Understanding Financial Management: Key Concepts and Strategies for Success in BA303

1. Business Finance BA303Michael Dimond

2. Introduction • What this class will cover • How do I get an A in this class? • Relevance • Schedule • Tools & resources

3. Doing Assigned Problems, Exams & Quizzes

4. Essential issues of financial management • Purpose of business • To create wealth for the owner. • A business may also serve some other purpose, but if the business is not profitable these other functions will eventually fail. • Jobs will be lost • Benefits to society will be eliminated • Improvements to the planet will stop • Purpose of financial management • To increase shareholder wealth. • The fundamental question • The fundamental question which must be asked in any business situation is, “what is this worth?”

5. Just to clear up this misconception… • Should managers only take actions which increase the share price? • Hey, it worked for Enron… wait, what? • How about GM? • Okay, how about the Mars Candy Company?

6. The goal is to increase value • Managers should only take actions which increase value, not just share price. • Share price should accurately reflect the value of a publicly traded company, but… • What if the investors are wrong? • What if the company is privately held? • How do we determine value?

7. The "Magic" Machine Note: This is not a trick question, merely a framework to help you think about the subject. • Consider the following scenario: • You have the opportunity to buy a machine which is guaranteed to produce $100 per month for the next five years. There are no operating costs and the device will vanish at the end of that time. • How much would you pay for this? • What factors influence your decision?

8. The "Magic" Machine Note: This is not a trick question, merely a framework to help you think about the subject. • Consider the following scenario: • You have the opportunity to buy a machine which is guaranteed to produce $100 per month for the next five years. There are no operating costs and the device will vanish at the end of that time. • How much would you pay for this? • What factors influence your decision? • You have 5 minutes…

9. The "Magic" Machine Note: This is not a trick question, merely a framework to help you think about the subject. • Consider the following scenario: • You have the opportunity to buy a machine which is guaranteed to produce $100 per month for the next five years. There are no operating costs and the device will vanish at the end of that time. • How much would you pay for this? • What factors influence your decision? • What did you decide?

10. The "Magic" Machine Note: This is not a trick question, merely a framework to help you think about the subject. • Consider the following scenario: • You have the opportunity to buy a machine which is guaranteed to produce $100 per month for the next five years. There are no operating costs and the device will vanish at the end of that time. • How much would you pay for this? • What factors influence your decision? • What drove your decision?

11. Basic return: reward ÷ cost • At its simplest, return is the reward you receive divided by the price you pay. • For example, if you buy something for $1,000 and sell it for $1,100… • How much is the reward? • What was the price? • What is the return?

12. Uncertainty = Risk • Risk is another word for uncertainty. • Things rarely happen exactly as anticipated. There is a possibility an outcome will be… • Better than expected (upside risk) • Worse than expected (downside risk) • People in general tend to avoid significant amounts of risk • Investors are risk averse

13. Risk vs Price • Think again about the so-called magic machine. If the $100 monthly cash flow was not guaranteed, how would this affect the price you are willing to pay?

14. Price vs Return • If we think of return as the reward divided by the price, we can see how the change in price affects the return: • 100/1000 = 10% • 100/900 = 11% • 100/1100 = 9%

15. Risk vs Return • As risk increases, the price decreases • As price decreases, return increases • :. As risk increases, return increases • Remember, return is the return demanded by investors, not a guaranteed result

16. Required Rate of Return • Risk & Return always correlate: Investors will find a price to give them a return which compensates them for the risk they are willing to bear: the Required Rate of Return. • The Required Rate of Return may have many labels. For example: Ke i Re E(r) WACC Kd “Hurdle Rate”

17. More about risk and return • Risk is uncertainty. Not just success or failure, but to what extent will something be as expected? • It may be necessary to consider scenarios and weigh them based on their likelihood. For example: • The experts in your company predict the following results and probabilities: • What is the expected rate of return? • The weighted average is 8.35% 0.75 x 0.05 = 0.0375 1.25 x 0.15 = 0.1875 8.5 x 0.60 = 5.1000 14.75 x 0.15 = 2.2125 16.25 x 0.05 = 0.8125 sum = 8.3500

18. More about risk and return • Variation or volatility is another form of uncertainty. • What is standard deviation? What does it represent?

19. More about risk and return • How do the following assets compare to Stock X? • When making a decision, which should you consider first? • Risk? • Return? • Which has the lowest potential return? • Which has the highest potential return? • Which has the most uncertainty? • What would be the Coefficient of Variation for each? • CoV = Std Deviation ÷ Return • What is Diversification? • Can all risk be diversified away?

20. Essential issues of corporate governance • Corporation vs other types of business entities • Board of directors • Managers • Agency cost

21. Understanding financial statements • Balance Sheet • Income Statement • Statement of Cash Flows • Statement of Shareholders’ Equity

25. The Time Value of Money (TVM) • Bring your financial calculator • Bring a copy of “How do I use this financial calculator” • Look on my website