Financial Management - An Overview

Financial management revision article series

Authors

• Narayana Rao

Published

Version 8

Last edited: 18 Oct 2009 on Knol

Exported: 26 Nov 2011

Updated on Blog 30.5.2012

Original URL: http://knol.google.com/k/-/-/2utb2lsm2k7a/377

Financial Management - The Scope

Financial management is concerned with monitoring financial markets, approving financial investment projects in the organization, procuring the finance from the market to finance the project, and conforming to the contracts signed with the providers of finance.

Thus the important activities are

1. Monitoring financial markets to understand the desires of the providers of finance

2. Investment decisions within the company

3. Financing decisions - From whom to procure funds?

4. Dividend decisions - Conforming to the contracts.

Evolution of Corporate Finance Area or Subject

The early phase of corporate finance subject had  focus on episodic events in the life cycle of a corporation. The typical and popular book of this phase is the book, The Financial Policy of Corporations by Arthur S. Dewing, Professor of Finance at Harvard University (published in 1918). The book had a descriptive and institutional material regarding formation of company, issuance of capital, major expansion, merger, reorganisation, and liquidation.

In the early 40s a transition occurred and along with the external focus related to major events, greater emphasis was placed on the day-to-day internal activities of financial management in the area of funds requirement analysis, planning, and control. A representative work of this phase is Essays on Business Finance by Wilford J . Eiteman et al. (published in 1953).

The modern phase began in mid-fifties with application of economic theory and quantitative methods of analysis. Financial decision making has become analytical and quantitative and financial decision making activity has become dominant.

Goals of Financial Management

Financial theory, rests on the premise that the objective of the firm should be to maximize the value of the firm to its equity shareholders.

This value is could be equal to the market price of shares in stock market with good liquidity. But financial managers may have to calculate the discounted value of expected future cash flows and compare with the market price. In case of discrepancies they may have to communicate to the financial markets their point of view.

Basic Considerations of Financial management: Risk and Return

In the context of evaluating an investment proposal, from the point of view of finance function, risk and return are the relevant dimensions. Higher return from a proposed project increases market value and higher risk decreases market value.

Financial Decisions in a Firm

While a formally specified person performs the financial market monitoring and procurement of finance functions, the investment decisions and performance of investments are in the hands of operating executives. Finance sense has to be there in each and every employee of an organization to make an organization financially viable and successful.

The marketing persons who do market research provide estimates of market size, revenue generation which form the basis of project proposals.

The engineers, who select location for the plant, equipment shape the investment decision of the firm by providing various alternatives.

The purchase managers actions influence the level of inventories.

The sales managers' assessments determine the receivables policy.

Department managers actually plan and control expenditures.

Thus many activities that are a part of financial function are performed by operating executives. But there are many tasks of finance function that can be done by specialist financial officers. Traditionally, the financial officers are grouped into controller's office and treasurer's office.

The treasurer's office is responsible for

Obtaining finance

Banking relationship

Cash management

Credit administration

Controller's office is responsible for

Financial accounting

Internal auditing

Taxation

Management accounting and control

 

References

Prasanna Chandra, Financial Management, 5^th Ed.,  Tata McGraw Hill, 2001
Brealey and Myers, Corporate Finance, Fifth Edition, Prentice Hall India, 2001

 

 

 Video Lecture on Introduction to  Financial Management

__________ __________

Analysing Financial Performance using Financial Statements

Financial management revision article series

Analytical Methods or Components

Ratio analysis

Ratios are calculated using line items from financial statements. For certain ratios there are ideal values indicated in the financial literature. Certain ratios need to have specific values based on company's declared policies. Like debtor turnover ratio must have a range of values based on the credit period specified or offered by the company to its credit customers.

Dupont analysis

It breaks down the return on equity into component parts.

Comparative analysis

Comparing similar ratios of other companies, one can assess the relative strength of the company under consideration.

Applications

Assessment of Financial Health of the Company

Statistical models using financial information or ratios

Two statistical models designed to predict the likelihood of severe financial distress for a corporation. One of these models is the Altman Z-Score [Altman, 2002]. This model is applicable to any type of firm. The other model is a scoring approach developed by Pilarski and Dinh that is applicable specifically to air carriers [Pilarski and Dinh, 1999].

Altman's 1968 Model

The following calculation is used to arrive at the total Z-Score:
Z = 1.20(X1) + 1.40 (X2) +3.30(X3) +.60(X4) + .99(X5)

X1 = Working Capital / Total Assets
X2 = Retained Earnings / Total Assets
X3 = Earnings before Interest and Taxes / Total Assets
X4 = Market Value Equity / Book Value of Total Debt
X5 = Sales / Total Assets
Z = Overall Score

Credit granting decisions

Equity investment decisions

(Graham - Rao Method )

Problems

Different company may use accounting policies with some differences. Hence comparison may sometimes create problems.

Guidelines

Inflation

Concept of Balanced Scorecard

 
Prasanna Chandra, Financial Management, 5^th Ed.,  Tata McGraw Hill, 2001
Brealey and Myers, Corporate Finance, Fifth Edition, Prentice Hall India, 2001
 

Original Knol - http://knol.google.com/k/narayana-rao/analysing-financial-performance-using/2utb2lsm2k7a/ 338

Private Equity - Business concept

Private equity firms exit from their investments through one of three ways:

an IPO,
a sale or merger of the company,
or a recapitalization.

Leading investment banks are committing their own capital or principal money to PE investments. Also various sponsors are floating PE funds to attract funds from HNIs into PE investments.



Most private equity funds require significant initial investment (usually upwards of $1,000,000) plus further investment for the first few years of the fund.

Limited partnership interest is the dominant legal form of private equity investments.

Once invested, money is locked-up in long-term investments which can last for as long as twelve years. Distributions are made only as investments are converted to cash; limited partners typically have no right to demand that sales be made.

If a private equity firm can't find good investment opportunities, it will not draw on an investor's commitment.

The risk of loss of capital is typically higher in venture capital funds, which invest in companies during the earliest phases of their development, and lower in mezzanine capital funds, which provide interim investments to companies which have already proven their viability but have yet to raise money from public markets.

Consistent with the risks outlined above, private equity can provide high returns, with the best private equity managers significantly outperforming the public markets.

The potential benefits of annual returns can range up to 30% for successful funds. It may not be the average return on PE funds.

PE Roots

The roots of PE and venture capital are same. In 1946, the American Research and Development Corporation (ARD) was formed to encourage private sector institutions to help provide funding for soldiers that were returning from World War II. They had an operating philosophy that was to become significant in the development of both private equity and venture capital: they believed that by providing management with skills and funding, they could encourage companies to succeed and in doing so, make a profit themselves. ARD succeeded in raising approximately $7.4 million, and they did have one rousing success; they funded Digital Equipment Corporation (DEC). By the 1970s such private participation had permeated into the private enterprise formation, but till in the late 1970s, the task was being largely carried out by investment arms of a few wealthy families, such as the Rockefellers and Whitneys. In the 1980’s, FedEx and Apple were able to grow because of private equity or venture funding, as were Cisco, Genentech, Microsoft, Avis, Beatrice Foods, Dr. Pepper, Gibson Greetings, and McCall Patterns.



Most private equity funds are offered only to institutional investors and individuals of substantial net worth. This is often required by the law as well, since private equity funds are generally less regulated than ordinary mutual funds. For example in the US, most funds require potential investors to qualify as accredited investors, which requires $1 million of net worth, $200,000 of individual income, or $300,000 of joint income (with spouse) for two documented years and an expectation that such income level will continue.


Books

Private Equity Funds: Business Structure and Operations,
By James M. Schell, Published 1999, Law Journal Press.
Gives attorneys, investment professionals, tax practitioners, and corporate lawyers the tools and guidance needed to handle various aspects of a private investment fund.

Private Equity: Fund Types, Risks and Returns, and Regulation
By Douglas Cumming
John Wiley, 2010
http://books.google.com/books?id=WPu3t_-RmLsC

Risk Premium

Risk premium plus Risk free rate of return is the rate of return demanded on a security by investors in the market.



Concept Definition and Explanation

Rate of return required on a security or asset has three components.
1. Pure time value of money.
2. Inflation premium
3. Risk premium

As securities are issued by corporate entitiies engaged in business activities, risk arises due to the following sources of risk.

1. Operating risk: Business organzations have fixed costs and as sales vary from year to year, in some years contribution from sales can be less than the fixed cost leading to reporting of loss by the company.

2. Financial risk: Many business organizations borrow to increase the capital employed in the business. This would lead to fixed interest cost commitment. In years when operating profits are low or small, the fixed interest cost will depress after-financial cost profit.

3. Liquidity risk or market risk: Securities are to be sold in the secondary market, and there are price fluctuations in the market depending on the liquidity conditions in the market.


Investors demand a risk premium to compensate them for the variability of return that arises due to various sources of risk of the security. This risk premium forms part of expected return as well as nominal return specified on fixed income securities.

References:
Reilly, Frank and Keith Brown, Investment Analysis and Portfolio Management

Research Papers

Equity Risk Premiums (ERP) : Determinants, Estimation and Implications: Empirical Study 2011 Edition by Aswath Damodaran
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1769064

_______________________________________________________________________________
Concept Articles

Blog Post by Aswath Damodaran, February 25, 2011
http://aswathdamodaran.blogspot.com/2011/02/equity-risk-premiums-2011-edition.html
________________________________________________________________________________

Stock Market Efficiency Theory and Implications for Financing Decisions

Financial Management Revision Article

Stock prices follow a distribution called random walk distribution.

Authors

• Narayana Rao

Published

All Rights Reserved

Version 8

Last edited: 24 Nov 2011

Exported: 26 Nov 2011

Original URL: http://knol.google.com/k/-/-/2utb2lsm2k7a/360

Random walk hypothesis of stock prices

Stock prices follow a distribution called random walk distribution. The simple explanation of this distribution is that the best estimate for the future state of the system is the present state itself. Random walk is explained as the walk of a drunkard. You don't know when he will turn and the best estimate for his future position is present position only.

A Poem written by me on random walk. The poem is from the knol Stock Market Poems - Collection 2 (all rights reserved).

Trend Talk and Random Walk

 

You can make money in quick time, said Dow

Speculate and make money now

I shall tell you how

through a theory named Dow.

 

Dow was the editor

of a stock market mirror

Wall Street Journal

for stock market personnel.

 

Trends, trends, trends

First one is for long term

Second one is for medium term

Third may be random

whose meaning you cannot fathom.

 

Follow the trend

which is your friend

You can make money in quick time

even with a dime

from anywhere

a telegraph office is there

 

 

There is no trend

to follow and send

stocks to further high end

Said a statistician

trying to become a physician.

 

Stock prices follow random walk

Similar to that of a drunkard

who may be blinkered

You don't know when he will turn

Each and every step is uncertain.

 

Each move is independent

irrespective of the time spent

Charts are valueless

You are clueless

 

Random walk, random walk

Ignore Wall Street talk

Save your time and dime

Invest for long time

Avoid the short time

 

Trend talk and

random walk

clash every day

Some one will pay

the other every day

 ----------------------

Efficient market hypothesis/theory (EMH)

The random walk hypothesis was extended to efficient markets hypothesis. According to this theoretical conjecture,stock markets are efficient with respect to processing the information.

Weak form, Semi-strong, and Strong forms

As the theoretical conjecture talks of efficient information processing, levels of information were brought into the refined forms of EMH.

Historical information released by the stock markets

Information released by the company regarding future activities

All information including information not released by the company.

Weak form EMH says stock market is efficient in processing historical information released by the stock markets.

Semi strong form EMH says stock market is efficient in processing information released by the company regarding future activities.

Strong form EMH says stock market is efficient in processing all information including information not released by the company.

Empirical evidence

Serial correlation tests

Runs tests

Filter tests

Event studies

Studies of performance of mutual fund managers or schemes

Market efficiency  - Implications for corporate finance

If the market is efficient, companies need not time their public issues.

 

References

 

Prasanna Chandra, Financial Management, 5^th Ed.,  Tata McGraw Hill, 2001

Brealey and Myers, Corporate Finance, Fifth Edition, Prentice Hall India, 2001

 

Copy posted to http://nraomtr.blogspot.com/2011/11/stock-market-efficiency-theory-and.html

 

 

Comments

nifty tips

Markets dramatically change they their flow and no one exactly produce or expect 100% from their profits . Choosing the right indicator or analyzing software blended with human aspect gives better results.

regards:- http://www.trade4target.com/

Nifty Tips - 30 Sep 2011

Valuation of Bonds and Equity Shares - Basic Principles and Models

Financial Management Revision Article

Basic Principle

The valuation of any asset, real financial is equal to the present value of cash flows expected from it.

Bond valuation

Valuation of a bond requires an estimate of expected cash flows and a required rate of return specified by the investor for whom the bond is being valued. If it is being valued for the market, the markets expected rate of return is to be determined or estimted.

A simplified bond valuation model or exercise is based on the following features of the bond.

Fixed coupon rate for the term of the bond.

Coupon payments are made annually and the next coupon payment is receivable in year from now.

The bond will be redeemed at par on maturity.

The bond is noncallable. It will not be redeemed before the maturity.

The formula for discounting the associated cash flows is

Sum of all  C/(1+r)^t (t = 1 to n)+ P/(1+r)ⁿ

Where C = annual coupon payment

r = required rate of return

n = number of years to maturity

P = Par value 

The formula can be modified for various complex features of bond, like half yearly payments, redemption at premium on maturity etc.

Equity Share Valuation

Dividend discount model

Dividend valuation model is conceptually a very sound approach.

According to this approach the value of an equity share is equal to the present value of dividends expected from its ownership plus the present value of the sale price expected when the equity share is sold.

Simple Model: Constant dividend with no growth

The simple model of equity share valuation has assumption that the dividend per share remains constant year after year at a value D. Dividend will be received at the end one year now from now and required rate of return or that of market is r.

Then Present value of the equity share = V = D/r

Model with growth less than the required rate of return

If there is an expected growth in dividends whch is g constant in all the years in the future and also less than r, the required rate of return, the valuation formula is

V = D/(r-g)

High Current Growth Companies

The simple valuation model proposed for companies that have a high growth in dividends currently is two growth period model. In this model during the first period of n years, the growth g1 is higher than r. In the remaining period growth g is less than r.

The present value of dividends of n years is found out and the present value  terminal value of [D_(n+1) /r-g] is added to it to find the value of the share.

More complexities can be added to the model.

References

 

Prasanna Chandra, Financial Management, 5^th Ed.,  Tata McGraw Hill, 2001

Brealey and Myers, Corporate Finance, Fifth Edition, Prentice Hall India, 2001

 

Originally posted in Knol
http://knol.google.com/k/narayana-rao/valuation-of-bonds-and-equity-shares/ 2utb2lsm2k7a/ 370