and term papers.

However, he started gambling in the market with 1However, he started gambling in the market with 1lakhlakh

There is a possibility of getting back or loosing.There is a possibility of getting back or loosing.

Because of asymmetric information, you will beBecause of asymmetric information, you will beprevented from giving loans to him.prevented from giving loans to him.


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Financial Intermediaries canFinancial Intermediaries can

solve these problems.solve these problems. With financial intermediaries in the market,With financial intermediaries in the market,

small saves will deposit their money in thesmall saves will deposit their money in the

banks and they screen out bad risk and goodbanks and they screen out bad risk and good

risk.risk.

So, the risks due to asymmetric informationSo, the risks due to asymmetric information

and adverse selection are removed.and adverse selection are removed.


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What is Finance Anyway?What is Finance Anyway?

What is this course all about?What is this course all about?

Accounting is the language of business.Accounting is the language of business.

Finance uses accounting informationFinance uses accounting information

together with other information to maketogether with other information to make

decisions that affect the market value of thedecisions that affect the market value of the

firm.firm.

There are Four primary decision areas thatThere are Four primary decision areas that

are of concern.are of concern.


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Four decision areas in finance:Four decision areas in finance:

Investment decisions - What assets shouldInvestment decisions - What assets shouldthe company hold? This determines thethe company hold? This determines theleft-hand side of the balance sheet.left-hand side of the balance sheet.

Financing decisions - How should theFinancing decisions - How should thecompany pay for the investments it makes?company pay for the investments it makes?This determines the right-hand side of theThis determines the right-hand side of thebalance sheet.balance sheet.

Dividend decisions - What should be doneDividend decisions - What should be donewith the profits of the business?with the profits of the business?

Working capital management decisionsWorking capital management decisions


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Acquisition of funds and their effectiveAcquisition of funds and their effective

utilization so as to achieve the goal ofutilization so as to achieve the goal of

financial Managementfinancial Management


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All management decisionsAll management decisions

should help to accomplish theshould help to accomplish thegoal of the firm!goal of the firm!

What should be the goal of the firm?What should be the goal of the firm?


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Goals of FirmGoals of Firm

What should be the goal of a corporation?What should be the goal of a corporation?

Maximize profit?Maximize profit?

Minimize costs?Minimize costs?

Maximize market share?Maximize market share?

Maximize the current value of the companysMaximize the current value of the companys

stock?stock?


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Goals of the FirmGoals of the Firm

Goal of the firm cam be stated in three waysGoal of the firm cam be stated in three waysMaximize Shareholder WealthMaximize Shareholder Wealth

Maximize the Value of the FirmMaximize the Value of the Firm

Maximize the Share PriceMaximize the Share Price

Profit maximization is not the same as wealthProfit maximization is not the same as wealth

maximization. It fails to account for:maximization. It fails to account for:differences in the level of cash flowsdifferences in the level of cash flows

the timing of the cash flows, andthe timing of the cash flows, and

the risk of the cash flows.the risk of the cash flows.


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Many people think the goal is toMany people think the goal is to

maximize profits.maximize profits.

Would this mean short-term profit, or long-Would this mean short-term profit, or long-

term profit? Businesses are sometimesterm profit? Businesses are sometimes

criticized for being overly concerned aboutcriticized for being overly concerned about

short-term profits results rather than theshort-term profits results rather than the

long-term strategic positioning of thelong-term strategic positioning of the

company.company.

h b i k? i k


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What about risk? Isnt riskWhat about risk? Isnt risk

important as well as profits?important as well as profits?

How would the stockholders of a smallHow would the stockholders of a smallbusiness react if they were told that theirbusiness react if they were told that their

manager canceled all casualty and liabilitymanager canceled all casualty and liabilityinsurance policies so that the money spentinsurance policies so that the money spenton premiums could go to profit instead.on premiums could go to profit instead.

Even though theEven though the expectedexpectedprofits increasedprofits increased

by this action, it is likely that stockholdersby this action, it is likely that stockholderswould be dissatisfied because of thewould be dissatisfied because of theincreased risk they would bear.increased risk they would bear.

Th kh ld


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The common stockholders areThe common stockholders are

the owners of the corporation!the owners of the corporation!

Stockholders elect a board of directors whoStockholders elect a board of directors whoin turn hire managers to maximize thein turn hire managers to maximize the

stockholdersstockholderswell being.well being. When stockholders perceive thatWhen stockholders perceive that

management is not doing this, they mightmanagement is not doing this, they mightattempt to remove and replace theattempt to remove and replace the

management, but this can be very difficultmanagement, but this can be very difficultin a large corporation with manyin a large corporation with manystockholders.stockholders.


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More likely, when stockholdersMore likely, when stockholders

are dissatisfied they will simplyare dissatisfied they will simplysell their stock shares.sell their stock shares.

This action by stockholders willThis action by stockholders will

cause the market price of thecause the market price of the

companys stock to fall.companys stock to fall.


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When stock price falls relativeWhen stock price falls relative

to the rest of the market (orto the rest of the market (orrelative to the rest of therelative to the rest of the

industry) ...industry) ...

Management is failing in their job toManagement is failing in their job to

increase the welfare (or wealth) of theincrease the welfare (or wealth) of the

stockholders (the owners).stockholders (the owners).


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Conversely, when stock price isConversely, when stock price is

rising relative to the rest of therising relative to the rest of themarket (or industry), ...market (or industry), ...

Management is accomplishing theirManagement is accomplishing their

goal of increasing the welfare (orgoal of increasing the welfare (or

wealth) of the stockholders (thewealth) of the stockholders (theowners).owners).

Th l f h fi h ld bTh l f th fi h ld b t


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The goal of the firm should be toThe goal of the firm should be to

maximize themaximize the stock pricestockprice!!

This is equivalent to saying the goal is toThis is equivalent to saying the goal is tomaximizemaximize owners wealthowners wealth..

Note that the stock price is affected byNote that the stock price is affected bymanagements decisions affectingmanagements decisions affecting bothboth riskriskand profit.and profit.

Stock price can be maintained or increasedStock price can be maintained or increasedonly when stockholders perceive that theyonly when stockholders perceive that theyare receiving profits that fully compensateare receiving profits that fully compensatethem for bearing the risk they perceive.them for bearing the risk they perceive.

I f l i i hI t t f l i t i th


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Important focal points in theImportant focal points in the

study of finance:study of finance:

Accounting and Finance often focus onAccounting and Finance often focus on

different thingsdifferent things

Finance is more focused onFinance is more focused on market valuesmarket values

rather than book values.rather than book values.

Finance is more focused onFinance is more focused on cash flowscash flows

rather than accounting income.rather than accounting income.

Wh i k lWh i k t l


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Why is market value moreWhy is market value more

important than book value?important than book value?

Book values are often based on datedBook values are often based on dated

values. They consist of the original cost ofvalues. They consist of the original cost of

the asset from some past time, minusthe asset from some past time, minusaccumulated depreciation (which may notaccumulated depreciation (which may not

represent the actual decline in the assetsrepresent the actual decline in the assets

value).value). Maximization of market value of theMaximization of market value of the

stockholders shares is the goal of the firm.stockholders shares is the goal of the firm.


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Why is cash flow more importantWhy is cash flow more important

than accounting income?than accounting income?

Cash flow to stockholders (in the form ofCash flow to stockholders (in the form of

dividends) is the only basis for valuation ofdividends) is the only basis for valuation ofthe common stock shares. Since the goal isthe common stock shares. Since the goal is

to maximize stock price, cash flow is moreto maximize stock price, cash flow is more

directly related than accounting income.directly related than accounting income.

Accounting methods recognize income atAccounting methods recognize income at

times other than when cash is actuallytimes other than when cash is actually

received or spent.received or spent.


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One more reason that cash flowOne more reason that cash flow

is important:is important:

WhenWhen cash is actually received is important,cash is actually received is important,

because it determines when cash can bebecause it determines when cash can beinvested to earn a return.invested to earn a return.

[Also:[Also: WhenWhen cash must be paid determinescash must be paid determines

when we need to start paying interest onwhen we need to start paying interest onmoney borrowed.]money borrowed.]

E l f h iE l f h ti


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Examples of when accountingExamples of when accounting

income is different from cashincome is different from cash

flow:flow:

Credit sales are recognized as accountingCredit sales are recognized as accounting

income, yet cash has not been received.income, yet cash has not been received. Depreciation expense is a legitimateDepreciation expense is a legitimate

accounting expense when calculatingaccounting expense when calculatingincome, yet depreciation expense is not aincome, yet depreciation expense is not acash outlay.cash outlay.

A loan brings cash into a business, but isA loan brings cash into a business, but isnot income.not income.


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More examples:More examples:

When new capital equipment is purchased,When new capital equipment is purchased,

the entire cost is a cash outflow, but onlythe entire cost is a cash outflow, but only

the depreciation expense (a portion of thethe depreciation expense (a portion of the

total cost) is an expense when computingtotal cost) is an expense when computingaccounting income.accounting income.

When dividends are paid, cash is paid out,When dividends are paid, cash is paid out,

though dividends are not included in thethough dividends are not included in thecalculation of accounting income.calculation of accounting income.


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Definitions: Operating income vs.Definitions: Operating income vs.

operating cash flowoperating cash flow

Operating income = earnings before interestOperating income = earnings before interest

and taxes (EBIT). This is the total incomeand taxes (EBIT). This is the total incomethat the company earned by operatingthat the company earned by operating

during the period. It is income available toduring the period. It is income available to

pay interest to creditors, taxes to thepay interest to creditors, taxes to the

government, and dividends to stockholders.government, and dividends to stockholders.


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Operating cash flow:Operating cash flow:

Operating cash flowOperating cash flow

= EBIT + Depreciation - Taxes.= EBIT + Depreciation - Taxes.

This definition recognizes thatThis definition recognizes that

depreciation expense is subtracted indepreciation expense is subtracted incomputing EBIT, though it is not a cashcomputing EBIT, though it is not a cash

outlay.outlay.

It also recognizes that taxes paid is a cashIt also recognizes that taxes paid is a cash

outlay.outlay.

R l f Fi i T i lRole of Finance in a Typical


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Board of Directors

President

VP: Sales VP: Finance VP: Operations

Treasurer Controller

Credit Manager

Inventory Manager

Capital Budgeting Director

Cost Accounting

Financial Accounting

Tax Department

Role of Finance in a TypicalRole of Finance in a Typical

Business OrganizationBusiness Organization

C t FiCorporate Finance


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Corporate FinanceCorporate Finance Every decision that a business makes has financialEvery decision that a business makes has financial

implications, and any decision which affects theimplications, and any decision which affects thefinances of a business is a corporate finance decision.finances of a business is a corporate finance decision.

Defined broadly, everything that a business does fitsDefined broadly, everything that a business does fits

under the rubric of corporate finance.under the rubric of corporate finance.

Regardless of whether you work for a corporation orRegardless of whether you work for a corporation orare an external party with an interest in a particularare an external party with an interest in a particular

corporation, understanding and being able to analyzecorporation, understanding and being able to analyzecorporate decisions is importantcorporate decisions is important

Fi P i i l f C FiFi t P i i l f C t Fi


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First Principles of Corporate FinanceFirst Principles of Corporate Finance

Invest in projects thatInvest in projects that yield a return greateryield a return greaterthan thethan the minimumminimum

acceptable hurdle rateacceptable hurdle rate with adjustments for project riskiness.with adjustments for project riskiness.

Choose aChoose a financing mixfinancing mix thatthat minimizes the hurdleminimizes the hurdle rate.rate.

If there are not enough investments that earn the hurdle rate,If there are not enough investments that earn the hurdle rate,

return the cashreturn the cash to stockholders.to stockholders.

These decision criteria will be consistent with the objectiveThese decision criteria will be consistent with the objectiveof the firm:of the firm: Maximize the Value of the FirmMaximize the Value of the Firm


65/66

Multinational/InternationalMultinational/International


Percentage of Revenue and Net Income fromPercentage of Revenue and Net Income from


66/66

gg

Overseas Operations for 10 Well-KnownOverseas Operations for 10 Well-Known

Corporations, 2001Corporations, 2001

7.810.5Sears, Roebuck

47.052.93M

58.118.3Merck

61.763.1McDonalds

51.735.5JP Morgan Chase & Co.

48.457.9IBM

60.626.1General Motors25.232.6General Electric

60.269.4Exxon Mobil

35.960.8Coca-Cola

% of Net Income from

overseas

% of Revenue from

overseas

Company

Fiinancial Management

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