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UNIT 1
Overview of Financial Management &
Financial Environment
 What is Finance?
 Forms of Business Organizations
 Organization of the Finance Function
 The financial environment
 Financial instruments, markets and
institutions
 Interest rates and yield curves
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What is Finance?

 Finance is the art and science of managing

resources (mostly financial resources, e.g.,
money).
 All units of the society earn or raise money
and spend or invest money.
 Finance is concerned with the process,
institutions, markets, and instruments involved
in transfer of resources among individuals,
businesses, and governments.
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What are some forms of

business organization?

 Sole proprietorship
 Partnership
 Corporation
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Legal Forms of Business Firms

 Three forms are common;

 Sole proprietorship; Owned by a single owner
and has unlimited liability.
 Partnerships; Owned by two or more owners
and (usually) have unlimited liability.
 Corporations/Company; An artificial being/entity
created by law (Companies Ordinance 1984).
Owned by stockholders.
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Legal Forms of Business Firms

 Types of company;
 Private Limited; 1) Restricted in transfer of shares,
2) No. of members cannot exceed fifty, 3)
Prohibited from offer of shares and/or debentures
to the public.
 Public Limited; No restrictions as above.
 Guarantee Limited; Companies whose members
undertake to contribute a certain sum towards the
assets of the company in the event of its
bankruptcy to meet the claims of creditors.
 Unlimited; Companies in which liability of members
is unlimited.
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Organization of the Finance Function

 Organization of finance function will

depend on the size of business.
 Typically, in a large company CFO is
responsible for all finance functions.
 Treasurer (chief financial manager) and
controller (chief accountant) work
under the CFO to fulfill all finance
functions of a company.
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Organization of the Finance Function

 Typical activities of a treasurer include;

 Financial planning & fund raising,
 Making capital expenditure decisions,
 Managing cash,
 Managing credit activities,
 Managing the pension fund, and
 Managing foreign exchange.
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Organization of the Finance Function

 Typical activities of a controller include;

 Corporate accounting and policies,
 Tax management,
 Financial accounting,
 Cost accounting.
 In Financial Management we are concerned with
the functions of treasurer.
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Major Decisions in
Financial Management
 Major decisions that a financial manager makes are;
 Investment Decisions, and
 Financial Decisions
 Investment decisions stipulate;
 What types of assets to invest in?
 How much to invest in each type of asset?
 Financing decisions stipulate;
 Which source be used for raising funds?
 How much from each source be raised?
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Major Decisions in Financial Management;
Balance Sheet View

Balance Sheet
Current Liability
Assets
Long Term Equity
Assets

Investment Decisions Financing Decisions

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What should management’s primary

objective be?
 The primary objective should be
shareholder wealth maximization,
which translates to maximizing stock
price.
Should firms behave ethically? YES!
Do firms have any responsibilities to
society at large? YES! Shareholders
are also members of society.
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Is maximizing stock price good for
society, employees, and customers?
 Employment growth is higher in firms
that try to maximize stock price. On
average, employment goes up in:
Firms that make managers into
owners (such as LBO firms)
Firms that were owned by the
government but that have been sold
to private investors
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Agency Issue

 Managers are the agents of shareholders.

 Theoretically managers care about the
shareholders wealth but practically they
are also concerned with their personal
wealth.
 The likelihood that managers will place
personal goals ahead of corporate goals
which may cause problems is termed as
agency problem.
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Agency Issue

 Two factors, i.e., market forces & agency

costs, help minimize agency problem.
 Market forces include;
 current major shareholders,
 potential major shareholders
 Agency costs are incurred by
shareholders to get management personal
goals in line with corporate goals.
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Agency Issue

 Agency costs include;

 Incentive plans; management compensation
plans that tend to tie management
compensation to share price; most popular
incentive plan involves the grant of stock
options
 Performance plans; plans that tie management
compensation to measures such as EPS,
growth in EPS, and other ratios of return.
Performance shares and/or cash bonuses are
used as compensation under these plans.
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What three factors affect stock prices?

 Amount of cash flows expected by

shareholders
 Timing of the cash flow stream
 Risk of the cash flows
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What factors determine cash flows?

 Sales revenues
 Current level
 Short-term growth rate in sales
 Long-term sustainable growth rate in sales
 Operating expenses (e.g., raw
materials, labor, etc.)
 Necessary investments in operating
capital (e.g., buildings, machines,
inventory, etc.)
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What factors affect the level and
risk of cash flows?
 Decisions made by financial managers:
 Investment decisions (product lines,
production processes, geographic
market, use of technology, marketing
strategy, etc.)
 Financing decisions (choice of debt
policy and dividend policy)
 The external environment (taxes,
regulation, etc.)
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Deficient vs. Surplus Unit

 Individuals, businesses, governments in

need of funds, i.e., their income is less than
their spending, are known as deficient units
(DU).
 Individuals, businesses, governments in
need of investing their surplus funds, i.e.,
their income is greater than their
spending, are known as surplus units (SU).
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Deficient vs. Surplus Unit

 In exchange of funds between deficient

and surplus units following
events/activities are noteworthy;
 DF receive funds, provided by SU,
but have to provide a guarantee called
financial asset or security.
 SU receive financial asset/security,
issued by DU, in return of their funds.
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Direct vs. Indirect Financing

 Exchange of funds b/w DU and SU without

any intermediation is known as direct
financing.
 Exchange of funds b/w DU and SU with the
help of an intermediary is known as indirect
financing.
 This important role of intermediation is
played by financial markets & institutions in
various ways.
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What are financial assets?

 A financial asset is a contract that
entitles the owner to some type of
payoff.
Debt
Equity
Derivatives
 In general, each financial asset
involves two parties, a provider of
cash (surplus unit) and a user of
cash (deficient unit).
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What are three ways that capital is

transferred between savers and
borrowers?

 Direct transfer (e.g., corporation issues

commercial paper to insurance company)
 Through an investment banking house
(e.g., IPO, seasoned equity offering, or
debt placement)
 Through a financial intermediary (e.g.,
individual deposits money in bank, bank
makes commercial loan to a company)
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Who are the providers (savers) and

users (borrowers) of capital?

 Households: Net savers

 Non-financial corporations: Net
users (borrowers)
 Governments: Net borrowers
 Financial corporations: Slightly
net borrowers, but almost
breakeven
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What are some financial intermediaries?

 Commercial banks
 Savings & Loans, mutual savings
banks, and credit unions
 Life insurance companies
 Mutual funds
 Pension funds
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What are some types of markets?

 A market is a method of
exchanging one asset (usually
cash) for another asset.
 Physical assets vs. financial assets
 Spot versus future markets
 Money versus capital markets
 Primary versus secondary markets
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Financial vs. Real Assets

 ‘Financial assets’ are paper or electronic

claims on some issuer (a deficient unit),
such as the government or a company.
 ‘Real assets’ are tangible assets such as
gold, silver, diamonds, real estate, etc.
 Financial assets also have ‘marketability’ &
‘liquidity’.
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Financial vs. Real Assets

 ‘Marketability’ means the ease of

buying or selling an asset.
 ‘Liquidity’ means the ability of an
asset to convert to cash without loss
of value.
 ‘Marketable securities’ are financial
assets easily and cheaply tradable in
organized markets.
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Overview of Financial Markets

 Provide platform for transfer of funds

from investors to firms.
 Provide avenue for temporarily parking
excess funds by the firms.
 Provide opportunity to investors for
liquidating current investments for
expenditure or investing into alternatives.
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Primary vs. Secondary Markets

 Primary market is a financial market where

securities are issued for the first time.
 In primary markets issuer is directly involved in
the sale transaction of securities, i.e., issuer gets
proceeds from the sale of securities.
 The first offering of stock to the public is referred
to as an initial public offering (IPO).
 Any offering of new stocks subsequent to IPO is
called seasoned or secondary offering.
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Primary vs. Secondary Markets

 Secondary market is a financial

market where the already issued or
existing securities are traded, i.e.,
sold and purchased.
 The issuer has no participation in the
trades of secondary markets.
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Public Offering vs. Private Placement

 Nonexclusive sale of securities to the

general public is called a public offering.
 Public offering is done by the help of a
special intermediary called investment
banker.
 Investment Banker: Firm specializing in the
sale of new securities to the public,
typically by underwriting the
offering/issue.
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Public Offering vs. Private Placement

 Underwriting means the investment

banker has guaranteed for a fixed
amount of proceeds to be received by
the issuer.
 Direct sale of securities to a select
group or an exclusive sale of securities
may also be conducted by the issuer
and is known as private placement.
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Public Offering vs. Private Placement

 Mostly institutional investors afford

to invest in private placements.
 Fees charged by investment bankers
may be avoided in private
placements.
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How are secondary markets organized?

 By “location”
Physical location exchanges
Computer/telephone networks
 By the way that orders from buyers
and sellers are matched
Open outcry auction
Dealers (i.e., market makers)
Electronic communications
networks (ECNs)
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Money vs. Capital Markets

 Markets dealing in short term, i.e.,

one year or lesser, securities are
known as money markets.
 Markets dealing in long term, i.e.,
more than one year, securities are
known as capital markets.
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Money Market Securities

 Short-term, highly liquid, low-risk financial

assets.
 Examples of securities traded in money
markets are treasury bills (T-Bills), negotiable
CDs, commercial papers, repos, banker’s
acceptance.
 Money market is dominated by large
financial institutions and governments.
 Size of transactions in money market are
typically large.
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Money Market Securities

 T-Bill (A Special Money Market

Security);
 Issued by federal government.
Used as a benchmark and proxy
for RFR.
 Sold fortnightly by SBP at
discount.
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Money Market Securities

 Commercial Paper:
 Issued by private firms at
discount.
 Sold directly by the issuer or
indirectly through a dealer.
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Capital Market Securities

 Long-term securities.
 Risk is higher than money market
securities because of the time to maturity
and their nature.
 Capital market securities are further
classified as;
 Fixed-Income Securities
 Equity Securities
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Fixed-Income Securities

 Specified payment & repayment

schedule, i.e., amount and date of
each payment are known in advance.
 Certain maturity.
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Fixed-Income Securities; Bonds

 Bonds are long-term debt instruments

representing the issuer’s contractual obligations.
 Interest payments and the principal repayment
are specified at the time of issue.
 Par (Face) value is the amount receivable by the
holder of a bond at the time of its maturity.
 Most bonds are coupon bonds, where coupon
refers to the periodic interest also known as
coupon income or interest income.
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Fixed-Income Securities; Bonds (continued)

 Some bonds are zero coupon bonds;

 Regular interest is not paid.
 Sold at discount.
 Redeemed at face value.
 Return is the difference between face
value and purchase price.
 Term-to-maturity for a bond means the time
period left till its maturity.
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Fixed-Income Securities; Bonds (continued)

 Price of a bond;
 A bond buyer must pay its seller the price of a
bond plus the interest accrued till that point.
 Interest rates in an economy and prices of the
bonds move inversely.
 Call Provision;
 A clause in the contract of a bond entitling the
issuer to call in a security and retire it by
paying off the obligation.
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Fixed-Income Securities; Bonds (continued)

 Corporate bonds are various types of

long-term debt securities issued by
corporations.
 Corporate bonds are senior securities.
 Debenture is an unsecured corporate
bond backed by the general credit-
worthiness of a corporation only.
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Fixed-Income Securities; Bonds (continued)

 Convertible corporate bonds have a

special clause in its contract to the
effect that the holder may opt to convert
this bond into shares of common stock.
 Convertible bond is an example of a
hybrid security.
 Prices of convertible bonds fluctuate
over a fairly wide range.
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Equity Securities

 Represent ownership in a
corporation.
 Provide a residual claim.
 Two forms are;
 Preferred Stock
 Common Stock
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Equity Securities; Preferred Stock

 An equity security that has an

intermediate claim over the firm’s
earnings and assets.
 Preferred stock has dual nature, i.e.,
exhibit properties of an equity
security as well as of a fixed-income
security, thus is termed hybrid
security.
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Equity Securities; Preferred Stock

 Equity characteristic makes a preferred

stock infinitely livable and pays dividends.
 As a fixed-income security dividend paid
on a preferred stock is fixed in amount
and known in advance.
 Income stream from preferred stock
continues forever unless the issue is
called or otherwise retired.
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Equity Securities; Common Stock

 Common stock is an equity security

representing ownership stake in a
corporation and have the residual claim
over the firm’s assets and earnings.
 A firm’s common stock may be held by a
few people and thereby is “closely held”.
 A firm may “go public” by offering its
common stock to general public.
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Equity Securities; Common Stock

 A firm may be listed on a stock

exchange if it fulfills all the
requirements of listing.
 Common stocks are paid after bond
holders and preferred stockholders.
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Equity Securities; Common Stock

 Common stockholders are entitled to vote in the

election of each director and on major issues.
Most common stockholders vote by proxy.
 Preemptive right in a corporation’s charter grants
existing stockholders the first right to purchase
any new common stock if issued by the
corporation.
 Right is a piece of paper giving each stockholder
the option to buy a specified number of new
shares during a specified time. Rights have value
and can be sold in the market.
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Equity Securities; Common Stock

 Common stocks also have par (stated or

face) value, but is not a significant economic
variable.
 Paid in Capital = Par value X No. of Shares
Outstanding
 Common stocks are usually sold at premium
to the par value.
 Additional Paid in Capital = Premium X No. of
Shares Outstanding
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Equity Securities; Common Stock

 Book Value = Paid in Capital + Additional

Paid in Capital + Retained Earnings
 Book Value per Share = Book Value / No. of
Shares Outstanding
 Market value per share is the price a share
is trading at in the secondary market.
 Market Capitalization = Market Value per
Share X No. of Shares Outstanding
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Equity Securities; Common Stock

 EPS = Earnings / No. of Shares Outstanding

 Dividends are cash payments, if declared, paid by
corporations to stockholders.
 DPS = Dividends / No. of Shares Outstanding
 Dividend Yield = Dividends in last 12 months /
Current Market Price
 Payout Ratio = Dividends / Earnings = DPS/EPS
 Retention Ratio = 1 – Payout Ratio = Retained
Earnings for a Year / Earnings
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Equity Securities; Common Stock

 The book value of Engro Chemical Pakistan

Limited (ENGRO) at year-end 2007 was Rs.
15,481,917,000/-. With 193, 469,198 shares (with a
face value of Rs. 10/- each) outstanding the book
value per share was approximately Rs. 80.02/-
(Rs. 15,481,917,000 ÷ 193, 469,198).
 Earnings per share of ENGRO for the year 2007
was Rs. 17.17/-. ENGRO had declared a total
dividend per share equal to Rs. 7/- in this year.
The payout ratio was 40.77% (7 ÷ 17.17)
approximately. The retention ratio was 59.23% (1
– 0.4077).
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Equity Securities; Common Stock

 Common stockholders may also be

paid in some ways other than cash.
Two options are considerable;
 Stock Dividend (in Pakistan the
trend is to issue bonus shares)
 Stock Split
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Equity Securities; Common Stock

 Stock dividend is a payment by firms to

its shareholders in the form of
additional stocks rather than cash.
 Stock split involves the issuance of a
larger number of shares in proportion
to the existing shares outstanding. A
stock split causes the par value and
book value of equity to change.
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Equity Securities; Common Stock

 Practically there is little difference

between a stock dividend and a stock split.
 Proportional ownership remains the same
as a result of either a stock dividend or a
stock split.
 However, there is considerable evidence
that stock dividends and splits do create
investor interest resulting in a higher
performance.
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Equity Securities; Common Stock

 A 20% stock dividend (bonus shares)

announced by the board of directors of
PPL means all holders of record
investors will receive 20 additional
shares for each 100 shares currently
held.
 A 2-for-1 stock split means the number
of outstanding shares will double. Two
new shares for every old share.