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1. The Financial System
Imagine the financial system as the heart of an economy. Just as the heart pumps blood throughout the body, the financial system circulates money throughout the economy. This system includes institutions like banks, insurance companies, stock markets, and even the government. They all work together to ensure money flows smoothly, enabling businesses to start, grow, and people to save and invest.
- Financial Institutions: Entities like banks, credit unions, and insurance companies that facilitate the flow of money in the economy.
- Financial Markets: Platforms where buyers and sellers trade financial assets, such as stocks, bonds, and currencies. Examples include the New York Stock Exchange (NYSE) or the Forex market.
2. Goals of the Corporation
Every person has ambitions or goals, be it buying a house or traveling the world. Similarly, corporations have goals. The primary goal of most corporations is to maximize shareholder value, which means to increase the worth of the company for its owners (the shareholders).
- Shareholder Value: The value delivered to the holders of a company’s shares. It’s reflected in the stock price and dividends the company pays out.
- Stakeholders: Anyone with an interest in a company, which can include employees, customers, suppliers, and more. Not to be confused with shareholders, who own a portion of the company.
3. Determinants of Value
Think of this as the ingredients in a recipe. For a company, the “ingredients” that determine its value include its assets (like machinery and buildings), its profits, its growth potential, the quality of its management, and more.
- Assets: Everything a company owns. It can be tangible like buildings, or intangible like patents or trademarks.
- Liabilities: What the company owes to others, like loans or unpaid bills.
- Equity: Essentially the value belonging to the owners. It’s the difference between assets and liabilities.
4. Modifying Accounting Data for Managerial Decisions: EVA, MVA, FCFs
These are tools that managers use to get a clearer picture of the company’s financial health, much like different medical tests check various aspects of human health.
- EVA (Economic Value Added): A measure of a company’s financial performance based on the residual wealth calculated by deducting the cost of capital from its operating profit.
- MVA (Market Value Added): The difference between the current market value of a company and the capital contributed by investors.
- FCFs (Free Cash Flows): The cash a company generates after accounting for cash outflows to support operations and maintain its capital assets. It’s like the money you have left after paying all your bills.
5. Components of Risk
Every decision has uncertainties. For companies, these uncertainties or risks can come from various sources like changing government policies, market competition, or even natural disasters.
- Systematic Risk: Risks that affect the entire market or segment, like interest rate changes. You can’t escape this risk through diversification.
- Unsystematic Risk: Risks specific to a single company, like a strike in one company’s factory. This can be reduced through diversification.
The financial staff’s task is to acquire and use funds to maximize the value of the firm. Finance people focus on the cash flows. There are risks associated with the financing ( cash flow management ). We should increase the cash flows of the company, decrease the risks of the company.
So generally if you are a financial manager, you try to increase the value of the company to the possible extend, the problem is as you increase the profitability return, risk starts to rise. There are certain points you have to find a trade off between those two.
Accounting numbers dose not tell us risks, they only tell us the result of the operation or financing. In the end, the value will be determined by the combination of the company performance as well as its risks.
The problem here is to find correct balance between the two measures, in finance we define cash flows in several ways,
- net income + depreciation is net cash flow
- net operating cash flow
- free cash flow
these are all different measures, generally the free cash flow is frequently used. Free cash flow is different from other two. The company makes investments in current assets, in fixed assets in order to generate income, you have to deduct the investment the company made in these assets from the income that it has generated so that you can find the net or the free cash flow. It is free so that it can be used anyway.