Introduction to

Financial
Management
 What is Finance?

 Finance is the study of how people

and businesses evaluate
investments and raise capital to fund
them.

 Finance is concerned with the

processes, institutions, markets, and
instruments involved in the transfer
of money among individuals,
businesses, and governments.
Three Questions Addressed by the
Study of Finance:

1. What long-term investments should the firm

undertake? (capital budgeting decisions)
2. How should the firm fund these
investments? (capital structure decisions)
3. How can the firm best manage its cash
flows as they arise in its day-to-day
operations? (working capital management
decisions)
 Why Study Finance?

 Knowledge of financial tools is critical to making

good decisions in both the professional world and
personal lives.
– Finance is an integral part of corporate world
– Many personal decisions require financial knowledge
(for example: buying a house, planning for retirement,
leasing a car)
Major Areas & Opportunities in
Finance

1. Financial Services
2. Financial Management (or Corporate
Finance or Managerial Finance)

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Major Areas & Opportunities in
Finance: Financial Services

 Financial Services is the area of finance

concerned with the design and delivery of
advice and financial products to individuals,
businesses, and government.
 Career opportunities include banking,
personal financial planning, security analysis,
stockbrokerage, mutual funds, real estate,
insurance, etc.

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Major Areas & Opportunities in
Finance: Financial Management

 Financial Management is concerned with the duties

of the financial manager in the business firm (private
or public, large or small, profit-seeking or not-for-
profit).
 Financial managers perform financial tasks like
planning, extending credit to customers, evaluating
proposed large expenditures, and raising money to
fund the firm’s operations.
 They are involved in developing corporate strategy
and improving the firm’s competitive position.

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Role of a Finance Manager

How much and what How to raise the

types of assets to capital to buy
acquire? assets?

How to run the firm so as to maximize its value? 1-8

Career Opportunities in Financial
Management

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The Managerial Finance Function

 The size and importance of the managerial finance

function depends on the size of the firm.
 In small companies, the finance function may be
performed by the company president or accounting
department.
 As the business expands, finance typically evolves
into a separate department linked to the president or
CEO.

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The Managerial Finance Function:
Relationship to Economics

 The field of finance is actually an outgrowth

of economics.
 In fact, finance is sometimes referred to as
financial economics.
 Financial managers must understand the
economic framework within which they
operate in order to react or anticipate
changes in conditions.

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The Managerial Finance Function:
Relationship to Economics

 The primary economic principle used by

financial managers is marginal cost-benefit
analysis which says that financial decisions
should be implemented only when added
benefits exceed added costs.

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Differences between Financial
Management and Accounting

 One major difference in perspective and

emphasis between finance and accounting is
that accountants generally use the accrual
method while in finance, the focus is on cash
flows.
 Finance and accounting also differ with
respect to decision-making.

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Differences between Financial
Management and Accounting (cont.)

 While accounting is primarily concerned with

the presentation of financial data, the
financial manager is primarily concerned with
analyzing and interpreting this information
for decision-making purposes.
 The financial manager uses this data as a
vital tool for making decisions about the
financial aspects of the firm.

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Forms of Business Organization

 Sole Proprietorship
 Partnership
 Corporation
Sole Proprietorship

 It is a business owned by a single individual that

is entitled to all the firm’s profits and is
responsible for all the firm’s debt.

 There is no separation between the business

and the owner when it comes to debts or being
sued.

 Sole proprietorships are generally financed by

personal loans from family and friends and
business loans from banks.
Sole Proprietorship (cont.)

 Advantages:
– Easy to start
– No need to consult others when making decisions
– Taxed at the personal tax rate

 Disadvantages:
– Personally liable for business debts
– Ceases on the death of the proprietor
Partnership

 A general partnership is an association of

two or more persons who come together as
co-owners for the purpose of operating a
business for profit.

 There is no separation between the

partnership and the owners with respect to
debts or being sued.
Partnership (cont.)

 Advantages:
– Relatively easy to start
– Taxed at the personal tax rate
– Access to funds from multiple
sources or partners

 Disadvantages:
– Partners jointly share unlimited
liability
Partnership (cont.)

 In limited partnerships, there are two

classes of partners: general and limited.
 The general partners run the business and
face unlimited liability for the firm’s debts,
while the limited partners are only liable for
the amount invested.
Corporation

 A corporation is an artificial being created by

law, separate and distinct from its owners.
 A corporation can individually sue and be
sued, purchase, sell or own property.
Corporation (cont.)

 A corporation is legally owned by its current

stockholders.
 The Board of directors are elected by the
firm’s shareholders.
 One responsibility of the board of directors is
to appoint the senior management team of
the firm.
Corporation (cont.)

 Advantages
– Liability of owners limited to
invested funds
– Life of corporation is not tied to
the owner
– Easier to transfer ownership
– Easier to raise capital
 Disadvantages
– Greater regulation
– Double taxation of dividends
How Does Finance Fit into the Firm’s
Organizational Structure?

 In a corporation, the Chief Financial Officer

(CFO) is responsible for managing the firm’s
financial affairs.
Sample Corporate Organization 1

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Sample Corporate Organization 2

Board of Directors

Chief Executive Officer (CEO)

Chief Operating Officer (COO) Chief Financial Officer (CFO)

Marketing, Production, Human Accounting, Treasury, Credit,

Resources, and Other Operating Legal, Capital Budgeting, and
Departments Investor Relations
The Goal of the Financial Manager

 The goal of the financial manager must be

consistent with the mission of the
corporation.
 What is the generally accepted mission of a
corporation?
Corporate Mission

To maximize shareholder’s wealth (as

measured by share prices)

The primary financial goal of management is

shareholder wealth maximization, which
translates to maximizing stock price.
Corporate Mission: Ayala Corp.

 …Anchored on values of integrity, long-term

vision, empowering leadership, and
commitment to national development, we
fulfill our mission to ensure long-term
profitability, increase shareholder value,
provide career opportunities, and create
synergies as we build mutually beneficial
partnerships and alliances with those who
share our philosophy and values.
Corporate Mission: Philex Mining

 ...By achieving our mission, we will enhance

shareholder value and contribute to nation-
building.
Goal of the Firm:
Maximize Shareholder Wealth!!! (cont.)

 The process of shareholder wealth

maximization can be described using the
following flow chart:

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Some Important Business Trends

 Recent corporate scandals have reinforced

the importance of business ethics, and have
spurred additional regulations and corporate
oversight.
 Increased globalization of business.
 The effects of ever-improving information
technology have had a profound effect on all
aspects of business finance.
 Corporate governance
Goal of the Firm:
What About Other Stakeholders?

 Stakeholders include all groups of individuals who

have a direct economic link to the firm including
employees, customers, suppliers, creditors, owners,
and others who have a direct economic link to the
firm.
 The "Stakeholder View" prescribes that the firm
makes a conscious effort to avoid actions that could
be detrimental to the wealth position of its
stakeholders.
 Such a view is considered to be "socially
responsible."
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Ethics in Finance

 Ethics is the standards of conduct or moral

judgment.
 Business ethics is a company’s attitude and
conduct toward its stakeholders.
 Ethical violations attract widespread publicity
 Negative publicity often leads to negative
impacts on a firm
Agency Considerations in
Corporate Finance

 Agency relationship exists when one or more

persons (known as the principal) contracts
with one or more persons (the agent) to
make decisions on their behalf.

 In a corporation, the managers are the

agents and the stockholders are the
principal.
Agency Considerations in
Corporate Finance (cont.)

 Agency problems arise when there is conflict of

interest between the stockholders and the managers.
Such problems are likely to arise more when the
managers have little or no ownership in the firm.
 Examples:
– Not pursuing risky project for fear of losing jobs, stealing,
expensive perks.

 All else equal, agency problems will reduce the firm

value.
How to Reduce Agency Problems?

1. Monitoring
(Examples: reports, meetings, auditors, board of directors,
financial markets, bankers, credit agencies)
2. Compensation plans
(Examples: performance based bonus, salary, stock
options, benefits)
3. Others
(Examples: threat of being fired, threat of takeovers, stock
market, regulations such as SOX)
THE FOUR BASIC PRINCIPLES OF
FINANCE
PRINCIPLE 1: Money Has a Time
Value.

 A peso received today is more valuable than

a peso received in the future.
– We can invest the peso received today to earn
interest. Thus, in the future, you will have more
than one peso, as you will receive the interest on
your investment plus your initial invested peso.
PRINCIPLE 2: There is a Risk-
Return Trade-off.

 We only take risk when we expect to be

compensated for the extra risk with additional
return.

 Higher the risk, higher will be the expected

return.
PRINCIPLE 3: Cash Flows Are The
Source of Value.

 Profit is an accounting concept designed to

measure a business’s performance over an
interval of time.

 Cash flow is the amount of cash that can

actually be taken out of the business over
this same interval.
Profits versus Cash

 It is possible for a firm to report profits but

have no cash.

 For example, if all sales are on credit, the

firm may report profits even though no cash
is being generated.
Incremental Cash Flow

 Financial decisions in a firm should consider

“incremental cash flow” i.e. the difference
between the cash flows the company will
produce with the potential new investment
it’s thinking about making and what it would
make without the investment.
PRINCIPLE 4: Market Prices
Reflect Information.

 Investors respond to new information by buying and

selling their investments.

 The speed with which investors act and the way that
prices respond to new information determines the
efficiency of the market. In efficient markets like
United States, this process occurs very quickly. As a
result, it is hard to profit from trading investments on
publicly released information.
PRINCIPLE 4: Market Prices
Reflect Information. (cont.)

 Investors in capital markets will tend to react

positively to good decisions made by the firm
resulting in higher stock prices.

 Stock prices will tend to decrease when there

is bad information released on the firm in the
capital market.
Financial Institutions & Markets
Financial Institutions & Markets

 Firms that require funds from external

sources can obtain them in three ways:
– through a bank or other financial institution
– through financial markets
– through private placements

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Three Players in the Financial
Markets

There are three principal sets of players that interact

within the financial markets
1. Borrowers: Individuals and businesses that need
money to finance their purchases or investments.
2. Savers (Investors): Those who have money to
invest. These are principally individuals although
firms also save when they have excess cash.
3. Financial Institutions (Intermediaries): The financial
institutions and markets help bring borrowers and
savers together.
Financial Intermediaries

SAVERS Financial BORROWERS

Intermediaries
 Commercial Banks – Everyone’s
Financial Marketplace

 Commercial banks collect the savings of individuals as

well as businesses and then lend those pooled savings to
other individuals and businesses.

 They make money by charging a rate of interest to

borrowers that exceeds the rate they pay to savers.
Non-Bank Financial Intermediaries

 These include:
– Insurance companies
– Investment banks
– Investment companies including mutual funds,
hedge funds and private equity firms.
Insurance Companies

 Insurance companies sell insurance to individuals

and businesses to protect their investments.

 They collect premium and hold the premium in

reserves until there is an insured loss and then pay
out claims to the holders of the insurance contracts.
Later, these reserves are deployed in various types of
investments including loans to individuals,
businesses and the government.
Investment Banks

 Investment banks are specialized financial

intermediaries that:
– help companies and governments raise money
– provide advisory services to client firms on major
transactions such as mergers
 Examples of firms that provide investment
banking services include BDO Capital and
ING Bank
Investment Companies

 Investment companies are financial

institutions that pool the savings of individual
savers and invest the money in the securities
issued by other companies purely for
investment purposes.
– Mutual funds
– Hedge funds
– Private equity firms
Mutual Funds

 Mutual funds are professionally managed

according to a stated investment objective.
 Individuals can invest in mutual funds by
buying shares in the mutual fund at the net
asset value (NAV). NAV is calculated daily
based on the total value of the fund divided
by the number of mutual fund shares
outstanding.
Hedge Funds

 Hedge funds are similar to mutual funds but

they tend to take more risk and are generally
open only to high net worth investors.
 Management fees also tends to be higher for
hedge funds and most funds include an
incentive fee based on the fund’s overall
performance.
Private Equity Firms

 Private equity firms include two major

groups: Venture capital (VC) firms and
Leveraged buyout firms (LBOs).
Private Equity Firms (cont.)

 Venture capital firms raise money from

investors (wealthy individuals and other
financial institutions) that they then use to
provide financing for private start-up
companies when they are first founded.
 For example, Venture capital firm, Kleiner
Perkins Caufield & Byers (KPCB) was
involved in the initial financing of Google.
Private Equity Firms (cont.)

 Leveraged buyout firms acquire established firms

that typically have not been performing very well with
the objective of making them profitable again and
selling them.
Financial Institutions & Markets:
Financial Institutions

 Financial institutions are intermediaries that

channel the savings of individuals, businesses, and
governments into loans or investments.
 The key suppliers and demanders of funds are
individuals, businesses, and governments.
 In general, individuals are net suppliers of funds,
while businesses and governments are net
demanders of funds.

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Financial Institutions & Markets:
Financial Markets

 Financial markets provide a forum in which

suppliers of funds and demanders of funds
can transact business directly.
 The two key financial markets are the money
market and the capital market.

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Money versus Capital Market

 The money market refers to debt

instruments with maturity of one year or less.
– Examples: Treasury bills (T-bills), Commercial
paper
 The capital market refers to long-term debt
and equity instruments.
– Examples: Common stock, Preferred stock,
Corporate bond, Treasury bond
Financial Institutions & Markets:
Financial Markets (cont.)

 Whether subsequently traded in the money or capital

market, securities are first issued through the
primary market.
 The primary market is the only one in which a
corporation or government is directly involved in and
receives the proceeds from the transaction.
 Once issued, securities then trade on the secondary
markets such as the Philippine Stock Exchange.

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THE SECURITIES MARKET
Security

 A security is a negotiable instrument that

represents a financial claim and can take the
form of ownership (such as stocks) or debt
agreement (such as bonds).

 The securities market allows businesses and

individual investors to trade the securities
issued by publicly-listed corporations.
Types of Securities

 Debt Securities: Firms borrow money by

selling debt securities in the debt market.
 If the debt has a maturity of less than one
year, it is traded in the money market.
 If the debt has a maturity of more than one
year, it is traded in the capital market.
Types of Securities (cont.)

 Most bonds pay a fixed interest rate on the

face or par value of bond.
 For example, a bond with a face value of
P1,000 and semi-annual coupon rate of 9%
will pay an interest of P45 every 6 months or
P90 per year, which is 9% of P1,000. When
the bond matures, the owner of the bond will
receive P1,000.
Types of Securities (cont.)

 Equity securities represent ownership of

the corporation.

 There are two major types of equity

securities: common stock (ordinary shares)
and preferred stock (preference shares).
Types of Securities (cont.)

 Common stock or ordinary share is a security that

represents equity ownership in a corporation,
provides voting rights, and entitles the holder to a
share of the company’s success in the form of
dividends and any capital appreciation in the value
of the security.
 Common stockholders are residual owners of the
firm i.e. they earn a return only after all other security
holder claims (debt and preferred equity) have been
satisfied in full.
Types of Securities (cont.)

 Dividend on common stock are neither fixed

nor guaranteed. Thus a company can
choose to reinvest all of the profits in a new
project and pay no dividends.
Types of Securities (cont.)

 Preferred stock or preference share is an

equity security. However, preferred
stockholders have preference with regard to:
– Dividends: They are paid before the common
stockholders.
– Claim on assets: They are paid before common
stockholders if the firm goes bankrupt and sells or
liquidates its assets.
Types of Securities (cont.)

 Preferred stock is also referred to as a hybrid

security as it has features of both common
stock and bonds.
Types of Securities (cont.)

 Similar to common stock in that:

• It has no maturity date
• The nonpayment of dividends does not bring on
bankruptcy for the firm
• The dividends paid on preferred stock are not deductible
for tax purposes
 Similar to corporate bonds in that:
• The dividends paid on the preferred stock, like interest
payments made on bonds, are typically a fixed amount
• It does not come with any voting rights
Stock Markets

 A stock market is a public market in which

the stocks of companies is traded.

 Stock markets are classified as either

organized security exchanges or over-the-
counter (OTC) market.
Stock Markets (cont.)

 Organized security exchanges are tangible

entities; that is, they physically occupy space
and financial instruments are traded on their
premises. For example, the Philippine Stock
Exchange (PSE) maintains two trading floors
- one in Ortigas Centre and another in Ayala
Avenue, Makati.
Stock Markets (cont.)

 The over-the-counter markets include all

security market except the organized
exchanges.
Reading Stock Price Quotes