Finance Principles: Role of Financial Management and Managerial Finance - Prof. Borua, Slides of Finance

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Principles of Finance BBA 15th Batch Saiful Islam Department of International Business Basics of Financial Management Principles of Managerial Finance Gitman and Zutter 16th Edition (or newer) Chapter 1 and Internet Sources LECTURE 1 Principles of Finance BBA 15th Batch Saiful Islam Department of International Business Learning Objectives • Definitions and functions of financial management • Organization of the financial management functions • Goal of financial managers • Profit Maximization vs. Wealth Maximization • Agency theory in financial management 2 Principles of Finance BBA 15th Batch Saiful Islam Department of International Business Financial Management • Financial management is concerned with acquisition, financing, and management of assets to attain organizational goals • Management involves core functions like • Planning • Organizing • Leading • Controlling 5 Principles of Finance BBA 15th Batch Saiful Islam Department of International Business Managerial Finance: Arts/ Science? • Finance is a matured science since it provides knowledge as to how and at what time a firm should invest to outstrip other firms • Finance is also an art as it has become more analytical where financial mangers examine different alternatives and apply the most desired on their own to raise and manage money • In modern time finance is a 'scientific art' 6 Principles of Finance BBA 15th Batch Saiful Islam Department of International Business Managerial Finance Function • The size and importance of the managerial finance function depends on the size of the firm • In small firms, the finance function is generally performed by the accounting department • As a firm grows, the finance function typically evolves into a separate department (Figure 1.1) 7 Principles of Finance BBA 15th Batch Saiful Islam Department of International Business Managerial Finance: Relationship to Accounting (1) 10 • The firm’s finance and accounting activities are closely-related and generally overlap • In small firms accountants often carry out the finance function, and in large firms financial analysts often help compile accounting information • 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 Principles of Finance BBA 15th Batch Saiful Islam Department of International Business Managerial Finance: Relationship to Accounting (2) 11 • Whether a firm earns a profit or experiences a loss, it must have a sufficient flow of cash to meet its obligations as they come due • This difference can be illustrated using a simple example. • The Nassau Corporation experienced the following activity last year: Sales $100,000 (1 yacht sold, 100% still uncollected) Costs $ 80,000 (all paid in full under supplier terms) Principles of Finance BBA 15th Batch Saiful Islam Department of International Business Managerial Finance: Relationship to Accounting (3) 12 • Now contrast the differences in performance under the accounting method (accrual basis) versus the financial view (cash basis): Income Statement Summary Accrual basis Cash basis Sales $100,000 $ 0 Less: Costs (80,000) (80,000) Net Profit/(Loss) $ 20,000 $(80,000) Principles of Finance BBA 15th Batch Saiful Islam Department of International Business Three different Decisions of Managerial Finance 15 1. Investment decision • Total amount of assets needed to be held by the firm (asset side) 2. Financing decision • Source of investments – debts, equity 3. Dividend decision • Asset management and • Operating assets Principles of Finance BBA 15th Batch Saiful Islam Department of International Business Functions of Financial Manager (1) 16 • Financing Decisions 1. Identify the amount of fund that will be needed 2. Identify the sources available for this amount of fund 3. Identify one or more optimal source(s) 4. If multiple source, how financing will be allocated to each • Purpose of financing • Consumption • Investment • Long term • Short term Principles of Finance BBA 15th Batch Saiful Islam Department of International Business Functions of Financial Manager (2) 17 • Investment Decisions 1. Determine the fund available to utilize 2. Determine the opportunities available to utilize fund 3. Determine the best possible opportunity 4. If multiple opportunity is chosen, how to allocate the fund for each • Investment (utilization of fund) • Long term investment • Short term investment Principles of Finance BBA 15th Batch Saiful Islam Department of International Business Goal of Financial Managers (2) 20 • The goal of the firm/manager should be wealth maximization • However, if customer are satisfied, sales will increase, as a result market share will be increased, eventually profit will be maximized and cost would be minimized. So everything will be reflected in the bottom line- Profit maximization • Now which goal we should pursue- Profit maximization or wealth maximization? Principles of Finance BBA 15th Batch Saiful Islam Department of International Business Profit Maximization or Wealth Maximization? (1) 21 • Business firm always run for profit, so ultimate goal is to maximize profit, and other goal are ultimately boiled to it • However, there are number of problems, deficiency of profit maximization concept 1. Ambiguity in the concept of profit 2. Accounting profit cannot represent cash flow 3. Possibility of manipulating profit 4. Ignoring timing of profit and time value of money Principles of Finance BBA 15th Batch Saiful Islam Department of International Business Profit Maximization or Wealth Maximization? (2) 22 • Another goal that can eliminate all these problems of profit maximization- Wealth maximization • Wealth maximization concept has following strengths • Clear concepts • Focus on market price of stock • Consideration of the time value of money • Consideration of risk and timing of return Principles of Finance BBA 15th Batch Saiful Islam Department of International Business Agency Relationships and Agency Costs 25 • In finance, there are two primary agency relationships, • Managers and stockholders • Managers and creditors • These are costs incurred in an attempt to push agents to act in the principal’s best interest. • They consist of three types, • Direct contracting costs • Monitoring costs • Loss of principal’s wealth due to residual, unresolved agency problems Principles of Finance BBA 15th Batch Saiful Islam Department of International Business How to Resolve Agency Problems? (1) 26 1. Monitoring • Stockholders • Bondholders • Board of Directors • Outside auditors • Issues opinion regarding whether reports are consistent with generally accepted accounting standards • Qualified or unqualified opinion Principles of Finance BBA 15th Batch Saiful Islam Department of International Business How to Resolve Agency Problems? (2) 27 2. Motivating managers to act in shareholders' best interests • There are four primary mechanisms for motivating managers to act in stockholders' best interests: • Managerial compensation • Direct intervention by stockholders • Threat of firing • Threat of takeovers