FHBM 1224 Ch_01

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FHBM 1224Financial Management

Foundation in Arts

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Subject Information

3 hours lecture + 1 hour tutorial

Text book: Ross, S. A., Westerfield, R. W.,and Jordan, B. D. (2010). Fundamentals ofcorporate finance.(9th ed.). New York:McGraw-Hill.

Lecturer:Ms. Liu / Ms. Leong

Tutor:Pn. Liu / Ms. LeongEmail:[email protected] /[email protected]

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Methods of Evaluation1. Assignment 25%

2. Mid-term Test 15%

3. Final exam 60%

Total 100%

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Teaching Materials Students are expected to download own

lecture notes or any other materials via the

website provided by Web Based Learning

Environment: http://wble.utar.edu.my

It is essential that each student has accessto this website.

Active subject-related discussion among

students in WBLE forum is strongly

encouraged.
http://wble.utar.edu.my/http://wble.utar.edu.my/

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UTAR Student Dress Code

Proper Attire

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Third week of the trimester onwards

Full implementation as follow:

1sttime offenders: details of students taken downand submitted to the academic advisor for further action

2ndtime offenders: details of students submitted to the

Dean/Deputy Dean for further action.

3rdtime offenders: Warning letter issued to the student

4thtime offenders: Student to be sent for counseling

5thtime offenders: Barredfrom entering the campus

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Learning Objectives Know the goal of financial management

Understand the conflicts of interestthatcan arise between owners and managers

Know the basic types of financial

management decisionsand the roleofthe financial manager

Know the financial implications of thedifferent forms of business

organization

Understand the various types of

financial markets

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What is

Financestudies andaddresses the ways in which

individuals, businesses andorganizations raise, allocateand usemonetary

resourcesover time, takinginto account the risksentailed in their projects.

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Lets say you earn RM3,000 per month, how

do you allocate the income?

Example

RM 3,000

5% for insurance

30% for installment

20% for retirement plan

45% for monthly expenditure

Car loan

House loan

Back

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Problems with these Goals

Each of these goals presentsproblems.

These goals are either associated

with increasing profitabilityorreducing risk.

They are not consistent with the

long-term interests of shareholders. It is necessary to find a goal that

can encompass both profitabilityand risk.

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The Firms Objective

The goal of financialmanagement is tomaximize shareholderswealth.

Shareholders wealth can be measured as

the current value per share of existingshares.

This goal overcomes the problemsencountered with the goals outlined

above.

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Agency problem: Conflict of interest between

principal and agent

Principalsdelegateauthority to

agents tomanage firms

Principals hire agents

Principals

(shareholders)

Agents(managers)

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Example: Agency Problem

You hire someone to sell yourhouse and agree to pay that person

a flat fee when he sells the house. The agents incentive is to make the

sale, notnecessarily to get you thebest price.

Hence, the agent may not be actingin your best interest.

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Management may maximize own welfare (job

securities) instead of owners wealth (higher profit)

Ownership (shareholders)Problem created

by separation of

Agency Relationships/Problems

Control (Management& Employees)

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Do Managers Act in Shareholders Interests?

The answer to this willdepend on two factors:

how closely management goals are alignedwith shareholder goals

the ease with which management can bereplacedif it does not act in shareholders

best interests.

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Example: Aligning goals

aligningyour agents interestwith yours,since you want your house to be sold at the

highest possible price, so does your agent.

From the previous example, if,you offer a commissionof,

say, 10% of the sales priceinstead of a flat fee, you are

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Ways to Overcome Agency Problem

management compensation schemes(ESOS)

monitoring of management (Board ofDirectors)

the threat of takeover

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Employee Stock Option Scheme

a plan through which a company awardsStock Options to the employees basedon their performance

employees have the right to buy theshares of the company on a

predetermined date at apredetermined price.

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Example: ESOS

An employee is granted the option to purchase 1,000sharesof the companysstock at a price of RM5 pershare(the "grant" price). The employee can exercise theoption at RM5 per share.

Plans allow employees to exercise their options after acertain number of years or when the companysstockreaches a certain price.

If the price of the stock increases to RM20 per share,for example, the employee may exercise his or her

option to buy 1,000 shares at RM5 and then sell thestock at the current market price of RM20.

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Board of Directors

Board of Directors (BoD) should have a majorityof independentdirectors.

Independent directors are individuals who are

not current or former employees of the companyand must not have any business dealings withthe company.

The BoD has the ultimate authority to hire andfiretop management so a strong board woulddeter management from engaging in actions thatare detrimental to shareholders.

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Threat of Takeover

Poorly-managed firms are more attractive asacquisitionsthan well-managed firms becauseof greater profit potential.

A hostile takeover is usually associated withjob-

loss. Hence, it gives management another incentive

to act in the shareholders interests.

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Responsibility of Financial Managers

To acquire funds (cash) needed by a firm

To direct those funds into profitable

activities To maximize value of a firm

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Financial Management Decisions1. Investment Decisions (Capital Budgeting)

What long-term investments or projects should thebusiness take on?

2. LT Financing Decisions (Capital Structure)

Should we use debt or equity?

3. ST Financial Decisions (Working CapitalManagement)

How do we manage the day-to-day finances of thefirm?

4. Dividend Decisions (Dividend Distribution Policy)

How much dividends should we pay to ourshareholders?

How much earnings should we retain forreinvestment?

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1. The Investment Decision

Capital budgetingis the planning andcontrol of cash outflows in the expectationof deriving future cash inflows from

investments in non-current assets.

Involves evaluating the:

size of future cash flows

timing of future cash flows

risk of future cash flows.

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Cash Flow Size

Accounting income does not mean cashflow.

For example, a sale is recorded at the timeof sale and a cost is recorded when it isincurred, not when the cash is exchanged.

Vs.

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Cash Flow Timing

A dollar today is worth more than a dollarat some future date.

There is a trade-offbetween the size ofan investments cash flow and when the

cash flow is received.

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Cash Flow Timing

Which is the better project?

Future Cash FlowsYear Project A Project B

1 $0 $20 000

2 $10 000 $10 0003 $20 000 $0

Total $30 000 $30 000

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Cash Flow Risk

The role of the financial manager is to dealwith the uncertaintyassociated withinvestment decisions.

Assessing the risk associated with thesize and timingof expected future cash

flows is critical to investment decisions.

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2. Long Term Financing Decisions

A firms capital structureis the specificmix of debt and equity used to finance thefirms operations.

Decisions need to be made on both thefinancing mix and how and where to raise

the money.

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3. Short Term Financial Decisions

- working capital management

How much cash and inventory should be

kept on hand?

Should credit terms be extended? If so,

what are the conditions?

How is short-term financing acquired?

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4. Dividend Decision

Involves the decision of whether to pay adividendto shareholders or maintain thefundswithin the firm for internal growth.

Factors important to this decision includegrowth opportunities, taxation and

shareholders preferences.

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Forms of Business Organization

Three major forms in Malaysia

1. Sole proprietorship

2. Partnership General

Limited

3. Corporation Private Limited Company ( Sdn Bhd )

Public Limited Company ( Bhd )
http://www.nolo.com/encyclopedia/articles/sb/which_form.html

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Sole Proprietorship

The business is owned by one person. The least regulated form of organization.

Owner keeps all the profits but assumes

unlimited liability for the businesssdebts.

Amount of equity raised is limited

to owners personal wealth.

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Partnership

The business is formed by two or more owners.

All partners share in profits and losses of thebusiness and have unlimited liability for debts.

Partnership dissolves if one partner sells out ordies.

More capital available but amount is limited tothe combined personal wealth of the partners.

Income is taxed as personal income to partners.

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Liability of Partners

General Partner- Has unlimited liability for all obligationsof the business disadvantage

Limited Partner

-Liability limited to the partnershipagreement advantage

- Limited partnership involves at leastone general partner and one or morelimited partners

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Corporation

A business created as a distinctlegal entity composed of one or

more individuals or entities.

Easy to raise capital. Shareholders and management are usually

separated.

Ownership can be readily transferred. Owners (shareholders) have limited liability.

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Private vs. Public Companies

Private Limited Company (Sdn Bhd)- cannot offer its shares for sale to the public

- shares normally held by one shareholder or a

small group of shareholders Public Limited Company (Bhd)

- offers its shares for sale to the public through astock exchange (e.g. Bursa Malaysia)

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Structure of Financial Markets

Primary Market Secondary Market

Money Market

Primary Market Secondary Market

Capital Market

Financial Markets

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Financial Market Components

Money markets Market for short-termsecurities ( 1 year)

Less risk, low return (Fixed Deposits, CommercialPaper)

Capital markets

Market for long-termsecurities

(> 1 year)

High risk, higher return

(Shares and Bonds )

P i S d M k t

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Primary vs. Secondary Markets

1. Primary- new securities or primary claims

are issued, resulting in cash inflow to the issuer.

- firms issuing common shares to public for the1sttime is known as Initial Public Offering

(IPO).2. Secondary - already existing financial claims

such as stocks and bonds are bought and sold,no resulting cash inflow to the issuer.

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The Corporation and Financial Markets

Corporation Investors

Government

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Capital

Securities

Government

Primary Market

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Secondary

market

Capital

Securities

Government

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Secondary

market

Capital

Securities

Government

Cash Flow

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Secondary

market

Capital

Securities

Government

Cash Flow

tax

Reinvest

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Secondary

market

Capital

Securities

Government

Cash Flow (dividends)

tax

Reinvest

M t f S i 1 Th di t

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Movement of Savings: 1.The direct

transfer of funds

cash

securities

saver

firm

Movement of Savings: 2 Indirect

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Movement of Savings: 2. Indirect

transfer with investment banker

securities

fundsfunds

securities

saver

investment

banker firm

M t f S i 3 I di t

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Movement of Savings: 3. Indirect

transfer with financial intermediary

funds

intermediarysecurities

funds

firmsecurities

financial

intermediary firmsaver

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Lecture Exercise

Match the following with the questions below:(a.) restructuring(b.) capital market(c.) money market(d.) inflation(e.) primary market(f.) secondary market

(g.) financial capital

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1.______This form of capital is found on the Statement ofFinancial Position under long-term liabilities and equity.

2.______The purchasing power of the dollar shrinks over

time.3.______A market where the securities being traded are

new public offerings.

4.______Securities with a maturity of less than 1 year.

5.______Redeploying the asset and liability structure of thefirm.

6.______Market composed of common stock, preferredstock, commercial and government bonds and otherlong-term securities.

7.______This market trades previously issued securities.

Answer: (1.) g (2.) d (3.) e (4.) c (5.) a (6.) b (7.) f

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"I hear and I forget.

I see and I remember.

I do and I understand."

-- Confucius

FHBM 1224 Ch_01

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Transcript of FHBM 1224 Ch_01