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Financial Management - Chapter 1 Notes

Corporations sell financial assets or securities like bonds and shares to pay for real assets and the cash flows they generate. There are two types of financial decisions managers make: investment decisions about purchasing and managing real assets, and financing decisions about how to obtain and repay funds through debt or equity. A corporation's goal is to maximize shareholder wealth by investing in projects with returns higher than the opportunity cost of capital. However, the separation of ownership and control can lead to agency problems if managers prioritize their own objectives over shareholders'.

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375 views

Financial Management - Chapter 1 Notes

Corporations sell financial assets or securities like bonds and shares to pay for real assets and the cash flows they generate. There are two types of financial decisions managers make: investment decisions about purchasing and managing real assets, and financing decisions about how to obtain and repay funds through debt or equity. A corporation's goal is to maximize shareholder wealth by investing in projects with returns higher than the opportunity cost of capital. However, the separation of ownership and control can lead to agency problems if managers prioritize their own objectives over shareholders'.

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sjshubham2
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© © All Rights Reserved
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Download as DOCX, PDF, TXT or read online on Scribd
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Introduction

A corporation pays for its real assets by selling claims on them and on the cash flow that they will
generate. These claims are called financial assets or securities. Securities include bonds, shares,
specialized instruments, etc. Bank loans are assets but not securities because they are not traded in
financial markets.

There are two types of decisions made by a financial manager (Table 1.1):

1. Investment Decisions/Capital Budgeting/CAPEX: Purchase, management & disposition of real


assets. It includes both tangible assets and intangible assets such as R&D. Todays investments
generate future returns but the timing of returns may vary as in case of nuclear plants and
Walmart.
2. Financing Decisions: Sale of financial assets and meeting obligations to banks, shareholders, etc.
Capital is the firms sources of long term financing. Choice between debt and equity financing is
called capital structure decision. If firm borrows, then the firm promises to pay back the debt
plus fixed rate of interest. If shareholders (equity investors) contribute cash, then they do not
get fixed return but fraction of future profits. Equity financing can be done by equity investors or
by reinvesting the cash generated by existing assets (which can otherwise be held as future cash
reserves or paid back to shareholders). Decision to pay dividends or repurchase shares is called
payout decision.

Infosys financing strategy is it carries no debts and finances almost everything by reinvesting cash flows.

Corporation
A corporation is a legal entity owned by its shareholders. It acts as a person who can borrow or lend
money, carry on business, pay taxes, etc. Corporations directors are elected by shareholders advising
top management and signing off some corporate actions. This establishes the separation of ownership
and control. Hudsons Bay Company is one of the oldest companies formed in 1670. Disadvantages of a
corporation is time and money required to manage legal machinery and also corporation pay tax on
their profits and shareholders are taxed again.

There are three objectives of shareholders, i.e., to maximize wealth, decide time pattern of consumption
and manage risk characteristics. Time pattern of consumption and risk characteristics is managed by
shareholders. Fundamental goal of a financial manager is to maximize market value of shareholders
investment and thus maximizing shareholders wealth. However, profit maximization is not a well-
defined financial objective as:

1. Short term profits should not be maximized by damaging long-term profits.


2. Profits increased by cutting dividends and investing cash in firm is not in shareholders best
interest if the return is low.

Decision of an investment manager to take up an investment project depends on shareholders. As long


as the corporations proposed investments offer higher rates of interests than its shareholders can earn
for themselves, they will invest otherwise they will demand their money back. The minimum rate of
return is called the hurdle rate or cost of capital. It is the opportunity cost of capital. Thus, Opportunity
cost of capital is the rate of return that shareholders can get by investing on their own at the same level
of risk as the proposed project. Financial managers invests in projects which earn more than opportunity
cost of capital.

Agency Problems
Separation of ownership and control may lead managers to fulfill their own objectives. E.g.: buy
corporate jets, schedule meetings at high-end places, shy away from risky projects for job safety, etc.
Conflicts between shareholders and managers objectives create agency problems. It arises when
agents (managers) work for principals (shareholders). However, good governance systems can ensure to
handle agency problems. E.g.: Well-designed incentives, accounting standards, investment disclosure,
etc.

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