2. Content
Defining finance.
Evolution of finance
Finance function
The firm’s goal.
Role of financial managers
Financial Markets and financial systems
Agency theory
3. The practice of “finance” exists for the creation
of value
Financial contracting brings about the
substitution of real wealth (i.e. real business
assets) for financial wealth (i.e. securities)
Investing in financial securities has better attributes
that in real assets. Value is created in tthe real assets
held by businesses, and then transmitted into the value
of financial wealth issued by businesses and held by
investors.
What is finance?
Defining Finance: a new paradigm. The Value
Creation Function of Finance
Norton y Scott, “A new Paradigm: the value creation
function of finance”, january 2001
4. Early View of Financial Management
In the past, the finance manager was only
involved in simple book keeping such as
documentations, record keeping, financial
reports preparation, and simple payments of the
company’s bills (Van Horne, James 2005.).
As time went on, the task of the finance manager
evolved going deeply into the major parts of the firm’s
activities, a role that critically developed to what is now
known as financial management.
5. M
o
d
e
r
n
A
p
p
r
o
a
c
h
1900-
1950-
1970-
1980-
1990-
Classical Approach
APT Model
(Ross, 1970)
Options Valuation Models (Black y Scholes, 1973)
Portfolio selection Theory
(Markowitz, 1952,1959)
CAPM (widening and reformulation)
Dividends Policy (Modigliani, Miller, 1963)
Capital Assets Pricing Model
(CAPM) (Sharpe, 1963-4, Lintner,
1965)
Efficient
Market Theory
(Fama, 1970)
Financial Structure
(Modigliani, Miller, 1958)
Agency Theory
Information Theory
Financial Innovation
Methods based on Fuzzy Sets Theory
(Kaufmann y Gil, 1986-87)
Chaos Theory,
Non Linear Dynamics
Markets Efficiency
Paradigmyears70
Behavioral finance
2000-
Finance: historic evolution
6. Finance Function-managing the cash flow
Operations
(plant,
equipment,
projects)
Financial
Manager
Financial
Markets
(investors)
1a.Raising
funds2.Investments
3.Cash from
operational
activities
4.Reinvesting
1b.Obligations
(stocks, debt
securities)
5.Dividends or
interest
payments
7. Real and Financial asset
Real assets can be tangible or intangible
Firms sell financial assets to raise funds
8. Equity and Borrowed fund
Shares
Ordinary
Preference
Creditors and Lenders
9. Finance Functions
Investment or long term asset mix decisions
Financing or capital-mix decisions
Dividend or profit allocation decisions
Liquidity or short-term asset mix decisions
10. THE FIRM’S GOAL
Economic theory holds that individuals want to maximize their utility.
People always have the options to choose what to do with their
earnings.
They can spend, save or invest it.
Spending could satisfy individuals’ wants but have not maximized
their utility because of losing the opportunity to have more earnings
if saved.
maximizing their utility could be hampered because of a lost of
opportunity to earn more in the near future.
If people chose to save their money and invest it in a firm, the
primary objective of the finance manager of that firm is to maximize
the return that it could offer to the people who trust the company.
11. THE FIRM’S GOAL
The people who bought the shares of stocks become the
common stockholder’s of the company and therefore
collectively own it. In turn running it is delegated to
managers who are to perform well in maximizing their
wealth or utility. In maximizing that wealth, these managers
must seek to maximize the value of the firm’s common
stock. And in doing so, they must increase the market
price or the current price of the stock.
12. THE FIRM’S GOAL
How is it done?
the firm must be able to increase its value by creating a good name
in terms of profitability, liquidity, effectiveness of management and
sustainability of the operations. The firm must be able to create a
good impression that they play a major role in the economy and in
the industry to which it belongs.
In this way, the market forces will favor them and create value by
creating more demands for their shares. As the demand for their
shares increase, and with limited authorized capital stocks to issue,
the price of the stock will go higher.
13. Why not maximize profit?
Finance people : Maximizing share holder wealth
Accounting people : Maximizing Profit
Arguments against Profit Maximization
Profit maximization does not consider risk or uncertainty whereas
wealth maximization does
Profit can be incensed by increasing the credit term but it may
hamper the cash flow.
In wealth maximization, before the increase in credit term is offered,
the cost and benefit will first be measured. The firm will try to answer
questions like:
14. It fails to determine the timing of benefits.
Project A Project B
Discount @
10%
Discounted
CF A
Discounted
CF B
1 100 25 0.909 91 23
2 50 50 0.826 41 41
3 25 100 0.751 19 75
NPV 151 139
15. Profit Maximization versus Stockholder
Wealth Maximization
Goal Objective Advantages Disadvantages
Profit
maximization
Stockholder
wealth
maximization
Large amount
of profits
Highest market
value of
common stock
1. Easy to calculate
profits
2. Easy to determine
the link between
financial decisions and
profits
1. Emphasizes the
long term
2. Recognizes risk or
uncertainty
3. Recognizes the
timing of returns
4. Considers
stockholders’ return
1. Emphasizes the short-term
2. Ignores risk or uncertainty
3. Ignores the timing of
returns
4. Requires immediate
resources
1. Offers no clear relationship
between financial decisions
and stock price
2. Can lead to management
anxiety and frustration
Source: Shim, Jae K., and Siegel, Joel G., Managerial Finance, McGraw Hill Book Company, 2006.
16. THE ROLE OF FINANCIAL
MANAGERS
Investment decisions
Financing decisions
Dividend decisions
Liquidity decisions
17. Investment Decisions
Investment decisions involves the decision of
allocation of capital or commitment of funds
to long-term assets that would yield benefits
in the future.
18. Financing Decisions
FM has to decide when, where and how to
acquire funds. The central issue is to decide
the proportion of equity and debt. When
share holders’ return is maximized firms’
capital structure would be optimum.
19. Dividend Decisions
FM must decide whether the firm should
distribute all profits, or retain them, or
distribute a portion and retain the balance.
The optimum dividend policy is one that
maximizes the market value of firm’s shares
20. Liquidity Decisions
Current assets should be managed efficiently
for safeguarding the firm against the dangers
of liquidity and insolvency.
22. Financial markets
The main goal of financial markets:
Take savings from those who do not wish to
consume (savings surplus units) and to
channel them to those who wish to invest
more than they have presently (saving
deficit units)
23. Financial markets and financial system
Financial
markets
Ф
Saving surplus
units (savers)
Saving deficit
units (investors)
Financial
intermediaries
Financial system
money
Return on
investments
Return on
investments
money
money
Return on
investments
Return on
investments
money
26. Money and capital markets
Money markets – short-term assets (maturity less
than 1 year) are traded:
Certificates of deposits (CDs)
Commercial papers (CPs)
Treasury bills
Capital markets – long-term assets (maturity longer
than 1 year) are traded:
Stocks
Corporate bonds
Long-term government bonds
27. Organized exchanges and over-the-
counter
Organized exchange – most of stocks, bonds and
derivatives are traded. Has a trading floor where
floor traders execute transactions in the secondary
market for their clients.
Stocks not listed on the organized exchanges are
traded in the over-the-counter (OTC) market.
Facilitates secondary market transactions. Unlike
the organized exchanges, the OTC market doesn’t
have a trading floor. The buy and sell orders are
completed through a telecommunications network.
28. Agency theory
Agency theory is known as a potential conflict of interest
between the stockholders and managers.
Such conflict starts when the stockholders entrust the
managers to make decision for the firm. With the power
vested among the managers, it has been recognized that
managers may have personal goals that conflicts with
the stockholders’ wealth maximization.
29. Agency Relationship: Stockholders and
Managers
This agency theory exists due to the creation
of an agency relationship. This relationship is
borne as soon as an individual or group of
people called the principals, hire the service
of an individual or organization called agent
to perform a service and exercise decision
making for the principal.
30. Agency theory is known as a potential conflict
of interest between the stockholders and
managers. Such conflict starts when the
stockholders entrust the managers to make
decision for the firm. With the power vested
among the managers, it has been recognized
that managers may have personal goals that
conflicts with the stockholders’ wealth
maximization
31. In many large corporations, potential agency conflicts have to be
noted specially when the managers own a small percentage of the
company’s stocks. However, managers may be encouraged to act
in maximizing stockholders’ wealth by giving them incentives for
good performance and punishment for poor performance.
Some of the incentives that maybe offered good performance are:
increase in salary, bonus, stock options, promotions and travel etc.
For poor performance, the punishment maybe as follows: no bonus,
threat of termination if he or she has been a poor performer for
several periods, no increase in salary etc. Other devices that may
be used by the company so that the managers will act in
accordance with the interest of the stockholders are threat of
takeovers by another company and shutdown.
32. Misconceptions of Financial
Management
Financial Management is not accounting
Financial Management is not a review of
mathematics.
Financial Management is not a branch of
statistics.
33. Social Responsibility
It is understandable that firms have to be responsible to provide
their employees with good working conditions, keep away from
polluting the air and water, and to produce goods or services to
customers in the safest way. However, to be socially responsible,
the firm has to incur costs.
However, socially responsible endeavors may not be costly at all
