Introduction to Financial Management

BM40002

Course Instructor

Dr. Devlina Chatterjee

Why are you taking this course?

• Need a breadth course that will not clash with other courses?

• Looks good on the resume?

• Want a job in a bank or a consulting firm?

• Understand how the business world works?

• Learning to manage your own personal finances?

• Understand current financial and economic news?

• Because your friends are taking it?

Why study finance?

• To manage your personal resources

• To deal with the world of business

• To pursue interesting and rewarding career opportunities

• To be able to understand the financial news and make sense of the way the world economy is evolving

• For the intellectual challenge

Course Description

Aim: Provide an introduction to financial management to non-business students

Learning Objectives:

• What is finance and why is it important?

• Understand the financial system and how it operates

• Learn the “language” of finance and business

• Be able to read and analyze financial statements

• Be able to understand the principles guiding financial decisions of the three main areas of finance viz. – Capital budgeting

– Capital Structure and Cost of Capital

– Working Capital Management

Course SyllabusSl No Topic Suggested Readings,

References

1 Financial Management – an Overview Chapter 1

2 The financial system Chapter 2

3 Understanding Financial Statements Chapter 3

4 Capitaline Database - Tutorial Handout

5 Analyzing Financial Statements Chapter 4, 6

6 Break-even analysis and leverages Chapter 6

7 Time value of money & calculation of present values. Chapter 8

8 Sources of long term finance, Securities Market Chapter 19, 21

9 Valuation of Securities Chapter 9

Midterm

10 Risk, Return & Portfolio Chapter 10

11 Cost of Capital Concepts Chapter 14

12 Basics of Capital Budgeting Chapter 11, 12, 13

13 Working Capital Estimation Chapter 22,23,24,25

14 Introduction to Mergers & Acquisition Chapter 28

15 International Financial Management Chapter 29

Some things to remember

• Grading Policy:

– Final exam – 50% (mandatory)

– Mid-semester exam – 30%

– Quizzes and assignments – 15%

– Attendance – 5%

Academic honesty and integrity is an absolute must. Cheating in any form will result in serious action.

Text Book: Fundamentals of Financial Management 5th

Edition, Prasanna Chandra, TATA McGraw Hill Publication, 2005

Introduction

What is finance?

Finance is the study of the behavior of individuals in the intertemporal allocation (over time) of their resources in an uncertainenvironment, and the study of the function of economic institutions and markets in making these allocations possible.

What does this mean?

• Some people have more cash than they need right now (Cash Surplus) – savers, lenders, investors

• Some people have less cash than they need right now (Cash Deficit) - entrepreneurs, existing firms

• How can those who need cash get it from those who don’t need it?

• How will the lenders or investors be rewarded for forgoing their present consumption?

• How can society ensure that the borrowers will pay back the money to the lenders (financial markets, institutions, regulatory bodies)

Three areas within finance

Financial management (Corporate finance)

— how firms raise and use funds to make short-term and long-term investments

Investment

— how the securities markets work

— how to evaluate and manage investments in stocks and bonds

Financial Markets and Institutions

— study of the banking system and markets

Financial Management

Financial Management deals with how the finances of a company

Three primary decisions:

• Capital Budgeting –what businesses should one invest in?

• Capital Structure – how should one finance these investments?

• Working Capital Management – how should one manage the day

to day financial transactions?

Possible goals of a firm

• Maximization of profits

• Maximization of market share

• Minimizing risk

• Maximizing the value for different stakeholders –customers, employees, suppliers

• How does one balance these divergent interests and points of view?

Pitfalls of some of these goals

Alternative Goals Pitfalls

Maximization of absolute profit Should not compare absolute profit for different size firms

Short term profits may be misleading about the long term viability of a firm

Riskiness of profits is not taken into account

Maximization of earnings per share

Accounting earnings may be manipulated showing higher earnings per share

Short term earnings may be misleading

Riskiness of the projects is not accounted for

Maximization of market share Market share may be gained by high expenditure on advertisement which may lead to lower profits

Minimization of risk Firm may be too cautious and hence miss some good opportunities

Accepted goal of financial management

• Maximization of the “value” of the firm

• Maximization of shareholder wealth

• Assuming the existence of free and efficient financial markets, the share price of a publicly listed firm may be taken to be a good proxy of the perceived “value” of the firm

Fundamental principle of finance

A business proposal raises the value of the firm only if its net present value if positive

Kinds of Business Organizations# of owners

Act under which incorporated

Liability Legal Entity Taxation

Sole Proprietorship

1 No registration required

Unlimited liability

No separate legal entity

Profit taxed as income

Partnership 2-20 Indian Partnership Act, 1932

Unlimited Liability

Distinct legal entity

Double taxation

Limited LiabilityPartnership

Limited liability

Distinct legal entity

Doubletaxation

Private Limited Company

2-50 Companies Act, 1956

Limited liability

Separate Legal Entity

Doubletaxation

Public limited company

7-no limit

Companies Act, 1956; SEBI Act, 1992

Limited liability

Separate Legal Entity

Doubletaxation

Organization of the finance function

Chief Finance

Officer

Treasurer

Controller

Cash

Manager

Credit

Manager

Capital

Budgeting

Manager

Fund

Raising

Manager

Financial

Accounting

Manager

Cost

Accounting

Manager

Tax

Manager

Data

Processing

Manager

Internal

Auditor

Portfolio

Manager

Finance and Accounting

Accounting Finance

Time-line Concerned with past Concerned with future

Nature of the job Accurate reporting and keeping track (score-keeping)

Making decisions for running the company(value-maximizing)

Recognizing income and expenditure

Accrual method Cash flow method

Level of certainty in the figures used

More certain – since it has to do with reporting past history

Less certain – since it deals with future which is uncertain

Regulatory pressure Highly regulated and can be held up to scrutiny by outsiders

Decisions can be held up to scrutiny by shareholders, but not so much by outsiders

The Financial System

THE FINANCIAL SYSTEM

Financial Institutions

Commercial Banks

Insurance CompaniesMutual FundsProvident FundsNon-Banking Financial

Companies

Suppliers of Funds

Individuals

BusinessesGovernments

Demanders of Funds

IndividualsBusinesses

Governments

Financial Markets

Money MarketCapital Market

Funds

Deposits/Shares

Funds

Loans

Funds

Securities Securities

Funds

Centre for Financial Management , Bangalore

Functions of the Financial System• Payment system – banks, credit card companies

• Pooling of funds

• Transfer of resources

• Risk management – pool, price and exchange risk (hedging, diversification, insurance)

• Price information for decentralized decision making

(interest rates, security prices help households in making consumption/saving decisions, firms in making investment/financing decisions)

• Dealing with incentive problem – Information asymmetry leads to agency problems – Moral hazard

– Adverse selection

Financial Assets

Financial assets are intangible assets that represent claims to future cash flows.

The terms financial asset, instrument, or security are used interchangeably

Examples :

• A 10-year bond issued by the GOI carrying an interest rate of 7 percent.

• Equity shares issued by TCS to the general investing public through an initial public offering.

• Call options granted by WIPRO to its employees.

Financial Markets

A financial market is a market for creation and exchangeof financial assets.

Play a pivotal role in allocating resources in the economy

Performs three important functions:

• Facilitate price discovery.

• Provide liquidity.

• Reduce the cost of transacting

– Search cost

– Information costs

Classification of financial markets

DEBT MARKETNATURE OF CLAIM

EQUITY MARKETMONEY MARKET

MATURITY OF CLAIMCAPITAL MARKETPRIMARY MARKET

SEASONING OF CLAIMSECONDARY MARKETCASH OR SPOT MARKET

TIMING OF DELIVERYFORWARD OR FUTURES MARKETEXCHANGE-TRADED MARKET

ORGANISATIONAL STRUCTURE OVER-THE-COUNTER MARKET

Financial Market Returns

• Interest Rate

Function of the unit of account, maturity, and default risk

• Rate of Return on Risky AssetsCash dividend Ending price – Beginning price

r = +Beginning price Beginning price

Dividend yield Capital yield

• Inflation and Real Interest Rate1 + Nominal rate

1 + Real rate =1 + Inflation rate

Determinants of rates of return

• Expected productivity of capital

• Degree of uncertainty about the productivity of capital

• Time preferences of people

• Degree of risk aversion

EQUILIBRIUM IN FINANCIAL MARKETS

(a) Supply and demand for loanable funds and determination of interest rate

Interest rate

Sf (lending)

(borrowing)

Df

S’fie

i’e

0 A BAmount of loanable funds

Centre for Financial Management , Bangalore

(b) Supply and demand for securities and determination of prices

PriceSS (borrowing)

D’s

Pe

P’e

0 A’ B’Amount of securities

Ds (lending)

Centre for Financial Management , Bangalore

Financial Intermediaries

Reserve Bank of India

Commercial banks

Developmental financial

institutions

Insurance companies

Other public

sector financial

institutions

Mutualfunds

Non-banking

financial

corporations

Public sector banks

All India institutions

Life Insurance Corporation

of India

POSB UnitTrust of

India

Public sector firms

Private sector insurance

companies

General Insurance

Corporation of

India

Private sector banks

State level institutions

NABARD

NHB Other mutual funds

Private sector firms

Rationale for Financial Intermediaries

• Diversification

• Lower transaction cost

• Economies of scale

• Confidentiality

• Signalling

Regulatory Infrastructure

• RESERVE BANK OF INDIA

• SEBI

Financial Sector Reforms in India

The financial sector reforms initiated from the early 1990s have focused on the following objectives:

• Removal of financial repression.

• Creation of an efficient, productive, and profitable financial sector.

• Evolution of market-determined interest rates.

• Granting of operational and functional autonomy to institutions.

• Opening of operational and functional autonomy to institutions.

• Opening up of the external sector in a calibrated fashion.

• Maintenance of financial stability in face of domestic and external disturbances.

Key Trends in Indian Financial Sector

• Market-determined interest rates and greater volatility

of interest rates

• Emergence of universal banks

• Emphasis on prudential regulation and supervision

• Gradual integration with the global financial system

• Increase in financial innovation