lec 2 introduction
TRANSCRIPT
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