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Introduc)on to financial management WEEK 1

Chapter 1 & 2


• A#end all classes with copies of slides.
• Read the text book.
• A#end all tutorials and par)cipate.
• Complete the weekly quizzes and assignments.
• If you are struggling
• A#end consulta@on
• A#end PAL.
• Don’t leave it to the last week.

The objective of managers
• Should be to maximise the wealth of the shareholders • A company also has other stakeholders that rely on it, for example:
• Managers: salaries, bonuses
• Employees: wages
• Creditors: interest & principle
• Suppliers: pay for goods/services
• Government: tax

The role of the =inancial manager • A firm generates cash flows by selling goods and services produced by its produc)ve assets and human capital
• When the cash flows generated from the produc@ve asset exceed the cash ouQlows (such as opera@ng cash flows) the remaining cash is called residual cash flows
• The company can choose to pay any profit to the owners as a cash dividend, or reinvest the cash in the business

Cash =low diagram


The role of the =inancial manager It is all about cash flows:

• A company is unprofitable when it fails to

generate sufficient cash inflows to pay opera@ng expenses, creditors and taxes.
• Firms that are unprofitable over @me will be forced into bankruptcy by their creditors.
• In bankruptcy, the company will either be reorganised, or the company’s assets will be liquidated. The role of the =inancial manager Three fundamental decisions in financial management:

1. The capital budge@ng decision:
• Which produc@ve assets should the firm buy?

2. The financing decision:
• How should the firm finance or pay for assets?

3. Working capital management decisions:
• How should day-to-day financial ma#ers be managed? How =inancial manager’s decisions affect the Balance Sheet


Managing the =inancial function Chief Execu)ve Officer (CEO)

• Ul@mate management responsibility and decisionmaking power in the firm
• Reports directly to the board of directors, which is accountable to the company’s owners

Company organisation chart


Managing the =inancial function Chief Financial Officer (CFO)

• Reports directly to the CEO and manages all aspects of the company’s financials
• CFO’s Key Financial Reports:
• The Controller prepares financial statements, oversees

the firm’s cost accoun@ng systems, prepares taxes, and works closely with the firm’s external auditors

Managing the =inancial function • CFO’s Key Financial Reports cont’d:

• The Treasurer looks a`er the collec@on and disbursement of cash, invests excess cash, raises new capital, handles foreign exchange, and oversees the firm’s pension fund managers
• Risk manager manages company’s financial and commodity risk
• Controller prepares financial statements, accoun@ng systems, tax and external auditors
• The Internal Auditor is responsible for in-depth risk assessments, performing audits of high-risk areas

Managing the =inancial function External auditors

• Provide an independent annual audit of the

firm’s financial statements
• Ensure that the financial numbers are reasonably accurate, and accoun@ng principles have been consistently applied

Managing the =inancial function Audit commiGee

• Has responsibility of overseeing the accoun@ng

func@on and prepara@on of the company financial statements
• Conducts inves@ga@ons of fraud and the` and also ensures that the external auditors are independent from management

The goal of the company
What should management maximise?

• Minimising risk or maximising profits

without regard to the other is not a successful strategy

The goal of the company
Why not maximise profits?
• Under crea@ve accoun@ng, a decision that increases

profits under one set of accoun@ng rules can reduce it under another.
Under crea@ve accoun@ng, a decision that increases profits under one set of accoun@ng rules can reduce it under another
Accoun@ng profits are not necessarily the same as cash flows Profit maximisa@on does not tell us the @ming cash flows are to be received
Profit maximisa@on ignores the uncertainty or risk associated with cash flows

The goal of the company
Maximise the value of the company’s share price

• When analysts and investors determine the

value of a company’s share price, they consider
• The size of the expected cash flows
• The @ming of the cash flows
• The riskiness of the cash flows.

• The mechanism for determining share prices is

based predominately on cash-flows from correct and well executed business decisions

Major factors affecting share prices 18

The goal of the company
Can management decisions affect share prices?

• There are many factors that can affect this:
• Short term
• Adver@sing campaign

• Long term
• Inves@ng on new building

Agency con=licts: separation of ownership and control
Ownership and control

• For large companies, the ownership of the firm

is spread over a number of shareholders and the company’s owners may effec@vely have li#le control over management
• Management may make decisions that benefit their self-interest rather than those of the shareholders Agency con=licts: separation of ownership and control
Agency rela)onships

• An agency rela@onships arises

whenever one party, called the principal, hires another party, called the agent
• Agents have a fiduciary duty to shareholders to put shareholders interests above their own

Agency con=licts: separation of ownership and control
Do managers really want to maximise share price?

• Shareholders own the company, but managers

control the money and have the opportunity to use it for their own benefit
Agency Costs

The costs of the conflict of interest between the company’s owners and its management

Agency con=licts: separation of ownership and control
Aligning the interests of management and shareholders

• Board of directors
• represent shareholders’ interest in major decisions regarding the company
• Management Compensa@on
• a significant por@on of management compensa@on is
@ed to firm performance (e.g. share price)

Agency con=licts: separation of ownership and control
Aligning the interests of management and shareholders

• Managerial labour market
• Companies with poor track record will have difficulty in a#rac@ng quality people
• The takeover market
• Corporate raiders may acquire a company at a discount due to its poor performance and replace current managers with a new manager

Agency con=licts: separation of ownership and control
Aligning the interests of management and shareholders

• Control of the firm
• If the interests of the manager and the firm are not aligned, then eventually the firm will under perform rela@ve to its true poten@al
• An Independent Board of Directors
• Lack of board independence is a key factor in the misalignment between board members’ and shareholders’ interests

Agency con=licts: separation of ownership and control
Sarbanes-Oxley and CLERP 9

• Greater Board & Auditor Independence
• Establish Internal Accoun@ng Controls
• Establish Ethics Program
• Expand Audit Commi#ee’s Oversight Powers
• Enhances disclosure and accountability to


The importance of ethics in business
Business Ethics

• A society’s ideas about what ac@ons are right and wrong
Are Business Ethics Different?
• Tradi@ons of morality are relevant to business and financial markets
• Corrup@on in business creates inefficiencies in an economy

The importance of ethics in business
The law is not enough
Ethicists argue that laws and market forces are not enough • Serious Consequences

• Legal cost of ethical mistakes can be

extremely high

The importance of ethics in business
Case Study
• Dick Smith Commercial
• Dick Smith IPO

Case study: Dick Smith
• Australia’s oldest electronics retailer.
• “I’m very proud that a business I started with $610 has lasted for 48 years and employed thousands of people”—Dick Smith
• Mr Smith sold the business to Woolworths in 1982, which ran it un@l September 2012 when it was bought by private equity firm Anchorage Capital Partners for $94 million.
• The business floated on the Australian Securi@es
Exchange in December
2013 for a massive $520 million. 30
“Dick Smith to close all stores, 3000 staff to go”, SMH, Feb 25 2016

Case study: Dick Smith
• A steep plunge in the share price last year leading up to the receivership.
• Overnight the retailer was placed into receivership by major lenders NAB and HSBC a`er weak sales and cash genera@on in the crucial Christmas trading period.
• Receivers for the troubled business announced on 25th
Feb the 301 Australian stores and 62 in New
Zealand shut their doors over the next eight weeks.
“Dick Smith to close all stores, 3000 staff to go”, SMH, Feb 25 2016


Case study: Dick Smith
“DeloiGe 'in firing line' aXer Dick Smith failure”

---Financial Review, 5 Jan 2016 “..why the gatekeeper didn't raise red flags about refinancing problems and inventory issues in the company's full-year accounts ….”

• Deloi#e gave Dick Smith's 2014-15 finances a clean bill of health in August. Deloi#e earned $338,000 for conduc@ng the audit, in addi@on to $103,927 for other services rendered.
• Inventory valua@on is fundamental, par@cularly in a retail audit.
Inventory is one of the biggest items on a retailer's balance sheet. As such, it is also one of the biggest sources of risk.
• What was the role of the auditor?

“Deloitte 'in firing line' after Dick Smith failure”, AFR, Jan 5 2016

Case study: Dick Smith
• A new auditor repor@ng regime is due to start in 2017.
• New "extended audit reports" will require auditors to call out key areas of risk and outline in some detail the stress tes@ng undertaken to sa@sfy themselves about the financial performance and posi@on of the company.
• In the past, this informa@on was for audit commi#ee and senior management eyes only.
• Ques@ons are being raised about whether this new regime could have averted this disaster.
• Broad consensus says "No". But it should reduce the shock factor. “Deloitte 'in firing line' after Dick Smith failure”, AFR, Jan 5 2016


Case study: Dick Smith
“How private equity won on Dick Smith and investors got burnt”

--Business Insider, Jan 7 2016
• While investors in Dick Smith Holdings shares could end up with nothing, the private equity firm that acquired Dick Smith from Woolworths in 2012 has already recouped its cash investment several @mes.
• How did Anchorage Capital Partners manage to acquire Dick
Smith from Woolworths in 2012 in a deal worth A$115 million and list it in the market for an equivalent total market value of
A$520 million?
“How private equity won on Dick Smith and investors got burnt”, Business Insider, Jan 7 2016

Case study: Dick Smith
• Private equity firms typically represent informed investors such as high net worth individuals, or fund managers looking for higher returns through leveraged investments.
• The firms have a very clear objec@ve: iden@fy businesses with poten@al for high returns based on their balance sheet, opera@ng poten@al or capacity for leverage and for tax benefits but to exit as soon as objec@ves are achieved.
• The objec@ve is not to acquire a business with the objec@ve of inves@ng for the longer term, but purely with a view to exi@ng at a point where the return for risk rela@on is maximised.
“How private equity won on Dick Smith and investors got burnt”, Business Insider, Jan 7 2016

Case study: Dick Smith
In the case of Dick Smith: • Anchorage received a price of more than A$2 a share, liquida@ng the majority of its holding.
• Anchorage will have made many @mes its in@al investment at the lis@ng of Dick Smith Holdings even a`er paying the upside to Woolworths if any requirement as part of the deal.
• The losers will be those who are commi#ed, management, shareholders, par@cularly those who held on since the Dick
Smith Holdings lis@ng and unsecured creditors with skin in the game vs Achorage which is simply involved.
• Ethics? What happened?

“How private equity won on Dick Smith and investors got burnt”, Business Insider, Jan 7 2016

Recap on time value of money
• Money has a @me value because a dollar today is worth more than a dollar tomorrow
• Future value (FV) measures what one or more cash flows are worth at the end of a specified period.
• Present value measures what one or more cash flows that are to be received in the future will be worth today
(at t=0).
• Compounding is the process of earning interest over
• Discoun@ng is the process of conver@ng future cash flows to their present values


Single cash =low
PV = n (1+ i)
FVn = value of investment at the end of period n

PV = original principle (P0) or present value i = the rate of interest per period n = the number of periods

Single cash =low
Compounding More Frequently Than Once a Year

• The more frequently the interest payments are compounded, the larger the future value of $1 for a given @me period.

Where: m = Number of compounding periods in a year.

Con)nuous compounding

• When compounding interval is so fine, un@l at the extreme, it is compounded con@nuously

Multiple cash =lows
PVAn = CF × Present value factor for an annuity
• any financial contract calling for equally spaced level cash flows over finite number of periods factor ) ⎤
⎡ (1 − Present value
= CF × ⎢

• Present value of ordinary annui@es i ⎣

1 ⎤

⎢ (1 + i ) n ⎥

= CF × ⎢ i ⎥
FVA n = CF ×⎢Future value factor for an annuity

Future value factor - 1 i ⎡(1+ i)n − 1⎤
= CF × ⎢


• Annuity due = Ordinary annuity value × (1+i)
= CF ×
• Future value of ordinary annui@es


Multiple cash =lows
Ordinary annuity: example
A financial contract pays $50,000 at the end of each year for 10 years. The appropriate discount rate is 5%. What is the present value of this series of cash flows?
PVA=$50,000∗ 1−1/(1+0.05 )↑10 /0.05 = $50,000*7.722=

What if the interest rate is 7%?
PVA=$50,000∗ 1−1/(1+0.07 )↑10 /0.07 = $50,000*7.024=


Multiple cash =lows
• A perpetuity is constant stream of cash flows that goes on for infinite period
• In share markets, preference shares issues are considered to be perpetui@es, with issuer paying a constant dividend to holders • Present value of perpetuity: • Example: A fund pays $100,000 every year at the end of each year. The annual interest rate is 0.08. What is the present value of this perpetuity? PVP=$100,000/0.08=$1,250,000


Multiple cash =lows
Growing annui@es
• Cash flows that increase each year at constant rate
• Example of growing annuity: valua@on of growing business whose cash flows increase every year at constant rate
• Present value of growing annui@es

• Example: A coffee shop is running for 10 years. It is expected to produce $300,000 at end of this year, and the number is expected to grow constantly at 2.5% per year. If the discount rate is 15%, what is the value of the 10 cash flows generated by the coffee shop?
PVA= 300,000/0.15−0.025 ∗(1−( 1.025/1.15 )↑10 )=$1,640,640


Multiple cash =lows
Growing perpetuity
• Present value of a growing perpetuity CF1 PVA ∞ =
(i - g) Example: Company ABC is expected to pay a dividend of $0.5 at end of this year. The dividend is growing at a constant rate of
2%. The cost of equity is 15%. What is the company’s share price? P=$0.5/(0.15-0.0.2)=$3.85

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