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Financial Management: An Overview - Prof. Majuya, Summaries of Finance

University of San Jose Recoletos (USJR)Finance
Prof. Russel Majuya

A comprehensive overview of financial management, covering key concepts such as working capital management, cash management, and the baumol model. It explores the relationship between stock price and profit maximization, highlighting the importance of cash flow projections and risk assessment. The document also delves into the significance of working capital management and its impact on a firm's liquidity, profitability, and risk. It further examines the optimal amount of current assets and the distinction between permanent and temporary working capital. The document concludes with a discussion on cash management, including motives for holding cash, objectives of cash management, and strategies for accelerating cash collections and controlling disbursements.

Typology: Summaries

2023/2024

Uploaded on 09/24/2024

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CHAPTER 1 An Overview of Financial Management
Finance in general
Career Opportunities
Issues of the New Millennium
Forms of Businesses
Goals of the Corporation
Agency Relationships
Finance consists of three interrelated areas:
Money and capital markets
Investments
Financial management
Career Opportunities in Finance
Money and capital markets
ofinancial institutions, including banks, insurance companies,
mutual funds, and investment banking firms.
Investments
owork for a brokerage house either in sales or as a security
analyst or as financial planners
Financial management
oFinance support staff, executives or managers
Role of Finance in a Typical Business Organization
Financial Management Issues of the New Millennium
The effect of changing technology
The globalization of business
Alternative Forms of Business Organization
Sole proprietorship
Partnership
Corporation
Sole proprietorships & Partnerships
Advantages
oEase of formation
oSubject to few regulations
oNo corporate income taxes
Disadvantages
oDifficult to raise capital
oUnlimited liability
oLimited life
Corporation
Advantages
oUnlimited life
oEasy transfer of ownership
oLimited liability
oEase of raising capital
Disadvantages
oDouble taxation
oCost of set-up and report filing
Financial Goals of the Corporation
The primary financial goal is shareholder wealth maximization, which
translates to maximizing stock price.
oDo firms have any responsibilities to society at large?
oIs stock price maximization good or bad for society?
oShould firms behave ethically?
Is stock price maximization the same as profit maximization?
No, despite a generally high correlation amongst stock price, EPS, and
cash flow.
Current stock price relies upon current earnings, as well as future
earnings and cash flow.
Some actions may cause an increase in earnings, yet cause the stock
price to decrease (and vice versa).
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CHAPTER 1 An Overview of Financial Management  Finance in general  Career Opportunities  Issues of the New Millennium  Forms of Businesses  Goals of the Corporation  Agency Relationships Finance consists of three interrelated areas:  Money and capital markets  Investments  Financial management Career Opportunities in Finance  Money and capital markets o financial institutions, including banks, insurance companies, mutual funds, and investment banking firms.  Investments o work for a brokerage house either in sales or as a security analyst or as financial planners  Financial management o Finance support staff, executives or managers Role of Finance in a Typical Business Organization Financial Management Issues of the New Millennium  The effect of changing technology  The globalization of business Alternative Forms of Business Organization  Sole proprietorship  Partnership  Corporation Sole proprietorships & Partnerships  Advantages o Ease of formation o Subject to few regulations o No corporate income taxes  Disadvantages o Difficult to raise capital o Unlimited liability o Limited life Corporation  Advantages o Unlimited life o Easy transfer of ownership o Limited liability o Ease of raising capital  Disadvantages o Double taxation o Cost of set-up and report filing Financial Goals of the Corporation  The primary financial goal is shareholder wealth maximization, which translates to maximizing stock price. o Do firms have any responsibilities to society at large? o Is stock price maximization good or bad for society? o Should firms behave ethically? Is stock price maximization the same as profit maximization?  No, despite a generally high correlation amongst stock price, EPS, and cash flow.  Current stock price relies upon current earnings, as well as future earnings and cash flow.  Some actions may cause an increase in earnings, yet cause the stock price to decrease (and vice versa).

Agency relationships  An agency relationship exists whenever a principal hires an agent to act on their behalf.  Within a corporation, agency relationships exist between: o Shareholders and managers o Shareholders and creditors Shareholders versus Managers  Managers are naturally inclined to act in their own best interests.  But the following factors affect managerial behavior: o Managerial compensation plans o Direct intervention by shareholders o The threat of firing o The threat of takeover Shareholders versus Creditors  Shareholders (through managers) could take actions to maximize stock price that are detrimental to creditors.  In the long run, such actions will raise the cost of debt and ultimately lower stock price. Factors that affect stock price  Projected cash flows to shareholders  Timing of the cash flow stream  Riskiness of the cash flows Basic Valuation Model  To estimate an asset’s value, one estimates the cash flow for each period t (CFt ), the life of the asset (n), and the appropriate discount rate (k)   Throughout the course, we discuss how to estimate the inputs and how financial management is used to improve them and thus maximize a firm’s value. Factors that Affect the Level and Riskiness of Cash Flows  Decisions made by financial managers: o Investment decisions o Financing decisions (the relative use of debt financing)  o Dividend policy decisions  The external environment Working Capital Background  Working Capital Management  WC Concepts and Objectives  Working Capital Policy  Issues on Working Capital  Its Components and WC Needed of the Frim Working Capital Management  Decisions relating to working capital and short term financing are referred to as working capital management. Short term financial management is concerned with decisions regarding to CA and CL.  Management of Working Capital refers to management of CA as well as CL.  An increase in working capital indicates that the business has either increased current assets (that is received cash, or other current assets) or has decreased current liabilities, for example has paid off some short-term creditors.  The fundamental principles of working capital management are reducing the capital employed and improving efficiency in the areas of receivables, inventories, and payables Working Capital Concepts Net Working Capital = Current Assets – Current Liabilities. Gross Working Capital = The firm’s investment in current assets. Working Capital Management = The administration of the firm’s current assets and the financing needed to support current assets. What Is Working Capital?

Impact on Liquidity Optimal Amount (Level) of Current Assets Impact on Expected Profitability Optimal Amount (Level) of Current Assets Impact on Expected Profitability Optimal Amount (Level) of Current Assets Impact on Risk Optimal Amount (Level) of Current Assets Summary of the Optimal Amount of Current Assets Permanent and Temporary Working Capital  Working capital is permanent to the extent that it supports constant or minimum level of sales

 There is always a minimum level of CA which is continuously required by a firm to carry on its business operations.  Therefore , the minimum level of investment in CA that is required to continue the business without interruption is referred as permanent working capital.  Temporary working capital supports seasonal peaks in business  This is the amount of investment required to take care of fluctuations in business activity or needed to meet fluctuations in demand consequent upon changes in production and sales as a result of seasonal changes. DISTINCTION  Permanent is stable over time whereas variable is fluctuating according to seasonal demands.  Investment in permanent portion can be predicted with some profitability but investment in variable can not be predicted easily.  Also, permanent capital requirements should be financed from L-T sources, but, S-T funds should be used to finance temporary working capital needs of a firm. Working Capital Financing Policies = Classifications of Working Capital  Components o Cash, marketable securities, receivables, and inventory  Time o Permanent o Temporary Permanent Working Capital The amount of current assets required to meet a firm’s long-term minimum needs. Temporary Working Capital The amount of current assets that varies with seasonal requirements. Financing Current Assets: Short-Term and Long-Term Mix Spontaneous Financing: Trade credit, and other payables and accruals, that arise spontaneously in the firm’s day-to-day operations.  Based on policies regarding payment for purchases, labor, taxes, and other expenses.  We are concerned with managing nonspontaneous financing of assets. Hedging (or Maturity Matching) Approach  A method of financing where each asset would be offset with a financing instrument of the same approximate maturity.

CASH MANAGEMENT

What is Cash?  In narrow sense: currency and generally accepted equivalents of cash like cheques, drafts etc.  In broad sense: includes near-cash assets, such as marketable securities and time deposits in banks. o They can be readily sold and converted into cash. o Can serve as a reserve pool of liquidity. o Also provide short term investment outlet for excess cash. Cash Management  Cash management is concerned with the managing of: o cash flows into and out of the firm, o cash flows within the firm, and o cash balances held by the firm at a point of time by financing deficit or investing surplus cash Four Facets of Cash Management  Cash planning  Managing the cash flows  Optimum cash level  investing surplus cash Motives of Holding Cash  Transaction motive  Precautionary motive  Speculative motive  compensating motive Transaction motive  Holding of cash to meet routine cash requirements to finance the transactions which a firm carries on in the ordinary course of business. Precautionary motive  The cash balances held in reserve for random and unforeseen fluctuations in cash flows.  A cushion to meet unexpected contingencies. o Floods, strikes and failure of imp customers o Unexpected slowdown in collection of accounts receivable o Sharp increase in cost of raw materials o Cancellation of some order of goods  Defensive in nature Speculative motive  Is a motive for holding cash/near-cash to quickly take advantage of opportunities typically outside the normal course of business.  Positive and aggressive approach  Helps to take advantage of: o An opportunity to purchase raw materials at reduced price o Make purchase at favorable price o Delay purchase on anticipation of decline in prices o Buying securities when interest rate is expected to decline Compensating motive  Is a motive for holding cash/near-cash to compensate banks for providing certain services or loans.  Clients are supposed to maintain a minimum balance of cash at the bank which they cannot use themselves. Objectives of cash management  Meeting payments schedule o It prevents insolvency o relationship with bank is not constrained o Helps in fostering good relationships. o Cash discount can be availed o Strong credit rating o Take advantage of business opportunities o Can meet unanticipated cash expenditure with a minimum of strain.  Minimizing funds committed to cash balances o High level of cash: large funds remain idle o Low level of cash: failure to meet payment schedule Managing Cash Collections and Disbursements  Accelerating Cash Collections  Controlling Disbursements

Accelerating Cash Collections Contd.......  Decentralised Collections o number of collection centres o Collection centres will collect cheques from customers and deposit in their local bank accounts o They will deposit the funds to a central bank  Lock-box System o Collection centers are established considering the customer locations and volume of remittances. o At each centre the firm hires a post office box o Remittances are directly picked from the bank whom the firm gives the authority  Advantages of lock-box system are o cheques are deposited immediately upon receipt of remittances. Eliminates the period between the time cheques are received by the firm and the time they are deposited in the bank for collection Controlling Disbursements  It means delay the payments as much as possible. Can help the firm in conserving cash and reducing the financial requirements. o Disbursement or Payment Float The size of the minimum cash balance depends on:  How quickly and cheaply a organization can raise cash when needed.  How accurately managers can predict cash requirements. Cash budget helps in this.  How much precautionary cash the managers need for emergencies. The organization’s maximum cash balance depends on:  Availability of (short-term) investment opportunities e.g. money market funds, CDs, commercial paper  Expected return on investment opportunities. o e.g. If expected returns are high, organizations should be quick to invest excess cash  Transaction cost of withdrawing cash and making an investment  Demand for Cash for daily transactions Cash Conversion Cycle  Measures the number of days from cash being paid to the suppliers up to the time cash is received from sales.  Period of time from the purchase of inventory up to collection of receivables.  CCC = ARP + AIP – APP where:  ARP = Average Receivable Period = Ave Receivables / Ave Daily Sales  AIP = Average Inventory Period = Ave Inventory / Ave Daily Sales  APP = Average Payable Period = Ave Payable / Ave Daily Purchases Cash Conversion Cycle Problem Cash ModelsBAUMOL MODEL Bumol recognized the similarities between cash and inventory management. He extended the economic order quantity (EOQ) model to examine its implications to cash management. The Baumol model assumes the cash manager invests excess funds in interest bearing securities and liquidates them to meet the firm's demand for cash. As investment returns increase, the opportunity cost of holding cash increases and the cash manager decreases cash balances. As transaction costs (cost of liquidating short-term investments) increase, the cash manager decreases the number of times he liquidates securities, leading to higher cash balances.