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1. •Financial ManagementFinancial Management
•An IntroductionAn Introduction

2. •What is Finance Anyway?What is Finance Anyway?
What is this course all about?What is this course all about?
• Accounting is the language of business.Accounting is the language of business.
• Finance uses accounting informationFinance uses accounting information
together with other information to maketogether with other information to make
decisions that affect the market value of thedecisions that affect the market value of the
firm.firm.
• There areThere are threethree primary decision areas thatprimary decision areas that
are of concern.are of concern.

3. •Three decision areas in finance:Three decision areas in finance:
• Investment decisions - What assets shouldInvestment decisions - What assets should
the company hold? This determines thethe company hold? This determines the
left-hand side of the balance sheet.left-hand side of the balance sheet.
• Financing decisions - How should theFinancing decisions - How should the
company pay for the investments it makes?company pay for the investments it makes?
This determines the right-hand side of theThis determines the right-hand side of the
balance sheet.balance sheet.
• Dividend decisions - What should be doneDividend decisions - What should be done
with the profits of the business?with the profits of the business?

4. •All management decisionsAll management decisions
should help to accomplish theshould help to accomplish the
goal of the firm!goal of the firm!
•What should be the goal of the firm?What should be the goal of the firm?

5. •Many people think the goal is toMany people think the goal is to
maximize profits.maximize profits.
• Would this mean short-term profit, or long-Would this mean short-term profit, or long-
term profit? Businesses are sometimesterm profit? Businesses are sometimes
criticized for being overly concerned aboutcriticized for being overly concerned about
short-term profits results rather than theshort-term profits results rather than the
long-term strategic positioning of thelong-term strategic positioning of the
company.company.

6. •What about risk? Isn’t riskWhat about risk? Isn’t risk
important as well as profits?important as well as profits?
• How would the stockholders of a smallHow would the stockholders of a small
business react if they were told that theirbusiness react if they were told that their
manager canceled all casualty and liabilitymanager canceled all casualty and liability
insurance policies so that the money spentinsurance policies so that the money spent
on premiums could go to profit instead.on premiums could go to profit instead.
• Even though theEven though the expectedexpected profits increasedprofits increased
by this action, it is likely that stockholdersby this action, it is likely that stockholders
would be dissatisfied because of thewould be dissatisfied because of the
increased risk they would bear.increased risk they would bear.

7. •The common stockholders areThe common stockholders are
the owners of the corporation!the owners of the corporation!
• Stockholders elect a board of directors whoStockholders elect a board of directors who
in turn hire managers to maximize thein turn hire managers to maximize the
stockholdersstockholders’’ well being.well being.
• When stockholders perceive thatWhen stockholders perceive that
management is not doing this, they mightmanagement is not doing this, they might
attempt to remove and replace theattempt to remove and replace the
management, but this can be very difficultmanagement, but this can be very difficult
in a large corporation with manyin a large corporation with many
stockholders.stockholders.

8. •More likely, when stockholdersMore likely, when stockholders
are dissatisfied they will simplyare dissatisfied they will simply
sell their stock shares.sell their stock shares.
•This action by stockholders willThis action by stockholders will
cause the market price of thecause the market price of the
company’s stock to fall.company’s stock to fall.

9. •When stock price falls relativeWhen stock price falls relative
to the rest of the market (orto the rest of the market (or
relative to the rest of therelative to the rest of the
industry) ...industry) ...
•Management is failing in their job toManagement is failing in their job to
increase the welfare (or wealth) of theincrease the welfare (or wealth) of the
stockholders (the owners).stockholders (the owners).

10. •Conversely, when stock price isConversely, when stock price is
rising relative to the rest of therising relative to the rest of the
market (or industry), ...market (or industry), ...
•Management is accomplishing theirManagement is accomplishing their
goal of increasing the welfare (orgoal of increasing the welfare (or
wealth) of the stockholders (thewealth) of the stockholders (the
owners).owners).

11. •The goal of the firm should be toThe goal of the firm should be to
maximize themaximize the stock pricestock price!!
• This is equivalent to saying the goal is toThis is equivalent to saying the goal is to
maximizemaximize owners’ wealthowners’ wealth..
• Note that the stock price is affected byNote that the stock price is affected by
management’s decisions affectingmanagement’s decisions affecting bothboth riskrisk
and profit.and profit.
• Stock price can be maintained or increasedStock price can be maintained or increased
only when stockholders perceive that theyonly when stockholders perceive that they
are receiving profits that fully compensateare receiving profits that fully compensate
them for bearing the risk they perceive.them for bearing the risk they perceive.

12. •Important focal points in theImportant focal points in the
study of finance:study of finance:
• Accounting and Finance often focus onAccounting and Finance often focus on
different thingsdifferent things
• Finance is more focused onFinance is more focused on market valuesmarket values
rather than book values.rather than book values.
• Finance is more focused onFinance is more focused on cash flowscash flows
rather than accounting income.rather than accounting income.

13. •Why is market value moreWhy is market value more
important than book value?important than book value?
• Book values are often based on datedBook values are often based on dated
values. They consist of the original cost ofvalues. They consist of the original cost of
the asset from some past time, minusthe asset from some past time, minus
accumulated depreciation (which may notaccumulated depreciation (which may not
represent the actual decline in the assets’represent the actual decline in the assets’
value).value).
• Maximization of market value of theMaximization of market value of the
stockholders’ shares is the goal of the firm.stockholders’ shares is the goal of the firm.

14. Why is cash flow more importantWhy is cash flow more important
than accounting income?than accounting income?
• Cash flow to stockholders (in the form ofCash flow to stockholders (in the form of
dividends) is the only basis for valuation ofdividends) is the only basis for valuation of
the common stock shares. Since the goal isthe common stock shares. Since the goal is
to maximize stock price, cash flow is moreto maximize stock price, cash flow is more
directly related than accounting income.directly related than accounting income.
• Accounting methods recognize income atAccounting methods recognize income at
times other than when cash is actuallytimes other than when cash is actually
received or spent.received or spent.

15. •One more reason that cash flowOne more reason that cash flow
is important:is important:
• WhenWhen cash is actually received is important,cash is actually received is important,
because it determines when cash can bebecause it determines when cash can be
invested to earn a return.invested to earn a return.
[Also:[Also: WhenWhen cash must be paid determinescash must be paid determines
when we need to start paying interest onwhen we need to start paying interest on
money borrowed.]money borrowed.]

16. •Examples of when accountingExamples of when accounting
income is different from cashincome is different from cash
flow:flow:
• Credit sales are recognized as accountingCredit sales are recognized as accounting
income, yet cash has not been received.income, yet cash has not been received.
• Depreciation expense is a legitimateDepreciation expense is a legitimate
accounting expense when calculatingaccounting expense when calculating
income, yet depreciation expense is not aincome, yet depreciation expense is not a
cash outlay.cash outlay.
• A loan brings cash into a business, but isA loan brings cash into a business, but is
not income.not income.

17. •More examples:More examples:
• When new capital equipment is purchased,When new capital equipment is purchased,
the entire cost is a cash outflow, but onlythe entire cost is a cash outflow, but only
the depreciation expense (a portion of thethe depreciation expense (a portion of the
total cost) is an expense when computingtotal cost) is an expense when computing
accounting income.accounting income.
• When dividends are paid, cash is paid out,When dividends are paid, cash is paid out,
though dividends are not included in thethough dividends are not included in the
calculation of accounting income.calculation of accounting income.

18. •Definitions: Operating income vs.Definitions: Operating income vs.
operating cash flowoperating cash flow
• Operating income = earnings before interestOperating income = earnings before interest
and taxes (EBIT). This is the total incomeand taxes (EBIT). This is the total income
that the company earned by operatingthat the company earned by operating
during the period. It is income available toduring the period. It is income available to
pay interest to creditors, taxes to thepay interest to creditors, taxes to the
government, and dividends to stockholders.government, and dividends to stockholders.

19. •Operating cash flow:Operating cash flow:
• Operating cash flowOperating cash flow
= EBIT + Depreciation - Taxes.= EBIT + Depreciation - Taxes.
This definition recognizes thatThis definition recognizes that
depreciation expense is subtracted indepreciation expense is subtracted in
computing EBIT, though it is not a cashcomputing EBIT, though it is not a cash
outlay.outlay.
• It also recognizes that taxes paid is a cashIt also recognizes that taxes paid is a cash
outlay.outlay.