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FIN211 Financial Management Lecture Notes Text reference: Chapter 1 Topic: Role of financial management This subject provides you with an opportunity to learn about financial management. Financial management, which refers to managing an entitys financial resources, is only one part of a vast range of human activity that takes place within the world of finance. Its a world of growing importance within the global economy and one that provides a range of career opportunities. Studying finance can be a challenge (theres a fair bit of maths involved), but I can think of no aspect of finance that is boring. It may not be as exciting to you as it is to me, but if you study it diligently you will certainly find it interesting and rewarding. Financial management involves understanding, analysis and decision-making. Financial decisions need to be well informed and are typically preceded by analysis, although financial analysts in large companies are more likely to make recommendations than decisions. Financial decisions are typically made by an entitys senior managers. Directors make the strategic financial decisions of companies. Even so, financial analysts will frequently be invited to make presentations to the board or a committee of directors (and maybe get to stay for lunch). An important point to note is that a large proportion of directors time is occupied with financial matters, which implies that those without an understanding of finance could be disadvantaged when

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dealing with the higher echelons of corporate management (which may at least partially explain why Financial Management is a core subject for any business degree). The main decisions of corporate financial management involve investment, financing and dividends. The overall objective is to manage wealth: to safeguard existing stocks and to create new wealth, maybe even to maximise wealth. An unregulated pursuit of wealth can lead to resource exploitation and even industrial sabotage and espionage. Entrepreneurial activity therefore needs to be regulated in the public interest. Corporate regulation is a political process, which can invoke ideological and ethical considerations (particularly in relation to resource utilisation and control, and environmental impacts). Note that the objective of financial management is wealth maximisation, rather than profit maximisation. The current (or present) value of expected (future) cash flows (note: cash inflows, not profits) will depend on their timing and degree of risk. Risk can be regarded as an attempt to quantify uncertainties about future events. If we include the timing of future events and exclude controlled experiments, nothing about the future is certain. The lowest level of uncertainty attaches to our solar system. Beyond that all future events have higher degrees of uncertainty. In the world of business expectations about future events tend to have high levels of uncertainty (or risk).

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Alternative investments may have identical expected outcomes, but with different levels of risk, or dispersion of possible outcomes around the expected outcome. The concept of an expected outcome is similar to the concept of an arithmetic mean, except that the weights are probabilities instead of frequencies. (If youve forgotten what an arithmetic mean is, now may be an appropriate time for you to refresh your understanding of elementary statistics.) For example: consider two investments. The first investment is throwing of a dice, which will pay $10 per point. The expected outcome is $35 (1/6 $10 + 1/6 $20 + 1/6 $30 + 1/6 $40 + 1/6 $50 + 1/6 $60). The second investment is tossing a coin, which will pay $70 for heads; zero for tails. The expected outcome is also $35 (0.5 $70 + 0.5 $0). Class exercise How much would you be prepared to pay for the first investment? How much would you be prepared to pay for the second investment? Those who pay more for the first investment are said to be risk averse because it is less risky than the second investment. In the world of finance, most investors are assumed to be risk averse. Those who pay more for the second investment are said to be risk takers (also referred to as risk lovers in some texts) because it is more risky than the first investment.

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An important point to note is that risk refers to the downside of possible outcomes, which is why we sometimes refer to downside risk. In many situations downside risk is accompanied by upside potential. You can see that the tossing a coin example has both higher downside risk (100% loss) and higher upside potential (win $70) than throwing a dice. For risk averse investors, less risky cash flows are more valuable than more risky cash flows. More risky cash flows and risky projects therefore have higher required rates of return than less risky cash flows and safer projects. For example, if you were prepared to pay $32 to invest in the dice game, your expected rate of return was ($35 $32) $32 = 9.375%. If you were prepared to pay $31 to invest in the coin game, your expected rate of return was ($35 $31) $31 12.9%. This risk-return trade-off is a fundamental axiom of finance: the higher the risk the higher the required rate of return. Required rates of return and interest rates reflect many factors, including risk and inflation. A fundamental notion is that there exists a time value of money; meaning that a dollar today has more value than a dollar tomorrow (or next year) even if the future dollar is certain. Class exercise You have a right to receive $1,150 with absolute certainty one year from now. Someone offers to buy that right from you paying cash.
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How much would you sell it for? If you are prepared to sell the right for $1,000; that would imply that your time value of money is 15%. i.e. $150 $1,000 = 15%. Alternatively, $1,150 $1,000 1 = 15%. In this example $1,150 is a future value (FV) and $1,000 is a present value (PV). 15% is the time value of money expressed as an annual percentage rate (APR), also abbreviated as i A risk-free rate of interest is associated with the return generated from investing in a short-dated government security; i.e. a security that can be redeemed for a known amount of cash within a short time-frame (the shorter the better, but no longer than 3 months). The required return on a risky asset includes a risk premium over and above the risk-free rate. In a corporate setting, the theoretical objective of financial management is to maximise shareholder wealth. But achievement of that objective is entrusted to managers who theoretically act as agents of the shareholders. Shareholders like thin boardroom carpets and thick dividends, but managers may see things differently. Managers may appreciate thick boardroom carpets, ornate office furniture and gold-plated taps in executive bathrooms things that tend to diminish rather than enhance shareholder wealth. Such conflicts of interest are part of the agency problem, which refers to the possibility that managers may not always act in the
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best interests of shareholders. There are various ways of dealing with the problem: e.g. profit-based bonuses and employee share schemes, especially schemes that offer employees options over the companys shares. (If the company does well, its share price goes up and options can be exercised at a profit. If the company does less well, its share price may fall, in which case the options may expire before they can be exercised.) An investment decision typically involves the acquisition of a real asset in exchange for a financial asset; e.g. the purchase of a motor vehicle (a real asset) for cash (a financial asset). Completion of the exchange marks the end of the transaction, with no further contact required between buyer and seller. Financing typically involves a temporary transfer of purchasing power from those with a current surplus to those with a current deficit. If I dont have enough cash to buy a car, a can try to borrow. Borrowing is a financial transaction involving an exchange of financial assets. The borrower receives cash in exchange for an alternative financial asset, which secures the borrowed amount. Such a security could be an IOU or a more formal agreement to repay the debt in the future, plus interest. A security of this type is a financial asset of the lender and a financial liability of the borrower. Note that every financial asset has a matching financial liability, so that financial transactions, involving the creation of financial assets and liabilities, unlike investments in real assets, create an

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ongoing relationship between the parties until the financial liability is extinguished. Note also that financial assets and liabilities sum to zero. Although financial transactions do not themselves create wealth, financial markets (in which financial transactions occur) play an essential role in mobilising capital and empowering enterprise. Technology is often an important aspect of wealth creation, although sometimes not as critical as finance. In many large projects the critical success factor is finance, not technology (e.g. the Channel Tunnel or the new airport at Hong Kong). Many securities can be traded in financial markets: capital markets for shares and longer-dated securities; money markets for shorter-dated securities such as bills of exchange and promissory notes. Players in financial markets are investors, speculators, hedgers or arbitrageurs. In an efficient market, prices reflect all currently available information, so its not possible to profit from received information. However, market prices also reflect market sentiment, which is unpredictable and continually shifting. Market prices can therefore change, even though nothing may have changed apart from sentiment. For example, if I back a horse at 10-1 with a $1 bet, I receive a ticket worth $10 if my horse wins. If the odds drop to 2-1, I still
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only stand to win $10, but my ticket now has a replacement value of $5: a 400% increase. But that increase may simply reflect a sentimental shift among punters, rather than new information: its the same horse, same jockey, same track, same weather. Nothing may have changed except sentiment.
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