Financial Management

Topic 1: Overview

Taehyun Kim

Financial Management
 Taehyun Kim
• Some Facts about myself
§ Chung-Ang University
§ Associate Professor of Finance
§ University of Notre Dame
§ Assistant Professor of Finance
§ University of Illinois at Urbana-Champaign
§ Ph.D. in Finance

• Research Interest
§ Corporate Finance; Capital Market
 Basic Areas Of Finance

1. Corporate finance (=~ Business Finance)

2. Investments
3. Financial institutions
4. International finance
 Basic Areas Of Finance

INTERNATIONAL

DOMESTIC
Corporate Financial
Investments
Finance Institutions

17-4
 Investments

Work with financial assets such as stocks and bonds

Value of financial assets, risk versus return, and asset
allocation
Job opportunities
§ Stockbroker or financial advisor
§ Portfolio manager
§ Security analyst
 Financial Institutions

Companies that specialize in financial matters

§ Banks – commercial and investment, credit unions
§ Insurance companies
§ Brokerage firms
Job opportunities
 International Finance

An area of specialization within each of the areas discussed

so far
May allow you to work in other countries or at least travel
on a regular basis
Need to be familiar with exchange rates and political risk
Need to understand the customs of other countries;
speaking a foreign language fluently is also helpful
 Why Study Finance?

— Marketing
— Budgets, marketing research, marketing financial
products
— Accounting
— Dual accounting and finance function, preparation of
financial statements
— Management
— Strategic thinking, job performance, profitability
— Personal finance
— Budgeting, retirement planning, college planning, day-
to-day cash flow issues
 Corporate Finance

Some important questions that are answered using finance

§ What long-term investments should the firm take on?
§ Where will we get the long-term financing to pay for
the investments?
§ How will we manage the everyday financial activities
of the firm?
 Financial Manager

Financial managers try to answer some, or all, of

these questions
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
Corporate Organization Chart
 Course Objectives

§ To develop financial evaluation and problem-solving Skills

§ To help you make good business decisions and enable you

to become successful financial professionals and business
leaders
 What is Financial Management?
Financial Management as a management function and practice.

§ Managing a company consists of various management functions such as

o Production management
o Marketing management
o Human resource management
o Financial management

§ In this sense, Financial Management means making financial decisions, which

is the job of financial managers of a company.
§ Focus is the top financial manager within a firm is usually the CFO(Chief
Financial Officer)

o Financial decisions are decisions about “money”.

o For example, “How can we get the money required for the our investment
project?”, “where do we have to invest our money into?”
 What is Financial Management?

Financial Management, however, as a first course in the

finance major, is not confined to the area of corporate
finance.

§ It provide various basic (and of course important)

concepts in finance.

§ In this sense, Financial Management can be understood

as “Principles of Finance” or “Introduction to Finance”.
 Financial Management Decisions
1. “Capital Budgeting”
§ What long-term investments or projects should the business
take on?
§ Decisions about “Long-term” investments involving fixed
assets.

2. “Capital Structure”
§ How should we pay for our assets?
§ Should we use debt or equity?

3. “Working Capital Management”

§ How do we manage the day-to-day finances of the firm?
 Forms of Business Organization
Sole Proprietorship

§ Business owned by one person.

§ Unlimited liability.

Partnership

§ Business owned by two or more people.

§ General Partnership
o Each partner is fully responsible for business debts.
§ Limited Partnership
o At least one general partner with unlimited liability.
o Limited partners have limited liability.

Corporation
 SOLE PROPRIETORSHIP

Advantages
§ Easiest to start
§ Least regulated
§ Single owner keeps all the profits
§ Taxed once as personal income
Disadvantages
§ Limited to life of owner
§ Equity capital limited to owners personal wealth
§ Unlimited liability
§ Difficult to sell ownership interest
 PARTNERSHIP
Advantages
§ Two or more owners
§ More capital available
§ Relatively easy to start
§ Income taxed once as personal income
Disadvantages
§ Unlimited liability
§ General partnership
§ Limited partnership
§ Partnership dissolves when one partner dies/wishes to
sell
§ Difficult to transfer ownership
 Corporations
Advantages
§ Separation of owners and managers.
§ Ownership is quickly and easily transferable.
§ Unlimited life
§ Easier to raise capital
§ Limited liability of owners (stockholders).
o She/he is not fully responsible for all debt of the
company.
o A stockholder can lose at most her/his investment
amount.
Disadvantages
§ Double taxation.(income taxed at the corporate rate and
then dividends taxed at the personal rate)
 Balance Sheet (B/S) of a Corporation
debit credit

debt
assets
equity

Assets = debt + equity _ Accounting identity

RHS of the B/S (credit) shows “where the money comes from”.
_ results of “financing” (capital raising)

LHS of the B/S (debit) shows “how the money is invested”.

_ results of “investment”
 Debt vs. Equity
Equity
§ Money from the owners (stockholders).

Debt
§ Borrowed money.

The most basic difference between debt and equity

§ Debt holders are contractually entitled to be paid in full before any

payments may be paid to equity holders.

o Payments of interests and principal are mandatory.

o Interests payments are prior over dividend payments.
o In the case of liquidation, payments to debt holders are prior over
those to equity holders.

_ equity holders (stockholders) have a residual claim.

 Stock Basics

Liabilities
Assets (Debt)

Equity
 Payoff Diagram for Equity

Equity Value

Firm Value

Face Value of Debt

 Financial Decisions

Balance Sheet

Debit Credit
(3)
Management of Short-Term
Cash Flows:
Working Capital Management
Current Liabilities
Current Assets

Long-Term Debt
(2)
Capital Raising
(1)
Fixed Assets Decision:
Investment Capital Structure
Decision: Shareholders’ Equity
Capital Budget
 The goal of Financial Management
All the decisions in a corporation is to achieve the purpose
of the corporation.
: To create value for the owners.
(To make money!!)

_ Maximization of the wealth of stockholders.

Then, how value is created from the financial decisions?

§ By raising “cheap” money.

§ By making “good” investment.
 How value is created

debit B/S credit

(2) (1)
Buying assets using money H H Money from investors
debt
(investments) (financing)
assets

(3) equity (4)

Money from business I I Money to investors
(return on investments) (Interest & Dividend)
 Goals of the Firm
Firms’ mission statements include:
§ Maximize shareholder value by:
o Selecting value creating projects
o Making smart financing decision

§ Be a preferred employer

§ Be a positive force in the communities

§ Operate with ethics and integrity, following the law and

their internal code of conduct
 Opening a Bar

§ Suppose we open a bar near Chung-Ang University.

What do we need to get started?
 What is Corporate Finance?
Investment Financing
Decisions Decisions
(2) (1)

Firm's Financial Financial

(4a)
operations manager markets

(3) (4b)

(1) Cash raised from investors: debt or equity

(2) Cash invested in firm: investment
(3) Cash generated by operations: earnings
(4a) Cash reinvested: retained earnings
(4b) Cash returned to investors: dividend or interest
 The Agency Problem
Agency relationships

§ Principal hires an agent to represent its interests.

§ Stockholders (principals) hire managers (agents) to run the
company.
o Separation of owners and managers.

Agency problem

§ Conflict of interest between principal and agent.

Management goals and agency costs

§ Management and stockholder interests (and thus their goals)

might differ.
Do Managers Act in the Shareholders’ Interests?
Whether managers will act in the best interests of stockholders depends on two factors.

§ How closely are management goals aligned with stockholder goals?

§ Can management be replaced if they do not pursue stockholder goals?

Managerial compensation

§ Incentives can be used to align management and stockholder interests.

o However, incentives need to be carefully structured to insure that they
achieve their goal.

Corporate control (control of the firm)

§ Threat of a takeover may result in better management.

Agency problems are not unique to corporations.

§ They exist whenever there is an agency relationship.

 WHAT IS INVESTMENTS?

Investment can be defined as the sacrifice of present

consumption for some future value .
§ This future value is possibly uncertain

Definition of Financial markets

§ Markets in which funds are transferred from people
who have an excess of available funds to people who
have a needs of funds.

Corporations raise money required for their investment

from investors through financial markets.
 WHAT ASSETS CAN WE INVEST IN?

Real assets
§ Land, buildings, equipment, and knowledge that can be
used to produce goods and services
Financial assets
§ Claims on real assets or the income generated by them
§ Do not contribute directly to the productive capacity of
the economy (can contribute indirectly by creating
efficiency)
What is the link between the two?
§ Firms use the money raised by the issuance of financial
assets to pay for real assets
§ Investors returns ultimately come from the income
produced by the real assets
 TAXONOMY OF FINANCIAL ASSETS
Equity [or Common Stock]
o Stock is Ownership shares in a corporation.
o Shareholders have voting rights and may receive dividends, and have
claim to residual cash flow
Fixed Income [or Bonds]
o An instrument issued by a borrower that obligates the issuer to make
specified payments ( interest payments ) to the holder and repay the
face value at maturity.
o Money Market Instruments I short-term, generally very low risk (ex.
T-bills, CDs, CP, etc.)
Capital Market Instruments
o longer-term fixed income instruments (ex. Treasury Notes/Bonds,
Corporate bonds, Munis, ABS)
Derivative Instruments
§ Contracts that provide payoffs that depend on the value of other assets (the
underlying asset)
o Ex. futures, forward contracts, options, swaps
o Used to hedge risk or for speculative reasons
 FINANCIAL INSTITUTIONS
Establishment that provide and support financial transactions
o Commercial Banks
o Accepts Deposits and Provide Loans
Investment Banks
§ Provides services, including underwriting debt/equity
offerings, acting as broker (M&A, etc)
Insurance Companies - Provide Insurance
Brokerages
§ Facilitate securities transactions between buyers and sellers
Investment Companies
§ Provides professionally managed portfolios of securities, by
pooling their funds with those of other investors
etc . . .
 Financial Markets
Money markets vs. capital markets.

§ Money Markets deal in short-term debt instruments.

§ Capital markets deal in long-term debt & equity instruments.

Primary market vs. secondary market.

§ In primary markets, securities such as bonds and stocks are

sold for the first time from the issuers to investors.

§ In secondary markets, already issued securities are traded

between investors and thus these markets do not involve
necessarily the issuers.
 KEY POINTS TO REMEMBER

Corporate Finance and the Financial Manager

Forms of Business Organization
The Goal of Financial Management
The Agency Problem and Control of the Corporation
Investments
Assets
Types of Financial Institutions