TOPIC 1

Overview of Financial Management

Career Opportunities
Issues
Form of Business Organization
Goals of the Corporation
Agency Relationship
Principles That Form The Foundations
of Financial Management
Career Opportunities:
1: Money and Capital Markets
Financial Institutions including
commercial/merchant banks, finance company,
insurance company, mutual funds, credit
company etc.

The type of knowledge required include valuation

techniques, factors causes interest rate to , financial
institutions regulation, types of financial instruments,
and also general knowledge of business functions like
management, accounting, marketing, IT, business
communication, human resource management etc.
Career Opportunities:
2.Investments
As a Sales or Security Analyst, finance graduates will join
the brokerage firms, banks, mutual funds, insurance
companies and financial consultant firms to provide advise
to individual and institutional investors on HOW TO INVEST
their funds.

The main functions is to advise on Sales, The Analyst of

Individual Securities, and Determining the Optimal Mix
of securities.
Career Opportunities:
3. Financial Management

Greatest number of jobs available from financial

institutions as well as governmental, industries and retails.

Responsibilities include plant expansion, issuance of different

types of securities, credit terms to customers, level of
inventory, management of working capital, dividend policy,
merger and acquisitions etc.
Financial Management
Issues
inflation and its effect
deregulation of financial institutions and its resulting
effect
the increase usage of information technology in
analysis and electronic transfer of information ( as well
as funds)
the effect of globalization of markets and business
operations.
Responsibilities:
Financial Managers
FORECASTING AND PLANNING - look ahead and lay the
plan to shape the company future.

INVESTMENT AND FINANCING Decision - determining the

optimal sales growth rate, capital expenditure, types of
assets etc

COORDINATION AND CONTROL - financial manager needs

to interact with non-financial managers to ensure that the
operation of the firm is harmonized e.g. marketing effect
production effect raw material/overhead/labor effect cash
flow effect equipment acquisition effect profit effect
dividend
Form of Business Organization

Sole Proprietorship
Partnership
Corporation
Hybrid
Form Of Business Organization:
1. Sole Proprietorship
Advantages
- ease of formation
- subject to few regulations
- no corporate tax - individual tax

Disadvantages
- limited life
- unlimited liability
- difficult to raise capital
Form of Business Organization:
2. Partnership
Advantages:

- ease of formation
- less expensive to operate
- tax is base on partners rather than partnership
- easy access to more funds and skills

Disadvantages:

- unlimited liability
- incapacitated or death of one partner will dissolve
the entire partnership.
- difficult to raise large amount of funds
Form of Business Organization:
3. Organization
Advantages

- unlimited life
- easy transfer of ownership
- limited liability
- ease of raising capital - access to public funds
- more tax incentives

Disadvantages
- high cost of set-up and report filing
- follow host of provision in the company act
Form of Business Organization:
Hybrid Form

Limited Partnership - limited partners vs. general partners

Limited Liability Partnership- all partners enjoy limited

liability as in corporation.

Professional Corporation- limited in term of corporate

liability but unlimited in term of professional (malpractice)
liability.

S Corporation- differ in term of taxes where it is more

similar to tax of partnership.
Corporate Goal

Throughout this course we will hold to the

principle that the goal of corporation is to
maximize the stockholder wealth which translates
into the maximization of the price of the firms
common stock.
Corporate Goal:
Manager Incentive vs. Shareholder Wealth
Shareholders elect board elect management. Management
suppose to operate for the best of the shareholder
BUT if the shareholding is diluted, management has a great
deal of autonomy.
Managers might pursue goals other than/in addition to the
interest of the shareholders.
Shareholders return is at reasonable level rather than
maximize level
However, managers in competitive environment will take
necessary actions consistent with shareholders wealth
maximization or they might be removed from their jobs
Corporate Goal
Shareholder Wealth vs. Social Responsibility

Is the maximization of shareholder wealth the ONLY

responsibility of firm?
Are firm also responsible for the welfare of its employee,
customers and the communities at large?
Increase in social responsibility lead to increase in cost
which effect the price of the share.
Other firm which does not follow suit will have lower cost
and price of product/services. This will attract more capital.
If it is made mandatory then the burden (cost) falls
uniformly on all business.
There is a need for government and industry to corporate
to establish the rules of corporate behavior.
Corporate Goal:
Shareholder Wealth vs.. Social Welfare

Maximizing of stock price improve social welfare when:

- the firm is able to produce high-quality

goods/services at the lowest possible cost,
- developed goods/services that the customer want
and need which requires new technology, new
product and new jobs
- necessitates efficient and courteous service, well
stocked merchandise and good location.
- BUT should avoid monopoly, violating safety
standards, and meet pollution control requirements
Business Ethics
Ethics means standard of conduct or moral behavior
Business ethics relates to companys attitude towards its
employee, customers, community and stockholders.
High ethical standards demand:
- fair and honest manner in dealings
- adhere to laws and regulations relating to
- safety and quality,
- fair employment practice,
- fair marketing and selling practices,
- community involvement,
- avoid bribery and illegal payment
 Business Ethics
Profit vs.. Ethics
Conflict arises between profit and ethics
Sometime ethics dominates but at some other time profit
dominates
The choice between the two is not clear cut.
If a new product being released have some negative effect
(although it is still questionable) but strong evidence of
benefit to customers, should the company release this
information (which would hurt sales and profit)?
Agency Relationships
The Shareholder is a separated entity to the company

The shareholder i.e. the principal hire (nominate) the

board/management i.e the agent to manage the company.

Thus the agency relationship arises.

In financial management agency relationship exist

- between the shareholders and management

- between the debtholders and the shareholder
Agency Relationships:
Agency Conflict
In a sole proprietorship the owner is the manager. Thus,
the owner-manager will act to maximize his own welfare.
In a situation where the owner is not the manager, or where
the ownership is highly diluted, agency conflict arises.
Where the manager is not the owner, or the manager owns
a small percentage of ownership, the shareholder wealth
maximization will take a secondary objective.
Managers will concentrate upon increasing its own job
security, increases its salaries and status, provide more
opportunities to middle- and lower-level managers and
satisfying his voracious appetite for salaries and
perquisites (benefits) - ALL AT THE EXPENSE OF
STOCKHOLDERS.
 Agency Relationships
Agency Cost

To ensure that the managers maximize the shareholders

wealth rather than the manager self-interest, agency cost is
incurred to monitor the action of the managers.
These monitoring activities include:

- auditing
- structuring the organization to avoid negative
managers actions
- opportunity cost i.e. requiring managers to seek
shareholders votes on important issues which
hinders managers quick/timely decisions.
Agency Relationships
Managerial Incentives
To ensure that the managers actions are in the best
interest of the shareholders, two extreme position can be
taken:

-one extreme is that managers compensation is base

purely upon changes in stock price (this would be difficult
because stock price changes is also effected by external
factors)

- the other extreme is to monitor every manager

actions and decisions (it will be too costly)
Agency Relationships
Managerial Incentives (cont.)
The solution lies in between the two extreme mentioned.
There are four possible methods to ensure managerial
actions towards share price maximization

- Performance-Based Incentive Plan

- Direct intervention by Shareholders

- The Threat of Firing

- Takeovers
Agency Conflicts
Shareholders vs.. Creditors
Creditors are parties that lend funds to the company. They
have a claim on the firm earning through interest payments
and principal. These claim is fixed in accordance to the
agreement made.
Shareholders on the other hand through their
directors/managers control the decision in the firm.
If the managers decide to invest in a risky business this will
increase the risk to the creditors. If everything goes well,
the shareholders will benefit from the exceptional returns
BUT not the creditors whose returns are fixed. If losses
were incurred then both parties will suffer.
To best serve the shareholders, managers must be fair to
both the shareholders and creditors or will be saddled with
high interest rate or restricted access to the debt market.
Maximizing Shareholders Wealth
Manager Actions
Should managers concentrate on maximizing profit to
ensure that shareholders wealth is maximize?

Before After
Shares Issued 1.0 million 2.0 million
Profits RM0.5 million RM0.8 million
Earning Per share RM0.50 RM0.40

Although the profit increases, the EPS falls by RM0.10.

Managers should concentrate upon EPS rather than the
corporate profits
Maximizing Shareholders Wealth
Managerial Actions
In addition to concentrating upon maximizing EPS
managers must also take into account the TIMING OF THE
EARNING.
-Money received today is always better than money
received tomorrow.
Another issue is the riskiness of the earning. We will
always assume that investors are risk averse. The higher
the risk the higher the required returns.
To a certain extent risk is being measured by the method
of financing. If debt financing is higher then the risk is
also higher.
Managers must also decide how much will be paid as
dividend and how much to retain. Both are preferred by
shareholders. Retaining Earning lead to higher future EPS
Ten Principles That Form The
Foundations of Financial
Management
 Principle 1: The Risk-Return
Trade-off

We wont take on additional risk unless

we expect to be compensated with
additional return.
Investment alternatives have different
amounts of risk and expected returns.
The more risk an investment has, the
higher will be its expected return.
 Principle 2: The Time Value of
Money

A dollar received today is worth more

than a dollar received in the future.

Because we can earn interest on money

received today, it is better to receive
money earlier rather than later.
 Principle 3: CashNot Profits
Is King

Cash Flow, not accounting profit, is

used to measure wealth.

Cash flows, not profits, are actually

received by the firm and can be
reinvested.
 Principle 4: Incremental Cash
Flows

It is only what changes that counts

The incremental cash flow is the

difference between the projected cash
flows if the project is accepted, versus
what they will be, if the project is not
accepted
 Principle 5: The Curse of
Competitive Markets

Why it is hard to find exceptionally

profitable projects

If an industry is generating large profits,

new entrants are usually attracted. The
additional competition and added
capacity can result in profits being
driven down to the required rate of
return
 Principle 6: Efficient Capital
Markets

The markets are quick and the prices

are right

The values of all assets and securities

at any instant in time fully reflect all
available information.
 Principle 7: The Agency Problem

Managers wont work for the owners

unless it is in their best interest

The separation of management and the

ownership of the firm creates an agency
problem. Managers may make
decisions that are not in line with the
goal of maximization of shareholder
wealth
 Principle 8: Taxes Bias Business
Decisions

When a new project is evaluated, the

after-tax incremental cash flows are
considered
 Principle 9: All Risk is Not
Equal

Some risk can be diversified away, and

some cannot

Diversification allows good and bad

events or observations to cancel each
other out, thus reducing total variability
without affecting expected return
 Principle 10: Ethical Behavior
Is Doing The Right Thing, and
Ethical Dilemmas Are
Everywhere In Finance

Each person has his or her own set of

values, which forms the basis for
personal judgments about what is the
right thing
END OF CHAPTER