OBJECTIVES OF FINANCIAL MANAGEMENT,

FINANCIAL ASSETS AND FINANCIAL

MARKETS
 Corporation
Advantages:
Unlimited life:
• A corporation can continue even after the death of its original
owners.
Easy transferability of ownership interest:
• Ownership interests can be divided into shares of stock, which in turn
can be transferred far more easily than can proprietorship &
partnership interests.
Limited Liability:
• The liability of the shareholders is limited up to the extent of nominal
value of shares held by them. Creditors and banks cannot confiscate
personal properties of director & shareholders in case of its
bankruptcy.
 Corporation
Limitations:

• Double Taxation:
Corporate earnings may be subject to double taxation – the
earnings of the corporation are taxed at corporate level,
and then any earnings paid out as dividends are taxed again
as income to the stockholders.
• Legal Formalities:
Setting up a corporation, and filing many official
documents, is more complex and time consuming than for
a proprietor ship or a partnership.
 Hybrids (Mixed):
• Hybrid organizations are specialized types of
partnerships, which combine the limited
liability advantage of a corporation with the
tax advantages of a partnership.
 S-Type Corporation
• S- Type corporations are Limited Liability
Corporations without double taxation. In a
regular corporation, the company itself is
taxed on business profits.
• In addition, the owners pay individual income
tax on money that they draw from the
corporation as salaries, bonuses, or dividends.
 S-Type Corporation
• In contrast, in an S corporation, all business profits
"pass through" to the owners, who report them on
their personal tax returns (as in sole proprietorships,
partnerships, and Limited Liability Companies).
• The S corporation itself does not pay any income
tax, although a co-owned S corporation must file an
informational tax return like a partnership or
Limited Liability Companies – to tell the tax
authorities what each shareholder's portion of the
corporate income is.
 Limited Liability Partnership (LLP)
• Limited Liability Partnership (LLP) is also a
form of partnership with allows limited
liability to the owners and avoids double
taxation. These organizations are similar in
many ways to the S Corporations; however,
LLPs offer more flexibility and benefits to the
owners.
 Personal Corporations (PC) or Professional
Corporations
• Personal Corporations (PC) or Professional
Corporations are generally formed by
professionals to protect them against
litigations. Professionals like doctors, lawyers
and accountants prefer to register their
business as Professional Corporations.
Balance Sheet – An FM Perspective
Internal and External Business
Environment
 Internal Business Environment:
• Internal environment of business normally
consists of the following.
• Finance
• Marketing
• Human Resources
• Operations (Production, Manufacturing)
• Technology
• Other Functions (Logistics, Communications)
 External Business Environment
The following business environment factors outside
an organization have a profound effect on the
functions and operations of an organization.
• Customers
• Suppliers
• Competitors
• Government/Legal Agencies & Regulations
• Macro Economy/Markets:
• Technological Revolution
 SWOT ANALYSIS
An analysis which is used in a business is called SWOT
Analysis. SWOT is an acronym where
• S stands for Strengths
• W stands for Weaknesses
• O stands for Opportunities
• T stands for Threats
• Strengths and weaknesses are within an organization, i.e.,
they pertain to the internal environment of the
organization.
• Opportunities and threats, on the other hand, pertain to
the external environment, i.e., outside the organization.
 Financial Markets
Capital Markets:
• These are the markets for the long term debt & corporate
stocks.
• Stock Exchange:
A stock exchange is a place where the listed shares, Term
finance certificates (TFC) and national investment trust
units (NIT) are exchanged and traded between buyers and
sellers.
• Long term bonds:
Long term government & corporate bonds are also traded
in capital markets.
 Money Markets
• Money market generally is a market where
there is buying and selling of short term liquid
debt instruments. (Short term means one year
or less). Liquid means something which is
easily en-cashable; an instrument that can be
easily exchanged for cash.
 Money Markets
• Following financial instruments are traded in money markets.
Short term Bonds

• Government of Pakistan: Federal Investment Bonds (FIB),

Treasury-Bills (TBills)
• Private Sector: Corporate Bonds, Debentures

• Call Money, Inter-bank short-term and overnight lending &

borrowing
• Loans, Leases, Insurance policies, Certificate of Deposits (CD’s)
• Badlah (money lending against shares), Road-side money lenders
 Real Assets or Physical Asset Markets
• Following are the active markets of real and
physical assets in Pakistan
• Cotton Exchange, Gold Market, Kapra Market
• Property (land, house, apartment, warehouse)
• Computer hardware, Used Cars, Wheat, Sugar,
Vegetables, etc.
OBJECTIVES OF FINANCIAL MANAGEMENT,
FINANCIAL ASSETS AND FINANCIAL
MARKETS
 Learning objectives:
After going through this lecture, you would be
able to have a better understanding of the
following concepts.
• Objectives of financial management as compared
to Economics and Financial Accounting
• Real and Financial assets
• Different types and characteristics of financial
assets and the similarities and differences among
them
 Learning objectives:
• How these financial assets are reported in the
balance sheet of a company
• Concept of Value and different kinds of Value
• Types of financial and real assets markets
 Learning objectives:
• While studying the course of financial
management, we will study, in detail, two
important areas of financial management,
known as:
1. Investments & Capital budgeting
2. Corporate financing.
 Learning objectives:
• Concepts such as interest, time value of money,
cash flows, risk & return, cost of capital, leverage,
financing would be thoroughly discussed. In the
later lectures, we will talk about some specialized
areas of finance like international finance & working
capital finance.
• In the previous lecture, we had discussed the
overall organizational hierarchy, and the hierarchy
of the finance department – the people responsible
for the financial management functions.
 Difference between Financial Management,
Economics & Financial Accounting

:
The objective of economics, as a subject, is
profit maximization; however, the scope of
economic profit maximization is vast and
loosely defined. In economics, we can talk
about profit maximization for an individual,
the whole society, or a particular class or
group.
 Objective of Economics

We can also talk about profit maximization for

the whole world in global terms. In social
economics, we may study the social profit
maximization for the societies, whereas, in
capitalistic economics we may study individual
or company’s profit.
Objective of Financial Management (FM)

• In comparison, financial management is more

focused. The objective of financial
management, specifically, is to maximize the
shareholders wealth in the present terms.
• Financial practitioners usually use the
discounting and the net present value
techniques while calculating the increase in
the wealth of shareholders.
Objective of Financial Accounting (FA):

• The objective of financial accounting is to collect

accurate, systematic, and timely financial data and other
financial information, and to compile and consolidate it
in an organized and systematic way, according to the
principles and rules of accounting, for reporting purpose.
• The financial managers use these reports to assess the
financial position of the company through various
financial management tools and then the financial
position can be compared to, or benchmarked against,
the industry norms.
Objective of Financial Accounting (FA):

The four different financial statements used

for the purpose of reporting and analysis are
1. Balance Sheet
2. P/L or Income Statement
3. Cash Flow Statement
4. Statement of Retained Earnings (or
Shareholders’ Equity Statement)
 Book Value Vs. Market Value

• In financial accounting, assets are recorded on the

basis of historical costs in the balance sheet,
• i.e., the assets are recorded at their original
purchase price. Of course, the depreciation on the
asset is duly subtracted from its original value as
the asset remains in use of the business.
• However, in financial management, book value is
seldom used and financial managers consider the
market value and the intrinsic value of assets.
 Book Value Vs. Market Value

• Market value may be defined as the value

currently prevailing in the market or the value
at which the sellers are ready to sell, and
buyers are ready to buy a particular asset.
• Intrinsic value or the fair value is calculated by
summing up the discounted future cash flows.
• In Financial accounting, we followed the
principle of accrual accounting in which
expenses & incomes are rerecorded when
they incur. In Financial management, we will
primarily be interested in cash & cash flows.
• In Financial management, we will use cash as
primary source for calculating value, although
the accrual data would also be useful for
analyzing a firm’s financial position.
 Types of Assets
Before getting into details, it is important to
understand a few concepts that would be frequently
used throughout the course.
• Real Assets:
Real assets are tangible assets that have physical
characteristics. For instance, land, house, equipment,
car, wheat, fruits, cotton, computers, etc., are different
kinds of real assets.
• Securities:
Security, also known as a financial asset, is a piece of
paper representing a claim on an
asset.
Securities can be classified into two categories.
• Direct Securities: Direct securities include stocks
and bonds. While valuing direct securities we take
into account the cash flows generated by the
underlying assets.
• Discounted Cash Flow (DCF) technique is often
used to determine the value of a stock or bond.
• Indirect Securities: Indirect securities include
derivatives, Futures and Options. The securities
do not generate any cash flow; however, its value
depends on the value of the underlying asset.
 Bonds
• Bonds represent debt. The important features
of bonds are given as under.
• Internationally, bonds are the most common
way for companies to raise funds.
• A bond is a long-term debt contract (on paper)
issued by the borrower (Issuer of the Bond i.e.,
a company that wishes to raise funds) to the
lenders (bondholders or Investors which may
include banks, financial institutions, and private
investors).
 Bonds
• Bonds issued by a company are usually shown
on the liabilities side of the Balance Sheet.
• A Bond requires the borrower to pay a pre-
determined amount of interest regularly to the
lender (bondholder). The interest rate or the
rate of return on a bond can be Fixed or
Floating. If an investor purchases a bond which
is offering a rate of 10 % for the life of the bond,
the rate would be fixed at 10 percent.
 Types of Bonds:
• Debentures: Unsecured – no asset backing
• Mortgage Bond: Secured by real property i.e.
Land, house
• Others: Eurobond, Zeros, Junk, etc.
• The details on these different types of bonds
would be discussed in later lectures.
 Stocks (or Shares):
• Stocks (or Shares) are paper certificates
representing ownership in a business.
Therefore, if a company has issued 1 million
shares and an investor owns 1 share only, he is
a part owner (or shareholder) of the company.
• Stocks or shares are represented in the equity
section of the balance sheet. A stock
certificate is perpetuity, i.e., it lasts as long as
the company does.
 Stocks (or Shares):
• Shareholders have a residual claim (last claim)
on whatever net income (or profit) and assets
are left over after the bondholders have been
fully paid off. It is the most common source of
raising funds under Islamic Shariah. Shares are
traded in Stock market e.g. Karachi Stock
Exchange (KSE), Lahore Stock Exchange (LSE) &
Islamabad Stock Exchange (ISE).
 Difference between Shares & Bonds:
• The main difference between shares and
bonds is that shares are representation of
ownership in a company while bonds are not
representative of ownership.
• The second difference is that shares last as
long as the company lasts where as bonds
have limited life.
 Difference between Shares & Bonds:
• Another difference is that the return on a
bond is predetermined, i.e., the investor
knows in advance how much return he would
get from a bond.
• However, a stockholder cannot be certain
about the return on a stock investment, since
the dividends may or may not be paid in a
certain year or the percentage of dividends
announced may vary.
 Types of Stocks (or Shares):
Common Stock:
Common shareholders receive dividends, or portion
of the net income which the management decides,
NOT to reinvest into the company in the form of
retained earnings.
• Dividends are paid in proportion to the number of
shares the stockholders own and are announced by
the board of directors, who may opt not to announce
a dividend in a particular year. Common Stockholders
have voting rights to elect the board of directors.
 Types of Stocks (or Shares):
Preferred Stock:
• It is the stock with a predetermined or fixed dividend.
In case, the board of directors announces dividends,
the preferred stockholders would have a priority
claim on them, i.e., they would be paid dividends
before any dividends are paid to the common
stockholders.
• However, if the board opts to retain earnings, the
preferred stock would not yield a dividend, and thus
cash flows from a preferred dividend are not as
certain as income of the bondholders.
 Types of Stocks (or Shares):
• Dividends are paid out of net income.
Shareholders get a part of the net profit of the
company during the year, proportional to their
shareholdings, and it is for the management
to decide how much of the profit is to be
distributed among the shareholders.
 Types of Stocks (or Shares):
• Now, we will see how these shares and bonds will
appear on the face of a balance sheet. We will have
to look at these shares and bonds from two aspects,
the shares and bonds that the company issues and
the shares and bonds that company invest in.
• The shares and bonds that a company purchases as
an investment will come on the asset side under the
section of marketable securities. These shares and
bonds have been purchased by the company to
generate extra income.
 Types of Stocks (or Shares):
• On the other hand, those shares and bonds that
the company issues to raise funds will appear
on the liability side.
• If the company has issued bonds, they will be
classified as liability. But if the company has
issued equity shares, they will appear under the
section of common equity on liability side in the
balance sheet.
• Where do bonds & stocks appear on the
Balance Sheet?
Bonds & stocks on the Balance Sheet
 The Concept of Value
• Finally, let’s talk about the most important
concept that we will keep on repeating
throughout the course; the concept of ‘value’.
In financial terms, there are different types of
values, which are given as under.
 Different Types of Value
Value
• Book Value:
Book Value is the value of an asset as shown on the
Balance Sheet. It is based onhistorical cost (or
purchase price) and accumulated depreciation.
• Market Value:
Market value of an asset is as quoted in the market,
which basically depends on the supply & demand of
the asset and the negotiations between buyers &
sellers.
 Different Types of Value
Value
• Liquidation Value:
The liquidation value is the value of an asset in a particular
situation, where the company is in the process of wrapping up
the business and its assets are valued and sold individually.
• Fair Value or Intrinsic Value:
The most important value concept in this course is of fair value or
the intrinsic value. In order to find the intrinsic value of an asset,
the present value of the working assets’ future cash flows is
calculated and summed up. If the intrinsic value of an asset is less
than its market value, the asset among investors is perceived as
“undervalued”.