Lecture 1: Financial Management Overview
Finance is a discipline concerned with determining value and making decisions based on that value
assessment. The finance function allocates resources, including the acquiring, investing and
managing of resources.
Scope of study for finance
Investments
- Study of financial transactions from the perspective of investors outside the firm
Financial markets and intermediaries
- Study of market where financial securities are bought and sold
- The study of financial institutions (such as commercial banks investment banks and insurance
companies) that facilitate the flow of money from savers to demanders of money
Corporate finance
- What long-term investment should the firm take on? (Capital budgeting decision)
- Where will we get the long-term financing to pay for the investment? (Capital structure decision)
- How will we manage the everyday financial activities of the firm? (Working capital management
decision)
Investment vehicle model
- Investors provide financing to the firm in exchange for financial securities (various claims on the
firm’s cash flows).
- The firm invests these funds in assets.
- Income generated by the firm’s assets is distributed to the investors
Balance sheet model
- Also known as the accounting model of the firm
- Investment decisions are represented on the asset side (left) of the balance sheet
- Financing decisions are presented on the liabilities and equity side (right) of the balance sheet
Financial manager
- 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.
Forms of business organisation (learn in biz law)
- Sole proprietorship
- Partnership
- Corporation
Corporation
- It is created via the Articles of Incorporation which set out the purpose of the business, establish
the number of shares that can be issued and set the number of directors to be appointed
,- Private companies: firm’s shares are usually closely held by a relatively small number of
shareholders. Shares are not traded on any exchange
- Public companies: firm’s shares are listed on a stock exchange, whereby the company’s share are
widely dispersed and traded in the secondary markets.
Corporations: 2 main sources of external financing
Debt
- Lenders: by lending money to the corporation, debt holders become the corporation’s creditors
and lenders
- Relationship determined by contract: a debt contract is a legally binding agreement. It specifies
principal, interest, maturity date and specific protective covenants
- Security and seniority: in case of bankruptcy, debt holders collect before equity holders.
However, different debt holders have different priority claim to the cash flows and assets of a
bankrupt firm, according to their respective debt contracts
Equity (share)
- Shareholder’s ownership rights- by buying shares in the corporation, shareholders become the
owners of the firm. Shareholders are the residual claimants of the firm
- Shareholder’s payoffs- receive monetary returns in the following ways:
- Dividend per share- paid to investors from the corporations after tax dollars
- Capital gain- from the sale of shares (ownership rights) at a price higher than they were
purchased for.
Goal of financial management
- The primary goal is shareholder wealth maximisation
- Maximising the value of the firm, wealth of its owners, the price of its stock and its contribution
to the economy
- Ultimately, the value of the firm is determined by the investors in the financial market.
3 aspects of cash flows that affect asset value and thus stock prices
- Amount of cash flows expected by shareholders
- Timing of the cash flow stream
- Riskiness of the cash flow stream
- All three determine the stock’s intrinsic value
Intrinsic value VS market value
- Intrinsic value is an estimate of a stock’s ‘true’ value based on accurate risk and return data
- Market value is based on perceived information as seen by the marginal investor
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?
- Woking capital management- how do we manage the day-to-day finances of the firm?
Agency problem
- Principal hires an agent to represent their interest
,- Stockholders hire managers, via the board of directors, to run the company
- Conflict of interest between principal and agent
Agency costs
- Direct agency costs: expenditures that benefit management: car and accommodation, big office,
high pay & monitoring cost: auditors, audit committee, corporate governance
- Indirect agency costs: lost opportunities which would increase firm value in the long run, if
accepted
How to handle the agency problem?
- Compensation plans that tie the fortunes of the managers to the fortunes of the firm
- Monitoring by lenders, stock market analysts and investors
- The threat that poorly performing managers will be fired
- The growing awareness of the importance of good corporate governance
- In large corporations, the separation of management and ownership provides the ease of share
ownership transfer.
Money market vs capital market
Money market
- Debt securities of one year maturity or less are traded: treasury securities, commercial paper,
bills, inter-bank loans
- Loosely connected dealer markets
- Banks are major players
Capital markets
- Where equity and long-term debt claims are traded
- Usually auction markets like the Singapore exchange
Primary market VS secondary market
Primary market
- For government and corporations initially issued securities
- Public offering- where securities are offered to public at large; needs underwriting, more
regulatory requirements, costly
Secondary market
- Where existing financial claims are traded
- Dealer market (OTC over the counter market)
- Auction market (SGX, NYSE)
- Where getting market value of securities is easier
,
Finance is a discipline concerned with determining value and making decisions based on that value
assessment. The finance function allocates resources, including the acquiring, investing and
managing of resources.
Scope of study for finance
Investments
- Study of financial transactions from the perspective of investors outside the firm
Financial markets and intermediaries
- Study of market where financial securities are bought and sold
- The study of financial institutions (such as commercial banks investment banks and insurance
companies) that facilitate the flow of money from savers to demanders of money
Corporate finance
- What long-term investment should the firm take on? (Capital budgeting decision)
- Where will we get the long-term financing to pay for the investment? (Capital structure decision)
- How will we manage the everyday financial activities of the firm? (Working capital management
decision)
Investment vehicle model
- Investors provide financing to the firm in exchange for financial securities (various claims on the
firm’s cash flows).
- The firm invests these funds in assets.
- Income generated by the firm’s assets is distributed to the investors
Balance sheet model
- Also known as the accounting model of the firm
- Investment decisions are represented on the asset side (left) of the balance sheet
- Financing decisions are presented on the liabilities and equity side (right) of the balance sheet
Financial manager
- 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.
Forms of business organisation (learn in biz law)
- Sole proprietorship
- Partnership
- Corporation
Corporation
- It is created via the Articles of Incorporation which set out the purpose of the business, establish
the number of shares that can be issued and set the number of directors to be appointed
,- Private companies: firm’s shares are usually closely held by a relatively small number of
shareholders. Shares are not traded on any exchange
- Public companies: firm’s shares are listed on a stock exchange, whereby the company’s share are
widely dispersed and traded in the secondary markets.
Corporations: 2 main sources of external financing
Debt
- Lenders: by lending money to the corporation, debt holders become the corporation’s creditors
and lenders
- Relationship determined by contract: a debt contract is a legally binding agreement. It specifies
principal, interest, maturity date and specific protective covenants
- Security and seniority: in case of bankruptcy, debt holders collect before equity holders.
However, different debt holders have different priority claim to the cash flows and assets of a
bankrupt firm, according to their respective debt contracts
Equity (share)
- Shareholder’s ownership rights- by buying shares in the corporation, shareholders become the
owners of the firm. Shareholders are the residual claimants of the firm
- Shareholder’s payoffs- receive monetary returns in the following ways:
- Dividend per share- paid to investors from the corporations after tax dollars
- Capital gain- from the sale of shares (ownership rights) at a price higher than they were
purchased for.
Goal of financial management
- The primary goal is shareholder wealth maximisation
- Maximising the value of the firm, wealth of its owners, the price of its stock and its contribution
to the economy
- Ultimately, the value of the firm is determined by the investors in the financial market.
3 aspects of cash flows that affect asset value and thus stock prices
- Amount of cash flows expected by shareholders
- Timing of the cash flow stream
- Riskiness of the cash flow stream
- All three determine the stock’s intrinsic value
Intrinsic value VS market value
- Intrinsic value is an estimate of a stock’s ‘true’ value based on accurate risk and return data
- Market value is based on perceived information as seen by the marginal investor
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?
- Woking capital management- how do we manage the day-to-day finances of the firm?
Agency problem
- Principal hires an agent to represent their interest
,- Stockholders hire managers, via the board of directors, to run the company
- Conflict of interest between principal and agent
Agency costs
- Direct agency costs: expenditures that benefit management: car and accommodation, big office,
high pay & monitoring cost: auditors, audit committee, corporate governance
- Indirect agency costs: lost opportunities which would increase firm value in the long run, if
accepted
How to handle the agency problem?
- Compensation plans that tie the fortunes of the managers to the fortunes of the firm
- Monitoring by lenders, stock market analysts and investors
- The threat that poorly performing managers will be fired
- The growing awareness of the importance of good corporate governance
- In large corporations, the separation of management and ownership provides the ease of share
ownership transfer.
Money market vs capital market
Money market
- Debt securities of one year maturity or less are traded: treasury securities, commercial paper,
bills, inter-bank loans
- Loosely connected dealer markets
- Banks are major players
Capital markets
- Where equity and long-term debt claims are traded
- Usually auction markets like the Singapore exchange
Primary market VS secondary market
Primary market
- For government and corporations initially issued securities
- Public offering- where securities are offered to public at large; needs underwriting, more
regulatory requirements, costly
Secondary market
- Where existing financial claims are traded
- Dealer market (OTC over the counter market)
- Auction market (SGX, NYSE)
- Where getting market value of securities is easier
,
