ACFI205 Financial Management MID TERM Lecture 1

Investment project appraisal Managers must assess the profitability and risk of proposed investment projects. They must accept or reject. What does finance function involve? - Financial Planning - Investment Project Appraisal - Financial Control - Financing and capital market operations. Capital Market Operations New finance may be raised through the capital markets, which includes stock markets and banks. Managers will often need advice on how finance can be raised through these markets. Financial Decisions Investment projects and business have to be financed. The possible sources of finance need to be identified and assessed. An appropriate balance must be struck between long-term and short-term sources of finance and between the contribution of shareholders and that of lenders. internally generated funds: (retentions from profits) Externally generated funds: (debt plus equity) financial control Managers must ensure that the plans are carried out. must: - regularly report actual outcomes eg. profitability of the investment projects. the levels of working capital and cashflows. - They must monitor performance and take the correct measures. What is the key assumption underpinning modern financial management? & Info regarding shareholders and stakeholders. That businesses exist to create wealth for their shareholders. Shareholders are considered of paramount importance as they own the business and bear the residual risk. However, if the business fails and its remaining assets are distributed, the shareholders 'claim' is irrelevant and the claims of stakeholders (employees, customers, lenders and suppliers) are given priority. Shareholders have a residual claim on the wealth generated by the business. They therefore have an incentive to increase the size of their claim by ensuring that the business undertakes new and risky ventures. Stakeholders have a fixed claim. Shareholder Wealth Maximisation Maximising the wealth of the firm's shareholders through achieving the highest possible value for the firm in the marketplace. It is the overriding objective of the firm and should influence all decisions. Wealth refers to = the market value of ordinary shares. The market value of these shares will reflect the future returns that shareholders are expected to receive over time from the shares and the level of risk they face. THE GOAL IS TO GENERATE THE HIGHEST POSSIBLE RETURN OVER THE LONG TERM. Profit Maximisation A business may seek to maximise profit rather than shareholders wealth. This term does not adequately capture all aspects of shareholder wealth. Profit represents the surplus generated by a business- income in excess of expenses. Different measures of profit and profitability. - operating profit (profit before interest and tax) - profit before tax - profit after tax - profit available to shareholders per ordinary shares -profit available to shareholders as a percentage of ordinary shareholder's funds invested Different profit measures may provide a different narrative of financial performance. Problems with profit maximisation concept 1. lack of precision: the term profit is imprecise. 2. lack of objectivity: the profit measures cannot be objectively determined. They are all influenced by the particular accounting policies and estimates employed such as depreciation, inventory and bad debts. 3. time period: the period over which profit should be maximised is unclear. This means conflict can occur between short-term and long-term profit maximisation. 4. risk: the goal of profit maximisation takes no account of the risks involved. Shareholders however are normally very concerned with risk and therefore may avoid high-risk projects with a larger potential profit. 5. opportunity cost: if managers reinvest current profits in order to generate larger profits in the future this can prevent shareholders from maximising their wealth. Present Value 1/(1 + % (0.00)) to the power of the number of years stated X the PV given eg. 1/(1+0.12) 8 X 10000 = 4038 Net Present Value (NPV) the same as the present value however the power changes to the corresponding years. Then add the totals to the negative number and then the positive is the answer. The Stakeholder Approach The business should serve all of who benefit or can be harmed by its operations. -employees -suppliers -customers -lenders -shareholders -the community -the government problems with stakeholder approach -lack of simple and clear cut objectives for managers to pursue. - multiple objectives of stakeholders which can be conflicting. - is the stakeholder approach promoted at the expense of shareholder wealth maximisation? Balancing risk and return the higher the risk the higher the return should be. -managers who pursue the shareholder wealth maximisation approach must choose investments that provide the highest returns in relation to the risks. - even at zero risk some return is required. more risk more return. Behaving ethically ethics are a key problem in the international competitive environment. there is a risk that shareholder wealth maximisation may be pursued by managers using methods that are unethical. managers should check the conformity of their actions to ethical norms. those businesses that treat stakeholders with integrity and ethically will flourish in the long-term. Corporate Governance the system in which businesses are directed and controlled. Normally those who own the business (shareholders) are usually divorced from the day-to-day running of the business. Employ managers which can be viewed as the agent of the principal (shareholder). PROBLEM: agents may pursue their own interests which conflicts with the shareholder's interests- agency problem. Rules to protects the shareholder's interests - Disclosure = involves producing adequate and timely informations regarding the manager's/director's performance. - Accountability = Defining the roles of the directors and monitoring them. (The UK law requires directors to act in the interest of the shareholders.) - Fairness = there are rules in place which forbids directors from benefitting from access to 'inside' information which shareholders don't have access to. FINANCIAL PLANNING Steps in the Planning Process - setting aims and objectives of the business in connection to wealth maximisation principle. - consider the available options - select option and develop long term plans -develop short term plans within the framework of the short term plan. role of projected financial statements they evaluate the long term strategy and the short term. the main financial statements are: - projected income statement -projected cash flow statement - projected balance sheet (statement of financial position) these provide info on the future performance of the business. future profitability, liquidity and financial position. Preparing a projected financial statement the key variables that affect performance and position are : 1. External : relates to government policies and economic conditions. -rate of taxation - interest rate of borrowing - rate of inflation 2. Internal: policies and business agreements. -capital expenditure commitment -financing agreements -inventories holding policies -credit period allowed to customers - payment policies for trade payables -accounting policies -dividend policy. main sources of cash flows -issue and redemption of long-term funds (inflow V outflow) eg. shares and loans. -purchase and sale of non-current assets. (outflow v inflow) - tax and dividends (outflow) -operating activities - sales revenue and operating expenses (inflow v outflow) per-cent- of-sales method this method assumes that the following income statement items can be expresses as a percentage of sales: -operating expenses -profit before tax however, tax is assumed to vary with the level of profit before tax and is expressed as a percentage of this figure. it has therefore an indirect relationship with sales. advantages of per-cent-of-sales method 1. the task of preparing the projected financial statement becomes more manageable 2. approximate figure for future financing requirements without need to prepare projected cash flow statements. can reduce cost and time needed to forecast elements for projected financial statements. disadvantages of per-cent-of-sales method 1. past relationship between items and sales may not apply for the present times eg. management policy changes on credit period given to customers can change the relationship 2. Expenses may not always vary with the level of sales