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Finance is the science and art of managing money. Finance functions involve
analysing the proper allocation of financial assets. The financial analysis applies
to business decision making of all types of businesses—private and public, large
and small, profit-seeking and not-for-profit.
The financial services area encompasses financial product design and the
delivery of financial advice. Loan officers, bank managers, and stock brokers are
some of the many financial services positions. The managerial finance area
encompasses the duties of the financial manager working in a business. Financial
analysts, cash managers, and credit analysts perform managerial finance roles.
There are three major forms of business organisation: (1) sole proprietorships, (2)
partnerships and (3) company/corporations.
Sole proprietorship
With unlimited personal liability, the proprietor can potentially lose all of their
personal assets, even those assets not invested in the business
When a new owner takes over the business, legally the firm becomes a new
proprietorship
Partnership
Shared ownership among two or more individuals, some of whom may, but do
not necessarily, have limited liability
The advantages and disadvantages are basically the same as sole proprietorship,
except that most partnerships have more source available for raising funds
because there are more owners, with more relatives, more friends and more
opportunities to raise funds through credit.
Even though they generally have greater capabilities than proprietorships to raise
funds to support growth, partnerships still have difficulty in attracting substantial
amounts of funds.
Under partnership law, each partner is liable for the debts of the business.
Therefore, if any partner is unable to meet their pro rata claim in the event the
partners must make good on unsatisfied claims, drawing on their personal assets
if necessary
Corporation
To illustrate the concept of limited liability, suppose you invested R10 000 to
become a partner in a business formed as a partnership that subsequently went
bankrupt, owing creditors R1 million. Because the owners liable for the debts of a
partnership, as a partner you would be assessed for a share of the company’s
debt; you could even be held liable for the entire R1 million if your partners could
not pay their shares. This is the danger of unlimited liability.
On the other hand, if you invested R10 000in the shares of a corporation that then
went bankrupt, your potential loss on the investment would be limited to your
R10 000 investment.
2. Ownership interests can be divided into shares, which can be transferred far
more easily than can proprietorship or partnership interest;
Shares can be bought and sold in minutes, whereas interests in proprietorships
and partnerships generally cannot.
3. A corporation can continue after its original owners and managers no longer
have a relationship with the business; thus it is said to have a limited life
The life of a corporation is based on the longevity of its shares, not the longevity
of those who own the shares (the owners).
Company
A company is a separate entity from the owners of the business. This means that
a company can be sued and taxed separately from the owners, and the owners
have limited liability.
A company can only be started if the business complies with the South African
Companies Act
A relatively new business form that offers the limited personal liability associated
with a corporation; however, the company’s income is taxed like that of a
partnership.
Financial managers need goals to guide and motive them when making
decisions on behalf of the organisation. Financial managers may formulate a
number of goals-to increase turnover, enhance market share, minimise costs,
avoid insolvency, maximise earnings per share or maximise profitability.
Profit maximisation
Maximising the rate of return
Maximising shareholders wealth
The goal of profit maximisation however has three main flaws. Firstly, accounting
profit can be manipulated through malpractice. Secondly, the goal of profit
maximisation ignores the issues of timing and risk associated with generating the
profit.
Shareholders’ wealth maximisation represents a forward-looking goal centred on
increasing the wealth of the owners, or shareholders, of the firm
The value of a firm can be measured by the market value of its shares. Thus, the
firm maximises value/wealth by maximising the value of its shares.
Value is measured as the present value of the cash flows that an investment is
expected to generate during its life. The three factors that determine value are:
(1) the amount of the future cash flows, (2) the timing of the future cash flows, and
(3) investors’ required rate of return. If the amount of the cash flows increases, the
cash flows are received sooner, investors’ required rate of return decreases, or
any combination of these events occur, the value of an investment will increase.
In a sole proprietorship and some partnerships, the owners are generally also the
managers of the business. It is therefore assumed that they will run the business in
such a manner as to maximise their own wealth. However, in publicly listed
companies, shares are held by a large number of shareholders. As the
shareholders cannot all be involved in the day-day management of the business,
managers are appointed.
Managers therefore become agents and are obligated to maximise the interests
of those who appointed them (the shareholders, also called the principals).
Unfortunately, it is often the case that managers run business to protect their own
interests (such as their job security, benefits and personal wealth) rather than to
promote the interests of the shareholders. This phenomenon is known as agency
problem
Example: You want to sell your house, but you do not have time to look for a
buyer. So you appoint an agent, Jack, to sell the house for you. You will pay Jack
R10 000 for selling the house. Your house is worth R500 000. In this scenario you are
the principal and Jack is the agent, who should take care of your interest.
Whether Jack sells the house for R300 000 or for R600 000, he will still receive
R10 000 for his efforts. However, he was appointed to look after your best interests,
and if he sells the house for less than R500 000 he has failed to do so. Jack’s fee
can be constructed as an agency cost because the agent deliberately did not
maximise the wealth of the principal.
2. Shareholder intervention
Along with such institutional shareholders as pension funds and mutual funds,
individual shareholders often ‘flex their muscles’ to ensure firms pursue goals that
are in the best interest of shareholders rather than mangers (where conflict might
arise). In addition, many institutional investors routinely monitor top companies to
ensure that managers pursue the goal of wealth maximisation.
In situations where large blocks of the shares are owned by relatively few
institutions that have enough clout to influence a fir’s operations, these
institutional owners often have enough voting power to overthrow management
teams that do not act in the best interests of shareholders.
Financial markets
Money markets
A money market is a market where short-term debt securities are bought and sold.
Short-term debt securities are those securities with a maturity of one year or less.
Money markets do not have a physical location, but participants (which include
individuals, businesses, government and financial institutions such as banks) are
connected electronically.
Capital markets
A capital market is a market where long-term debt securities are bought and sold.
Long-term debt securities have a maturity of more than one year, and the main
securities bought and sold are shares and bonds.
A secondary market is a market in which the original securities that were bought
in the primary market can be traded. For instance, If you were one of the investors
who bought shares in the original public offering for R10 and you decide to sell
your shares, you will do so in the secondary market.
Financial institution
Financial institution, such as commercial banks, life insurers, pension funds and
collective investment schemes (which include unit trusts), bring savers and lenders
together in an effort to allocate funds efficiently. Think, for instance, about your
local bank. If you save money in your account, you will receive a certain amount
of interest. The bank pays you that interest in return for the opportunity to lend
your money to some party in need of funds.
So, if the owner of the bakery is in need of a specific amount of money, he can
go to the bank and apply for a loan, for which he would be charged a certain
interest rate. So, in effect, the bank acts as a financial intermediary:
ASSESSMENT FORMAT
The role of managerial finance and the financial market environment will be
assessed mainly by means of multiple-choice questions (MCQs) because of its
highly theoretical nature. In the examination, you will be required to continuously
apply these basic concepts to other areas of finance.
REVIEW QUESTIONS
Question 1
1. Ethan chooses to pursue a risky investment for the company’s fund because
his compensation will substantially rise if it succeeds.
2. Emma instructs her staff to skip safety inspections in one of the company’s
factories, knowing that it will likely fail the inspection and will have to incur
significant costs to fix it.
3. Olivia ignores an opportunity for her company to invest in a new drug to fight
Alzheimer’s disease judging the drug’s chances of succeeding as low.
4. Henry chooses to enhance his firm’s reputation at some costs to shareholders
by sponsoring a team of athletes for the Special Olympics.
Answer 1
Question 2
Which of the following is typically the major factor in limiting the growth of a sole
proprietorship?
Answer: 4
Question 3
Answer: 3
Question 4
Answer:4
Question 5
Which of the following should be the primary goal pursued by the financial
manager of a company?
Answer: 2
Question 6
If all else were equal, in which of the following forms of business would the
possibility of an agency problem be the greatest?
1. A sole proprietorship.
2. A foreign corporation that is publicly traded.
3. A foreign corporation with concentrated ownership – that is, relatively few
owners.
4. A partnership in which all partners share management and decision-making
responsibilities equally.
Answer: 2
Question 7
Answer: 4
Question 8
Answer: 4
Question 9
1. Actions that maximise a firm's stock price are inconsistent with maximising
social welfare.
2. If government did not mandate socially responsible corporate actions, such
as those relating to product safety and fair hiring practices, most firms in
competitive markets probably would not pursue such policies voluntarily.
3. In extremely competitive industries, we would expect firms would voluntarily
engage in many socially beneficial projects to try to maximise their stocks'
values.
4. The concepts of social and ethical responsibility on the part of corporations
are completely different and neither is relevant in the maximisation of stock
price.
Answer: 2
Question 10
1. The difficulties that arise in professional baseball when players become free
agents.
2. The difficulties that arise when a principal hires an agency to represent their
company.
3. The difficulties that arise when a principal hires an agent and cannot fully
monitor the agent's actions.
4. When a principal hires an agent and must monitor every move they make
because they have found the agent to be unethical.
Answer: 3
Question 11
The agency problem shows up in many different situations within a firm. Which of
the following is not a good example of this problem?
Answer: 3
Question 12
Answer: 3
Question 13
Which one of the following statements about the company form of business
organisation is incorrect?
Answer: 2
Question 14
Answer: 1
Question 15
Until this year, Cheers Inc. was organised as a partnership. This year, the partners
have decided to organise the business as a corporation. As a result of this change
in organisational form, which of the following statements are most correct?
1. Cheers will now be subject to fewer regulations.
2. Cheers will now find it more difficult to raise additional capital.
3. Cheers’ investors will now find it more difficult to transfer ownership.
4. Cheers’ shareholders (the ex-partners) will now have limited liability.
Answer: 4