Financial Management : An Overview

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Financial Management An Overview
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Question

• Why is it that some companies, in some
  industries, provide more value to shareholders?
• In answering this question, you might like to use
  the information provided separately on the market
  capitalization of some large Indian companies

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Concepts of Value

• Gross Profit/ Net Profit
• ROA/ ROCE/ RONW
• Market value or market capitalization
• Market value added
• Economic value added

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An overview of financial management

Financial Management
Maximization of Share Value
Financial Decisions
Liquidity Decision
Investment Decision
Financing Decision
Dividend Decision
Risk
Return
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A simple view of a firm

• Liabilities
• Debt ( borrowed money )
• Equity ( owners Funds )

• Assets

Investments already made. These generate cash
flows today
Investments yet to be made. These future
investments are expected to create additional
value
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The Balance-Sheet Model of A Firm
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The Balance-Sheet Model of A Firm
The Capital Investment Decision
Current Liabilities
Current Assets
Long-Term Debt
What long-term investments should the firm engage
in?
Fixed Assets 1 Tangible 2 Intangible
Shareholders Equity
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The Balance-Sheet Model of A Firm
The Capital Structure Decision
Current Liabilities
Current Assets
Long-Term Debt
How can the firm raise the money for the required
investments?
Fixed Assets 1 Tangible 2 Intangible
Shareholders Equity
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The Balance-Sheet Model of A Firm
The Net Working Capital Investment Decision
Current Liabilities
Current Assets
Net Working Capital
Long-Term Debt

• How much short-term cash flow does a company need
  to pay its bills?

Fixed Assets 1 Tangible 2 Intangible
Shareholders Equity
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Stakeholders and their expectations

• SECURITY
• COMPENSATION
• JOB SATISFACTION

• FAIR
• EMPLOYMENT
• NO DISCRIMINATION

• COMPENSATION
• PRESTIGE
• POWER

EMPLOYEES

• TAXES
• EMPLOYMENT

• EMPLOYMENT
• PRESERVATION OF
• THE ENVIRONMENT

MINORITY GROUP
MANAGERS
FIRM
GOVERNMENT
COMMUNITY

• REGULAR
• PAYMENT
• CONTINUITY
• OF BUSINESS

CREDITORS
SUPPLIERS

• INTEREST
• SECURITY OF
• CAPITAL

SHARE HOLDERS
CUSTOMERS

• PRODUCT QUALITY
• SERVICE
• VALUE

• DIVIDENDS
• CAPITAL GROWITH
• SAFETY OF INVESTMENT

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Question Agency Costs

• There is a conflict of interest between
  shareholders and managers. In theory,
  shareholders are expected to exercise control
  over managers through the annual meeting or the
  board of directors. In practice, why might these
  disciplinary mechanisms not work?

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Question

• Maximizing firm value, defined as its market
  capitalization, has been suggested as the major
  goal in corporate finance. Does this conflict
  with a firms responsibility to its customers, to
  employees and to society in general?

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Possible answers

• Maximizing stock price is not incompatible with
  meeting employee needs/objectives. In particular
• Employees are often stockholders in many firms
• Firms that maximize stock price generally are
  firms that have treated employees well.

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Possible answers

• Maximizing stock price does not mean that
  customers are not critical to success. In most
  businesses, keeping customers happy is the route
  to stock price maximization.

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Possible answers

• Maximizing stock price does not imply that a
  company has to be a social outlaw.
• In fact, companies, such as ONGC and Hindustan
  Lever, who are among the most valuable companies
  in India today, are also the companies who have
  shown a high degree of sensitivity to the needs
  of society.

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Building a profitable business is hard work
Maximizing firm value
Increasing return
Managing Investment
Investment in Fixed assets
Increasing revenues and ontrolling costs
Working capital management
Quantity
Quality
Operating risk / Leverage
Financial risk / Leverage
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The DU PONT Formula
Return on Net Worth (RONW)

• Net Profit Sales to Total Assets
• To Sales x Total Assets x to Net Worth
• Margin Activity Leverage
  

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Which of these two companies is more risky ?
(Figures in rupees) Firm A Firm B
1 Sales 100,000 100,000
2 Variable costs 40,000 60,000
3 Contribution ( 1- 2) 60,000 40,000
4 Less Fixed operating costs 40,000 20,000
5 Operating profit ( 3-4) 20,000 20,000
6 Less interest on loans 12,000 8,000
7 Profit before tax 8,000 12,000
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Which of these two companies is more risky ?
Leverage measures Leverage measures Leverage measures
8 Operating leverage ( Line 3 / Line 5 ) 3.0 2.00
9 Financial leverage ( Line 5 / Line 7 ) 2.5 1.67
10 Total or combined leverage ( Line 8 x Line 9 ) 7.5 3.34
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Risk matrix
High
(1) High financial and low operating risk
(2) High financial and high operating risk
Financial leverage
(3) Low financial and low operating risk
(4) High operating risk and low financial risk
Low
High
Operating leverage