Financial Management Department

1. An Overview of Financial Management (bdh) v1.2 Feb 17 Primary Financial Management Activities in a Corporation Financial Management Department Capital Budgeting Decision Investment Decision Strategic Decisions What assets to acquire? How much to invest? (Not in Isolation) Composition Decision (Debt vs. Equity) Debt Maturity Decision (Long vs. Short) Plant & Equipment Working Capital Decide how should assets be financed? Bonds Equity (Stocks) Other Return vs. Risk Trade-off Decision Stakeholder Benefit

2. An Overview of Financial Management (bdh) v1.2 Feb 17 The Main Finance Career Categories: Financial Management (This is the main focus of this course) • (You work for any company) • Decide how to “finance” the firm; i.e. figure out how to come up with the funds needed to pay for day-to-day operations and long-term improvements/expansion • how much debt to issue & carry • how much equity (stock) to issue • how much earnings to retain/how much dividend to pay out • manage short-term assets and liabilities • minimize the cost of financing • Increase the firm’s cash flows through investments in securities and other financial assets • Minimize risk to cash flows • Implied in the above tasks is the ability to asses the value of financial assets Financial & Investment Services (Focus of advanced finance courses) • (You work for an investment/brokerage firm, full service bank, mutual fund company, an insurance company, etc.) • 3 main functions: • sales of financial services and products • analysis of individual securities and portfolios • manage investment portfolios • Financial consulting (providing the Financial Management services listed above)

3. An Overview of Financial Management (bdh) v1.2 Feb 17 There’s Only Two Things That Finance People Do: • Rearranging/Translating/Exchanging Cash Flows Over Time: • Exchanging a single cash flow (now) for a series of cash flows (in the future) • getting a personal loan or issuing corporate debt • entering into a mortgage • selling securities (receive lump sum in exchange for paying stock dividends & bond interest payments in the future) • Exchanging a series of cash flows (in the future) for a single cash flow (now) • retiring a loan or corporate debt • paying off a mortgage • buying securities (pay a lump sum payment in exchange for stock dividends & bond interest in the future) • Converting today’s dollars into equivalent future value • Converting future dollars into equivalent present value (in terms of “today’s” dollars) • Choosing the best/most advantageous arrangement/timing of cash flows (making financial decisions) • Speculation (exchanging a cash flow for the possibility of receiving a larger one sometime in the future) • Capital gain appreciation/growth: buying a financial asset and hoping it growths in value • Dealing in derivative securities (forwards, futures & options) • Advise people on the above What’s a Security? • Managing Risk • Identifying risk to cash flows • Assessing risk to cash flows • Mitigate risk to cash flows

4. An Overview of Financial Management (bdh) v1.2 Feb 17 The Difference Between Finance and Accounting Finance: • Focused on the future (How to pay for what we want in the future) • Must deal with uncertainty (must use probability statistics) • Primarily concerned with deciding how to acquire, generate and distribute assets & capital resources • Strategic decision making Accounting: • Focused mainly on the past (How did we pay for what we have) • Very little uncertainty (the past is certain) • Primarily concerned with keeping track of how assets and capital are paid for & allocated/distributed • Limited decision making, possibly strategic Risk: Definitions: • Webster’s: a hazard; a peril; exposure to loss or injury • The chance that an outcome other than that which was expected will occur • The chance that an outcome other than that which was desired will occur (i.e. lose money)(this is the ”finance” definition) • Risk = Uncertainty of future cash flows

5. An Overview of Financial Management (bdh) v1.2 Feb 17 Primary Finance Axioms: 1. As far as the finance world is concerned, any asset (stocks, bonds, a project, a company, etc.) has positive value today (the “present value” of an asset) only if it gets more valuable in the future: • it generates future positive cash flows and/or….. • it appreciates in value over time This is because Finance is focused on the future 2. Risk affects value: • Risk Aversion: given two securities equally priced but with different degrees of risk, the rational investor would choose the one with lower risk • Valuation Implications: • all else being equal, a security whose cash flows are more certain is more valuable than a security with relatively less certain cash flows • if two securities offer the same ROR, the riskier one is priced lower if the seller of that security wants anybody to buy it (the less riskier one is priced higher) • ROR Implications: if two securities are priced the same, the riskier one must offer higher expected returns if the seller of that security wants anybody to buy it 3. The timing of cash flows matters; cash received sooner is better: • it can be utilized (invested) sooner to produce additional income • restore liquidity sooner

6. An Overview of Financial Management (bdh) v1.2 Feb 17 Review of Some Important Basic Concepts (this stuff is not in your book) Difference Between Price and Value • The value of a financial asset is based upon expected future cash flows • this is the “theoretical value”, “fair market value (FMV)”, “true market price”, “true market value”, “intrinsic value” or “no-arbitrage price” • it is what the asset should be worth based on fundamental financial and accounting valuation principles (much more on this later) • The price (“market price” or “real market price”) of something is • what the seller wants you to pay for it • what the “real” market allows (based on Laws of Supply / Demand) • Price is usually not equal to fair market value: • “fair market value” is the value of something based on theory and does not include profit • “price” is based on market/economic forces (supply and/or demand) and usually includes profit, transaction costs, etc. • What makes the fair market value of something change? • change in expected/estimated future cash flows • change in future cash flow discount rate (more on this later) • What makes the price of something change? • the same things that make fair market value change • market forces (supply & demand) Profit • It is the difference between Market Price and Value • Profit = Market Price - Value • Profit = Sales Price – COGS (Accounting Definition)

7. An Overview of Financial Management (bdh) v1.2 Feb 17 Profit (continued) • In the case of an investment: Profit = Available market price at the end of the holding period - Price paid at the beginning of the holding period (i.e. you buy a security, you hold it for a while, its price changes, you sell it) Percent (%) Profit or Rate of Profit • The percentage increase in the price (or value) of a financial asset • May involve time • Also Called: • Return • Percent Return (% Rtn) • Rate of Return (ROR) • Yield • Return on Investment (ROI) • General Equation: Profit / Investment • ROR may be thought of as rate of wealth creation Rate of Profit Examples: 1) (Spot Transaction) (Passage of time does not matter) A lawn mower manufacturing company charges $300 for a lawn mower that cost $270 to produce and ship. What is the return on this product? Return = (Sales price - COGS) / COGS = ($300 - $270) / $270 = $30 / $270 = 0.1111 = 11.11% = % Profit = % Rtn = ROR = Yield = ROI Profit Investment

8. An Overview of Financial Management (bdh) v1.2 Feb 17 Percent (%) Profit or Rate of Profit (continued) 2) Holding Period Return (Passage of time matters) A year ago you bought 100 shares of Intel stock for a total of $4,329. Today you sold that 100 shares for $4,489. What was your rate of return? Return = (New Price - Old Price) / Old Price = ($4,489 - $4,329) / $4,329 = $160 / $4,329 = 0.03696 = 3.696% The equation (New-Old)/Old is not unique to finance: Example 1: The temperature at dawn was 24o and at 3:00 pm it was 56o. By how much did the temperature change in percent? Answer: %D Temperature: (New-Old)/Old = (56o – 24o)/24o (Note: D = change) = 1.3333 = 133% Check Answer: 24o(1 + 1.3333) = 24o(2.3333) = 56o Example 2: At the beginning of 2005 the population of Albuquerque was 450,000. At the end of 2005 the population was 461,200. What was the percent change in population? %D Population = (New – Old)/Old = (461,200 - 450,000)/ 450,000 = 0.02489 = 2.489% Check Answer: 450,000(1 + 0.02489) = 461,200; The general equation to find the value of some variable increased by some percent is: New = Old(1 + %D) Profit Investment

9. An Overview of Financial Management (bdh) v1.2 Feb 17 Percent (%) Profit or Rate of Profit (continued) 3) (Security Spot Transaction) (Passage of time does not matter) A company intends to sell securities valued at $1,020.50. The sales price will be $1,086.00. What is the ROR? Return = (Sales Price - FMV) / FMV = ($1,086.00 - $1,020.50) / $1,020.50 = $65.50 / $1,020.50 = 0.064184 = 6.4184% • The FMV of the security is the investment: it is the amount of money (in today’s dollars) the company must promise to pay in the future to those who buy the security Profit Investment

10. An Overview of Financial Management (bdh) v1.2 Feb 17 Alternate Form of % Profit Equation: (New Price – Old Price) / Old Price = New Price Old Price Old Price Old Price = New Price/Old Price – 1 • In Finance, we are more concerned with Rate of Return (%) than we are with Profit ($) Consider these two investment options: A) Invest $5,000 now and receive $5,500 in one year B) Invest $100,000 now and receive $108,000 in one year Find Profit: ProfitA = $5,500 - $5,000 = $500 ProfitB = $108,000 - $100,000 = $8,000 Find Rate of Return (ROR): ROIA = ($5,500 - $5,000) / $5,000 = 0.10 = 10% ROIB = ($108,000 - $100,000) / $100,000 = 0.08 = 8% Point: • Opt B has a higher total dollar profit but Opt A was actually more profitable because it produced more money with respect to the amount of money invested • In other words, a higher proportion of Opt A’s investment was “returned” as profit (10% as opposed to 8%) • Investments expressed as Rates of Return can be compared on the same basis and without bias. -