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CHAPTER 1 Introduction to Financial Management

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CHAPTER 1 Introduction to Financial Management What is Finance? Goals of the Corporation Conflicts Between Managers and Shareholders Stock Prices and Intrinsic Value – PowerPoint PPT presentation

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Title: CHAPTER 1 Introduction to Financial Management


1
CHAPTER 1Introduction to Financial Management
  • What is Finance?
  • Goals of the Corporation
  • Conflicts Between Managers and Shareholders
  • Stock Prices and Intrinsic Value
  • Describe the managerial finance function
  • Forms of Businesses

2
What is Finance?
  • Finance can be defined as the art and science of
    managing money.
  • Finance is concerned with the process,
    institutions, markets, and instruments involved
    in the transfer of money among individuals,
    businesses, and governments.

3
Corporate Organization
1-3
4
Major Areas Opportunities in Finance Financial
Management
  • Financial Management is concerned with the
    duties of the financial manager in the business
    firm.
  • The financial manager actively manages the
    financial affairs of any type of business,
    whether private or public, large or small,
    profit-seeking or not-for-profit.
  • They are also more involved in developing
    corporate strategy and improving the firms
    competitive position.

5
Responsibility of the Financial Staff
  • Forecasting and planning
  • Investment and financing decisions
  • Coordination and control of Working capital
  • Transactions in the financial markets
  • Dividend Policy
  • Managing risk

Financial Management for the Hospitality industry
by Andrew, Damitio Schmidgall ( 2005)
1-5
6
Financial Goals of the Corporation
  • The primary financial goal is shareholder wealth
    maximization, which translated from stock price
    maximization.

7
Financial Goals of the Corporation
  • Renong Corporation
  • RM 2.25/ shares
  • An individual owns 1,000 Unit of shares
  • Total Wealth
  • RM2.25 x 1000 Unit
  • RM2,250

8
Financial Goals of the Corporation
  • Investors Wealth Maximization
  • t0 RM2.25/shares Investors wealth
    RM2,250
  • t1 RM3.75/shares Investors wealth
    RM3,750

9
Factors that affect stock price
  • Projected cash flows to shareholders
  • Timing of the cash flow stream
  • Riskiness of the cash flows

10
A. Projected of cash flows to shareholders
Capital gain
  • Dividend

Purchase shares _at_ RM2.25/shares Sell shares _at_
RM3.75/ shares Capital gain RM3.75-2.25
RM 1.50/ shares
i.e RM0.02 for every share owned 1,000 units x
RM0.02 RM20 -Net income to be distributed to
shareholders -Profit Dividend
Projected cash
flows to s/holders share price
wealth maximization materialize
11
B. Timing of the cash flow stream
  • Investors expect consistency in the cash flows to
    be received
  • ie. dividend payment

12
C. Riskiness of the cash flows
  • Must reduce the possibilities of interruption on
    the cash flows
  • Possibility of interruption may arise due to
    mismanagement in the company
  • Mismanagement Profit Dividend
  • Stock price Wealth maximization

13
Organization structure
14
Conflicts Between Managers and Stockholders
  • Managers are naturally inclined to act in their
    own best interests (which are not always the same
    as the interest of stockholders).
  • This give rise to Agency Problem

15
Example of Agency problem
CEO Denise spent more than 2m of company money
on his wifes birthday
Reduce profit
Reduce dividend
Reduce expected cash flow
Reduce wealth maximization
16
Source of Conflicts Between Managers and
Stockholders
CEO
Salary RM1.2m/ year
Companys No. of shareholders profit
(t1) 100 individual RM 10m/ yr
RM100,000/ individual
Companys profit (t2) After new
strategy RM30m/ yr RM300,000/ individual
17
How minimize agency problem
  • Managerial compensation plans
  • Bonus Options
  • Stock Options
  • Direct intervention by shareholders
  • The threat of Firing

1-17
18
Stock Prices and Intrinsic Value
  • In equilibrium, a stocks price should equal its
    true or intrinsic value.

19
Stock Prices and Intrinsic Value
Stock Prices
Intrinsic value
Market price (Quoted)
Projected cash flows
Supply demand for the shares
Market Intrinsic price value
20
Stock Prices and Intrinsic Value
1-20
21
Financial Goals of the Corporation
  • Is stock price maximization good or bad for
    society?
  • Should firms behave ethically?

22
Should firms behave ethically
  • Desperate attempt to maximize stock price may
    lead to
  • Window dressing
  • Earning management

23
  • Example
  • An asset should be depreciated for 5 years,
    but instead it was depreciated over a 10 years
    life (i.e Asset value RM10m)
  • -If 5 years total depreciation expense RM2m/yr
  • -If 10 years total depreciation expense RM1m/yr

24
Depreciation expense
5 years (RM2m/yr)
10 years (RM1m/ yr)
lt
Net Income
Net Income
25
  • Example 2 3
  • Goods ordered but not shipped
  • A company considers goods that have been ordered
    but not yet shipped to be part of revenue earned.
  • Extended reporting period
  • Companies try to meet revenue expectations by
    keeping their books open for few days- even a
    few weeks into the next reporting period in order
    to generate last minute sales revenues

26
Alternative Forms of Business Organization
  • Proprietorship
  • Partnership
  • Corporation

27
Proprietorships Partnerships
  • Advantages
  • Ease of formation
  • Subject to few regulations
  • Confidentiality
  • Can limit the amount of information that they
    must file. ie. can leave their competitors
    guessing.
  • Flexibility
  • Family member can easily decide how much they
    want to pay for one another without having to
    worry about shareholders scrutinity

28
Proprietorships Partnerships
  • Disadvantages
  • Difficult to raise large sums of capital
  • Because a private company do not sell shares or
    issue bonds to the public, it spends a lot more
    of time finding investors who are willing to
    risks their funds
  • Sometimes difficult to find potential investors
    to invest in the company that have the same
    vision.
  • Unlimited liability

29
Corporation
  • Advantages
  • Unlimited life
  • Easy transfer of ownership
  • Limited liability
  • Ease of raising capital
  • Disadvantages
  • Double taxation
  • Cost of set-up and report filing
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