An Overview of Financial Management

An overview of financial
management
Financial overview
Learning objectives
To understand the
• Finance function
• Main financial goal
• Underlying principles of finance.

Benefits of a limited company
• Limited liability
• Transferability of ownership
• Permanence
• Access to markets.
Figure 1.1 The Finance function in a large organisation
Investment and financing
Investment decision Financing decision

• How much should • How much capital
we invest? do we require?
• In which projects? • In which form?
Financial goal
• Primary
– To maximise shareholder value
• Secondary
– Profitability
– Growth in sales or earnings
– Non-financial.
Figure 1.3 The risk–return trade-off
Figure 1.4 Main elements in strategic planning
Figure 1.5 Factors influencing the value of the firm
Summary
• Financial managers should raise and use funds
to maximise shareholder value.
• Cash is the lifeblood of the business.
• Financial management has evolved and adapted
to changing economic events.
• The agency problem can be reduced by
managerial incentives and close monitoring.
• Investors expect a higher return where risks are
greater.
Capital Structure and Firm
Value
Does Capital Structure affect value?
• Across industries/ Across Firms/ Across Years
• Is capital structure managed?
– If so much time is spent on capital structure then there must be
some value to it
– Investment opportunities and strategy (needs)
– Financing (sources)
• Cash balance
• Distribution: Dividend and repurchases
• Debt capacity
• Equity capacity
• Existing debt and equity
– Other financial policies: Financial Hedging, Cash Flow Volatility,
Forms of Compensation.
Does Capital Structure affect value?
• Market timing: Managers take advantage of superior
information
– Issue equity when it is overvalued
– Issue debt when it is undervalued
• Signaling: Managers use financing to signal future
prospects of firms
– Issue equity to signal good growth opportunities
(preserve financial flexibility)
– Issue debt when expected cash flows are strong and
stable.
Formal Model of Capital Structure
– Firms prefer to raise capital
• Internally generated funds
• Debt
• Equity
– Implies capital structure is derived from
• Financing needs and capital availability
• Dynamic rather than static
• Asymmetric information and signaling
Capital Structure Decisions
Outline
Meaning of Capital Structure

Optimal Capital Structure
How much should a firm borrow? Does
capital structure matter? Does it influence
the value of the firm?
Limits to the use of debt
How companies establish their capital
structure?
Capital Structure
 A mix of debt, preferred stock, and common stock with which

the firm plans to finance its investments.
 Objective is to have such a mix of debt, preferred stock, and
common equity which will maximize shareholder wealth or
maximize market price per share
 WACC depends on the mix of different securities in the capital
structure. A change in the mix of different securities in the
capital structure will cause a change in the WACC. Thus, there
will be a mix of different securities in the capital structure at
which WACC will be the least.
 An optimal capital structure means a mix of different securities
which will maximize the stock price share or minimize WACC.
Leverage and Capital Structure
 Leverage means use of fixed cost source of funds.

Generally, it refers to use of debt in the capital structure
of the firm
 How much leverage should be there in a firm? Why is
this question important? Two reasons:
– a higher debt ratio can enhance the rate of return on equity
capital during good economic times
– a higher debt ratio also increases the riskiness of the firm’s
earnings stream
 Capital structure decision involves a trade off between
risk and return to maximize market price per share
Does capital structure matter?
Not really; According to Modigliani and

Miller (1958) article, in a world without
corporate taxes, it mix between debt and
equity does not matter
Value of the firm is independent of capital
structure decisions
Value of a firm equals operating income
divided by overall cost of capital.
 Thus, mix between debt and equity is not important.
Any benefit of low cost debt is completely offset by an
increase in the cost of equity due to use of borrowing.
 Thus, overall cost of capital remains same and value of
the firm does not change if we change the mix
between debt and equity.
 Assumption of a world without taxes is quite
unrealistic. M&M revisited their theory in their 1961
article.
 They assume a world with corporate taxes
M&M with corporate taxes
 If we follow M&M (1958), we should not worry about

mixture of debt and equity in the capital structure.
 These decisions should be relegated to the background
because they do not affect the value of the firm. So, financial
managers should not worry about these decisions.
 Still financial managers do show concern for a debt policy,
which is carefully developed. And we find a pattern among
companies in the use of debt in different industries.
 M-M’s argument that the value and the cost of capital of a
firm remains constant with leverage will not hold when
corporate taxes are assumed to exist.
 In their 1963 article, they recognize that the value of the firm
will increase or the cost of capital will decrease with leverage
because interest on debt is a tax deductible expense.
 The value of the levered firm will be greater than the
unlevered firm because the return to bondholders escapes
taxation at the corporate level.
 The value of the levered firm will be more than the value of
unlevered firm by the amount of the present value of the tax
shield due to tax savings given by the tax deductibility of
interest expense on debt.
 Present value of the tax shield is given by Tc  D
 Value of a leverered firm = [(1-Tc)EBIT/re] + TcD
Example
 Firm L has employed a 6 percent debt of $300,000, while firm U is

unlevered. Both the firms earn a before tax earnings of $120,000. The pure
equity capitalization rate is 10 percent and the corporate tax rate is 34
percent. Find the market value of the firms.
(1 - Tc) EBIT (1 - 0.34) $120,000
 Vu = --------------- = ----------------------------- = $792,000
re 0.10
VL = VU + Tc D
= 792,000 + 0.34  $300,000

= $894,000
M&M Proposition II with
corporate taxes
Re = rA + D/E  (1 - Tc)  (rA - rD)
Limits to the Use of Debt
 According to MM theory with taxes, value of levered firm

equals the value of unlevered plus the value of the tax
shield
 Accordingly, the more the debt in the capital structure, the
higher will be the value of a levered firm.
 One can always increase firm value by increasing
leverage, implying that firms should issue maximum debt.
 This is inconsistent with the real world, where firms
generally employ moderate amount of debt.
 The answer lies in bankruptcy costs. Debt provides tax
benefits to the firm.
 However, it also puts pressure on the firm, because interest
and principal payments are obligations. If these
obligations are not met, the firm may risk some sort of
financial distress.
 The possibility of bankruptcy has a negative effect on the
value of the firm. However, it is not the risk of bankruptcy
itself that lowers value. Rather it is the cost associated
with bankruptcy that lowers value.
 As the proportion of debt in the firm’s capital structure is
increased, the probability of bankruptcy also increases.
Consequently, the rate of return required by bondholders
increases with leverage.
 The optimal ratio of debt to equity is determined
by taking an increasing amounts of debt until the
marginal gain from leverage is equal to the
marginal expected loss from the bankruptcy costs
How Firms Establish Capital
Structure?
 Most corporations have low debt-asset ratios
 Changes in Financial Leverage affect Firm Value
 There are differences in the Capital Structures of
Different Industries
 Most companies have a target debt ratio
 Target debt ratio is dependent on taxes, types of
assets, uncertainty of operating income, and pecking
order and financial slack.
Dividend policy
Concepts and exemplification

Objective
Understand the role of dividend policy in

the context of the firm’s overall financial
policy.
Outline
• Types of dividends
• The dividend time line
• Stock price reaction
• Dividend policy irrelevance
• Theories explaining dividend policy
Dividends come in many forms:
 Regular cash dividend

 Extra dividends
 Liquidating dividends
 Shares repurchases
• Stock dividends
Dividend time Line
• Declaration date
• Cum-dividend date
• Ex-dividend date
• Record date
• Payment date
Ex-dividend day: Stock price
reaction
The stock price will drop by the amount
forgone by the average investor
Clarification:
Pcum = D0 + D1/(1+ r)2 + D2/(1+r)3 +
……
Pex = D1/(1+ r)2 + D2/(1+r)3 +
……
Stock price reaction (con't)
With taxes, the price drop ~ D(1-Td)/(1-

Tcg)
Td = tax on dividend (average investor)

Tcg = tax on capital gain (average
investor)
Dividend Policy: Does it matter? Is there an
optimal dividend policy?
If no, focus on the investment decision
If yes, what is the optimal policy?

View # 1: Dividend policy is
irrelevant
Shareholders are able to undo firm's
dividend policy.
M&M: firm value is independent of the
dividend decision.
View # 1: Dividend policy is relevant
Bird-in-hand story
A $1 in dividend now is worth more than
$2 in dividend later on.
Signaling
Dividend increase = Good times ahead
The free cash-flow hypothesis
$1 in dividend is $1 less to spend on M&A
View # 1: Dividend policy is relevant (cont’d)
Clientele effect
Some want dividends while others want
capital gains
Tax effect
Tax effect
REC Company has $1,000 in extra cash. It can invest this cash in a 5-
year T-bill at 8%, or it can pay the cash to the shareholders as a dividend.
Shareholders can also invest in T-bills. Assume a 44% corporate tax, a
40% individual tax on interest, and 30% individual tax on dividend
income.
If dividend is paid now, shareholders get
1000(1-0.3)[1+ (0.08)(1-0.4)]5=$884.9
If dividend is invested, shareholders get
1000[1+ (0.08)(1-0.44)]5(1-0.3) =$871.5
Shareholders would be indifferent between receiving the dividend now
as opposed to receiving it later if and only if:
(1-TE)[1+r(1-TP)] = [1+r(1-TC)](1-TE)
Tax effect (cont’d)
 Investors would like a dividend according

to their tax preferences:
• Tax-exempt investors, investors in low tax
brackets, etc. prefer high current dividend
• Investors in high tax brackets prefer
capital gains
Agency costs explanation of
dividends
Paying dividends can result in a need for
external financing.
Raising equity and/or debt more often
intensifies market’s scrutiny of the company.
Reality check
• Earnings increase one year before dividend initiation.

• Earnings decrease one year before dividend omission.
• Following dividend initiation, earnings increases appear
to be permanent.
• Following dividend omission, earnings decreases appear
to be temporary.
• Weak reaction to earnings changes following dividend
changes.
Overview of financial policy:
Why is it important?
Capital structure policy, long-term financing
policy, dividend policy, etc.…do have some impact
on market valuation.
Remember, however:
Capital budgeting is the bread and butter of
wealth maximization.
Financial policy is only fine-tuning.

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An overview of financial

• Main financial goal

• Underlying principles of finance.

Investment decision Financing decision

Meaning of Capital Structure

 A mix of debt, preferred stock, and common stock with which

 Leverage means use of fixed cost source of funds.

Not really; According to Modigliani and

 If we follow M&M (1958), we should not worry about

 Firm L has employed a 6 percent debt of $300,000, while firm U is

= 792,000 + 0.34  $300,000

 According to MM theory with taxes, value of levered firm

Concepts and exemplification

Understand the role of dividend policy in

 Regular cash dividend

With taxes, the price drop ~ D(1-Td)/(1-

Td = tax on dividend (average investor)

If no, focus on the investment decision

If yes, what is the optimal policy?

 Investors would like a dividend according

• Earnings increase one year before dividend initiation.

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