what is financial management and example| what are the objectives of financial management

When we think about finance, what comes to mind may include bank accounts,stock market, mortgages, mutual funds, hedge funds,derivative securities, venture capital, private equity, IPOs. Of course, these areall parts of finance-- financial products, services,markets, and institutions. But in fact, finance is a lotmore important and fundamental to our economy and our welfare. It is really about how to makethe best economic decisions or how to best utilize thelimited resources we have to meet our economic needs. We would like to illustratethis point with an example. 

Suppose that you are amarketing manager at a company. You are thinking abouta new marketing campaign for your existing product line. Independent of thedetails of the plan being online orthrough regular media, the ultimate goal is toincrease future profit from increasing sales. Of course, the plancould cost some money. Let's assume that the costof the whole marketing plan is $10 million today. If launched, you willincrease the firm's profit from new sales by $12million next year for sure. 

To keep thingssimple, let's assume this is the only benefitfrom this marketing plan.  The overall cash flow for themarketing plan which we also refer to as a projectusing a more generic term is given in the chart. A downward arrow represents acash outflow, a negative cash flow. And upward arrow represents acash inflow, a positive cash flow. Your decision is whetherto launch this project. How do you make this decision? You'll be toosimplistic to simply say our net profit is $12 minus $10. That's $2 million. Thus, this is a good deal. This is because $12 millionin new profits is next year. And it cannot be simply netwith the $10 million cost today. They are money at differentpoints in time thus cannot be compared directly. But how should wecompare them then? 

We can also viewthis as an investment investing $10 million todayand returning $12 million next year, yieldinga sure return of 20%. Is a return of 20% a good deal? Maybe. Maybe not. It depends. In the absence ofother information, answers to these questions maybecome a subjective judgment. However, suppose now weknow that one-year bank deposits offer a sureinterest rate of 5%. Then we can't answerthis question easily. Clearly, the projectoffers a good deal. It gives us a surereturn of 20%, which is much higher than one canget from other investment opportunities in thefinancial market such as bank deposits, which are easilyavailable to everyone. Thus, by taking on this project,we are earning higher returns and thus creating valuefor the shareholders and the society at large. What if the interestrate in a market is 25%? Then clearly, this isnot a good project. Shareholders can easilyinvest their money in a market to earn 25%, whichis higher than the return the project gives.

 Investing in the projectwould be destroying value rather than creating value. In the scenario abovelabeled A in the graph, we only need to value asingle cash flow, $12 million for sure in one year. How about if the $12 millionis spread over the next three years, $4 millioneach year, shown in the plot as scenario B? In this case, weneed to know how to value cash roles indifferent points in time. Given that the cash flow arrivesin the future, most likely they are uncertain. This is scenario C in which$4 million each year only represents our forecastof the cash flow. Its realization is uncertain. It can be lower orhigher than $4 million. This is reflected also bythe lighter blue color we use to describe the cash flow. In this case, theassessment of the project further requires us to knowhow to value risky cash flows in the future. This example leads totwo key conclusions. First, a business decision,in this case, a marketing campaign, ultimatelyis about how to value a projector its cash flows. This is fundamentallya finance problem. Second, the valuation isnot a subjective exercise but determined bythe financial market. 

Of course, whatwe call a project can be any business activity. It can be a marketingcampaign like in example. It can also be an expansionof the current product line, the R&D initiative,an acquisition of another business, an upgradeof the current IT system, the reorganization ofexisting workforce, and so on. So finance is the basic tool weneed to value these activities and to make sound decisions. The previous example illustratethe fundamental importance of finance in economicdecision-making. It is about the bottom lineof any business activity. More generally, abusiness activity involves acquiringand disposing assets. Here an asset refers toanything and everything that is of economic value. Its shape and formcan be very generic. It can be a real assetlike a plant and machinery or a financial assetlike cash and bonds. It can be tangiblelike land and stocks or intangible like brandname, goodwill, and ideas. All business activities servetwo basic economic functions-- one, to grow wealth orcreate value and two, to manage existing wealth tobest meet future economic needs as shown by the previousexample we have just discussed. Therefore, a businessdecision starts with the valuation of assets. You can't create and managewhat you can't measure. 

Value is an objective measure. It is determined bythe financial market. Valuation is the centralissue of finance and business decision-making. So the questions we wouldlike to answer in this course are as follows. First, how to value assets? As we've seen, allbusiness decision-makings first require theproper valuation of the assets involved. Second, how should firms makesound financial decisions? For example, whatprojects to invest in. That's sometimes alsocalled capital budgeting or real investment decisions. How to finance a project,that's a financing decision by either issuingfinancial claims or securities such asloans, bonds, and stocks. Third, what to payto shareholders.

 That's often referred to as payout policy. And also, what risk totake on or to avoid. And that's sometimes also referred to as risk management. And third, how should householdsmake financial decisions? We will address these questions by developing and applying a unified analytical framework and a set of basic finance principles.