Financial Management (Lecture 1)

Financial Management(N12403) Lecture 1 Introduction

Lecturer: Farzad Javidanrad

(Autumn 2014-2015)

Some Preliminaries • Types of Firms: 1. Sole Trader (sole proprietorship): Small business entity (unit) run by an individual who gets all profits with total responsibility about all debts. Most common and cheapest type of business structure in the world. Not many regulations applied in its establishment. The owner has unlimited liability (legal responsibility) for business debts & obligations. In the case of bankruptcy (liquidation) the owner’s assets can be treated as the business asset in order to clear the debt.  Tax is calculated based on the owner’s income tax. The life of this type of firm is limited by the life of the owner.

Some Preliminaries 2. Partnership: Small/Medium business entity with two or more owners who equally responsible (in case of General Partnership) for all debts of the business. General Partnerships: All partners are liable for the debts.

Two types of partnerships Limited Partnerships: At least one partner is considered as the general manager and have unlimited liability.

The liability of the limited partner(s) is limited to the contribution of each partner. They are taxed based on their personal income. The life of the business is terminated if the general partner(s) dies or quits.

Some Preliminaries 3. Corporations: Large company (or a group of companies) authorised by law to act as a single legal entity run by a set of directors elected by shareholders (owners) with limited liability which means they are not totally responsible for the amount debt of the company when it fails. (e.g. BP, Tesco, British Airways and etc.)

 The ownership belongs to the shareholders but the management of the corporation is with the Chief Executive Officer (CEO), which is the most senior manager of the corporation and has maximum responsibility in the company. The CEO manages several subordinate executives, including the Chief Financial Officer (CFO), also known as Finance Director in the UK, who is responsible for financial planning (investment decisions and financial decisions) and risk assessment.

Role of a Financial Manager in a Corporation

Adopted from Hillier’s PPT , The McGraw-Hill Companies, 2012

The Goal of Financial Management

Adopted from Hillier’s PPT , The McGraw-Hill Companies, 2012

Types of Firms Sole Proprietorship

Partnership

Limited Corporation

• Owned and Managed by one person • Very easy to form • Profits taxed as personal income • Unlimited liability • Life of company linked to life of owner • Amount of funding is limited by owner’s personal wealth

• Easy to form • Requires a partnership agreement • Limited and unlimited partners • Partnership is terminated when a partner dies or leaves the firm • Difficult to raise cash • Profits taxed as personal income • Controlled by general partners – sometimes votes are required on major business decisions

• Articles and Memorandum of Incorporation Required • Limited Liability • Profits taxed at corporate tax rate • Board of Directors • Life of company hypothetically unlimited

Adopted from Hillier’s PPT , The McGraw-Hill Companies, 2012

Some Preliminaries The separation of ownership and management gives a chance of permanent life to a corporation. Shareholders can transfer their shares to others and CEOs can be replaced by the owners but the corporation can continue as long as it is profitable for the owners. Shareholders have limited liabilities based on their participation in investment in the company (number of shares). Their shares represent partial or fractional ownership of the company. By issuing bonds and shares corporations are able to finance their investment projects. Bond holders are lenders (creditors) and shareholders (or stockholders) are investors. In case of bankruptcy, lenders have higher priority on claiming the assets, compare to investors, i.e., they will be paid first from selling the assets. If the liabilities are more than assets, shareholders’ equity (residual value) will be negative.

Partnership VS Corporation

Adopted from Hillier’s PPT , The McGraw-Hill Companies, 2012

Partnership VS Corporation

Adopted from Hillier’s PPT , The McGraw-Hill Companies, 2012

Corporate Governance & Corporate Finance • Corporate Governance: It refers to a set of rules, practices and mechanisms by which a corporation is directed and controlled. These rules and practices should guarantee keeping the balance between different and sometimes conflicting rights of stakeholders including shareholders, creditors, managers, customers, government and local or international communities. • Corporate Finance: It is the part of finance that deals with the financial activities necessary for running a corporation and maximising the value of the company in favour of the shareholders (owners).

Corporations • Corporations invest in variety of assets to increase their flow of returns and consequently to maximise the market value of their shares and in order to finance these investments they either use their own resources (re-investment) or outside resources (borrowing / selling shares). • Assets: An economic (tangible or intangible) resources with a price (subject to fluctuations) which is owned /controlled by individual(s) or companies with a capability of producing future returns. E.g. machines, inventories, buildings, lands, cash, vehicles, patents and etc.

Real & Financial Assets • Assets can be divided into real or financial: Real assets are physical or tangible assets such as commodities, machineries, buildings, precious metals/stones, arts, equipment and etc.

Financial assets are non-physical or intangible assets such as bank accounts, bonds, shares and etc. Financial assets are more liquid than real assets, which means they can be converted to money quickly. Money is the most liquid asset as it can be used for purchasing goods and services or for meeting the obligations and offsetting the claims. Adopted from http://www.batr.org/totalitariancollectivism/100911.html

Financial Assets & Securities • If corporations borrow from individuals or financial institutions, in fact, they sell claims (promises) on their existing assets or their future cash flow to the lenders. It means lenders can claim them based on their contract. • If the claims are not transferable or tradable they are just financial assets (such as bank deposits, bank loans) but if they are tradable in the financial markets they are special financial assets which are called securities (such as bonds, shares).

Balance Sheet • Balance Sheet: A financial statement that reviews a company's assets, liabilities and shareholders' equity at a specific time such as the end of financial year. • This statement shows how a company deals with its assets and debts and it is a measure for investors (shareholders) and creditors (bondholders) to assess the companies value. • In any balance sheet there should be a balance between asset side and the liability side at the end of financial year, i.e.: Assets= Liabilities + Shareholder’s Equity The logic behind the formula is clear: A company should purchase its assets either through investors (shareholders) or creditors.

Balance Sheet • Here is an example of a simple balance sheet. • The difference between current assets (short-term assets) and current liabilities (short-term liabilities) is called Net Working Capital. • Non-current items refer to the longterm elements in the balance sheet. Adopted from http://www.accounting-tutorial.com/definition-balance-sheet-components

Balance Sheet of Inmarsat plc in 2009 & 2010

Adopted from Hillier’s PPT , The McGraw-Hill Companies, 2012

Investment & Financing Decisions • Two important and broad questions that a financial manager (CFO) in any corporation should face with: Investment Decision

a) What investments should be made? and how to manage the new & existing assets? What is the risk of acquiring the new assets and what is the risk or/and opportunity of keeping existing assets? Financing Decision

b) How should the new investments be financed? and how the obligations to investors or lenders should be met? Is the reinvestment option is doable? What is the payout policy?

Capital Structure • Corporations can borrow from lenders (in exchange for a promise to pay back the debt plus a fixed/variable rate of interest) or they can issue shares to attract equity investors (share holders) in the stock market (in exchange for sharing profit and/or cash flow through dividend). • The decision to go for debt or equity financing is called the capital structure decision. • In some ways financing decisions are less important than investment decisions. Financial managers say that “value comes mainly from the asset side of the balance sheet.” In fact the most successful corporations sometimes have the simplest financing strategies. (Principle of Corp. p. 4)

Microsoft Example • Microsoft as an example: Price of shares (at the end of 2011)=$26 Number of shares =8.4 billion So, Market Capitalisation =26 × 8.4 = $218 𝑏𝑖𝑙𝑙𝑖𝑜𝑛 Not by going to debt, just by re-investment of cash flow

Separation of Ownership & Control • Some corporations are known as public companies which means their shares are traded in the market (New York, London, Tokyo and other Stock Exchange markets) and any one can buy their shares (e.g. Microsoft, Facebook, …). • The owners are dispersed around the globe and none of them has the main power to control the company. This means there is a separation of ownership and control, which gives the corporations a permanence characteristic.

Principal-Agent Problems • Separation of ownership and control generates Principal-Agent Problems. It happens in business and even in politics (between politicians and voters). The problem arises when the directors/managers pursue their own interests rather than those of the owners. • In other words, it concerns about the problem of encouraging the agent (here; the managers/directors) to work in the best interests of the principal (here; the shareholders=owners) rather than their own interests. • e.g. going for short-term projects when long-term strategies are more beneficial or going for risky projects with high returns in an unstable economic atmosphere). • Lack of attention to this problem may bring the value of the company down which has a direct impact of the wealth of the shareholders.

Principal-Agent Problems • It might arise as the result of conflicting interests and the presence of asymmetric information, as one party has more information than another. • How to attack the problem?

a) Shareholders (principles) can offer some considerable incentives for the managers and directors who work hard to increase the value of the company (increase the wealth of the shareholders) b) They can increase their monitoring on the decisions of the agents c) They can increase their control over very important decisions. • But all of them are costly and create, what is called as agency cost for the principals.

Hurdle Rate & Opportunity Cost • Shareholders expect to have a return from a new investments (offered by the financial manager of the corporation) above the return they can get by investing their money in other projects (with the similar level of risk taking). This expected minimum return is called hurdle rate which can be interpreted here as an opportunity cost of the shareholder’s capital. http://catngeek.files.wordpress.com/2013/02/pause-dc3a9jeuner-culture-05.jpg

Opportunity Cost of Capital • Opportunity Cost is the cost of losing a return from the best alternative action (policy/investment) that has occurred because of choosing a specific action (policy/investment). • In case you are able to choose between several mutually exclusive options (opportunities) the cost of losing the return (foregone return) from the best alternative option (opportunity) is your opportunity cost.

• What is your opportunity cost as being a student?

Time Value of Money • A £100 today or a £100 next year; which one would you accept? • In some cases, such as Germany in 1923, we need to change the time horizon from “year” to “day”.

Compound Rate of Interest • The difference between £100 today and £100 next year is caused by interest rate (r) or/and inflation. • If 𝑟 = 7% and £100 is invested, the future value of that £100 after a year will be:

£100 + £100 × 0.07 = £100 1 + 0.07 = £107 And if the investment is going on for more years we will have: £100 × 1.07 = £107 £107 × 1.07 = £100 × 1.072 = £114.49 £114.49 × 1.07 = £100 × 1.073 = £122.50

1st year 2nd year 3rd year

Your investment increases at a compound rate as you have a interest on both the original value and its interests. (compound interest)

Future Value & Present Value • In general, for any interest rate 𝑟 the future value (FV) of 𝐶0 after 𝑡 years will be: 𝐹𝑉 = 𝐶0 × (1 + 𝑟)𝑡 • Now, imagine the question is reversed: How much do we need to invest today to generate £114.49 after two years if the compound rate of interest is 7%? • Obviously, £114.49 = £100 2 (1.07) • It means the present value of £114.49, which can be obtained after two years, is £100.

Future Value & Present Value • In general, at any interest rate 𝑟, the present value (PV) of 𝐶𝑡 , which is obtained after 𝑡 years, can be calculated by: 𝐶𝑡 𝑃𝑉 = (1 + 𝑟)𝑡 Where

1 (1+𝑟)𝑡

is called the discount factor and 𝐶𝑡 is the future value.

• To value of an investment opportunity a financial manager should pay attention to: 1. The present value of the expected cash flow from the investment project 2. The total cost (or even expected cost, if it continues for several years) 3. The opportunity cost of the investment project.

About Cash Flow

The most important item to take from financial statements (see Table 3.4 Hillier, p. 69)

Total Cash Flow comes from operating activities, investing activities, and financing activities

Adopted from Hillier’s PPT , The McGraw-Hill Companies, 2012

Cash Flows from Assets = Cash Flows to Creditors and Equity Investors

Cash Flow is NOT the same as Net Working Capital

The Present Value of a Multiple Cash Inflows • If an investment project has a series of expected cash flows 𝐶1 , 𝐶2 , ⋯ , 𝐶𝑡 extending over 𝑡 years and if we also assume that the interest (or discount) rate 𝑟 has no significant change in this period, the present value of all expected returns will be calculated by : 𝐶1 𝐶2 𝐶𝑡 𝑃𝑉 = + + ⋯+ 2 (1 + 𝑟) (1 + 𝑟) 1+𝑟

𝑡 𝑡

= 𝑖=1

𝐶𝑖 1+𝑟

𝑖

• This is sometimes called the discounted cash flow (DCF), where ∑ is the symbol of summation for the series. • DCF can only be used if a financial manager is certain about the expected future cash flows. This means, risk is not considered in this calculation. Using DCF when risk is involved leads us to a wrong calculation.

The Net Present Value • If the cost of a project is paid in the beginning, so, there will be only one cash outflow (a negative value) but if there is a series of cash outflows the present value of them can be calculated by the same formula. • In both cases, the net present value (NPV) of an investment project is: 𝑁𝑃𝑉 = 𝑃𝑉 − 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 > 0 Case 1: Just one investment (𝐼0 ) in the beginning: 𝑡

𝑁𝑃𝑉 = 𝑖=1

𝐶𝑖 − 𝐼0 > 0 𝑖 1+𝑟

Case 2: Series of investment during the life time of the project: 𝑡

𝑁𝑃𝑉 = 𝑖=1

𝐶𝑖 − 𝑖 1+𝑟

𝑚

𝑗=0

𝐼𝑗 1+𝑟

𝑗

> 0 (𝑚 ≤ 𝑡)

The NPV & Rate of Return Rules • When the returns (cash inflows) are on-time (without any delay) and also no risk is involved, The NPV can be used as a rule to accept or reject an investment project. Among all possible projects the one with the highest NPV might be the best project to invest on. • Rate of Return is another rule that financial managers might consider to decide whether or not to invest on a project.

• Rate of return of a project shows the share of profit in the investment. In other word, it represents what proportion of the investment is the profit, so; 𝑃𝑟𝑜𝑓𝑖𝑡 𝑅𝑎𝑡𝑒 𝑜𝑓 𝑟𝑒𝑡𝑢𝑟𝑛 = 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡

The NPV & Rate of Return Rules • Suppose we know a project is as risky as investing money in the stock market and suppose we know the rate of interest paid in the stock market for such investment is 𝛼% ; if the rate of return (as a percentage) resulting from investing in the project is bigger than 𝛼, we can consider the project as a profitable project. • So, the second rule for a financial manager to accept an investment project is: 𝑅𝑎𝑡𝑒 𝑜𝑓 𝑟𝑒𝑡𝑢𝑟𝑛 > 𝛼 • In case, the financial manager decides to invest in the project (instead of investing in the stock market) the opportunity cost of the decision is losing 𝛼% of the total investment.