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Summary The ultimate test 1 summaries of Financial management
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Week 1: Financial ManagementChapter 1: The Financial Manager and the firm
The role of the Financial Manager
- To use a blend of quantitative tools and analyses to make financial decisions that create
value for the owners of the firm
- Corporate finance is about maximizing firm value or shareholder value/wealth
- Maximizing firm value is all about cash flows
Cashflows
- Firm generates cash inflows by selling the goods and services produced by its productive
assets and human capital
- A firm is successful in creating value when these cash inflows exceed the cash outlaws
needed to pay operating expenses, creditors and taxes.
- The firm can pay the remaining cash (residual cash flows) to the owners as a cash
dividend, or reinvest the cash in the business
- Failure to generate sufficient cash flows may result in the firm being bankrupt or
insolvent (requiring either a business rescue plan or liquidation)
- The value of any asset is determined by the future cash flows it will generate
Liquidation = When you have to give all assets to bank
Insolvent = Liabilities > Assets
The role of the Financial Manager
Cash flows between firm and its owners and stakeholders
,Fundamental decisions financial managers make to create firm value
1. The capital budgeting decision
- Known as capital expenditure (CAPEX) decision
- It involves deciding what productive assets to buy (tangible and intangible)
Eg: Plant, machines, patents, trademarks
- The decision rule: Accept investment project if the value of future cash inflows exceeds
the costs of the project (creating value)
Why is the capital budgeting decision considered the most important decision?
- It is the productive assets that generate most of the firm’s cash inflows
- CAPEX decisions are long-term = any mistake lasts a long time
- CAPEX involve huge cash outlays = mistakes result in financial loss
2. The financing decision or capital structure decision
- How productive assets are financed
- Involves trade-offs between advantages and disadvantages of debt and equity financing
- 2 ways of raising equity finance are -> Share issue and reinvesting residual cash flow
- Firm value comes mainly from the investment rather than the financing decision
- Debt comes with higher risk
- Cost of capital includes cost of debt and cost of equity
- If internal rate of return is less > reject
3. The working capital management (WCM) decision
- Determines how current assets and current liabilities are managed
- Seeks to maximize value creation and to minimize or avoid destroying value
- Mismanagement can cause a firm to go into bankruptcy even though the firm is
profitable
- Net working capital is the difference between current assets and current liabilities
Examples:
Ø Deciding on the level of inventory
Ø Whether to sell inventory on credit
Ø Where to invest idle cash
Failed Investment example
- Daimler-Berz bought Chrysler: 40 Bil (investment decision)
- Struggled to sell both luxury and economy-prices cars
- In 2003 merger failed resulting in drop in share price
- Chrysler was eventually sold for $6 Bil, 34$ less than cost
,How the financial managers decisions affect the balance sheet
Forms of Business Organizations
Sole proprietorship (sole-trader business):
An unincorporated owner-managed business
ADVANTAGES:
Ø Easy and cheap to form
Ø Least regulated
Ø All business income taxed once as personal income of owner
Ø All the profits belong to you
DISADVANTAGES:
Ø No perpetual succession
Ø Unlimited liability
Ø Equity capital limited to wealth of the owner
Ø Difficult to sell ownership interest
, Partnership
Formed by 2 or more persons who operate in terms of an agreement
ADVANTAGES:
Ø Business income taxed once as personal income of partners
Ø Ability to raise more equity capital
Ø Ability to share expertise and duties
DISADVANTAGES:
Ø No perpetual succession
Ø Partners are jointly and severally liable for partnership debt
Ø Possible nasty disputes
Ø Difficulty to sell ownership interest
Company
An incorporated legal entity that is separate from its owners and is governed by the
Companies Act
ADVANTAGES:
Ø Owners have limited liability
Ø Company has perpetual succession
Ø More equity capital can be raised
Ø Easy to sell ownership interest
DISADVANTAGES:
Ø Separation of ownership and management gives rise to the agency problem
Ø Double tax of company profits
Ø More regulated
Types of companies
Private company (Pty; Ltd)
Prohibits sell of its securities to the public and restricts transferability of its securities
Public company (Ltd)
Can either be listed or unlisted
Ø Shareholders elect the board of directors at an AGM
Ø The board is the most important governing body in a company and its main roles are to
represent shareholders and to appoint the CEO
Ø The CEO is responsible for the day-to-day management of the company and reports to
the board
Ø An audit committee is a key sub-committee of the board
Ø The CFO or the financial director reports to the CEO and is responsible for managing the
financial function
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