Chapter 1

An Introduction to Financial Management

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Learning Goals
1. Define finance, its major areas and opportunities available in this field, and the legal forms of business organization. 2. Describe the managerial finance function and its relationship to economics and accounting. 3. Identify the primary activities of the financial manager. 4. Explain the goal of the firm, corporate governance, the role of ethics, and the agency issue. 5. Understand financial institutions and markets, and the role they play in managerial finance.
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What is Finance?
Finance can be defined as the art and science of managing money. Finance is concerned with the process, institutions, markets, and instruments involved in the transfer of money among individuals, businesses, and governments.

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Major Areas & Opportunities in Finance: Financial Services

Financial Services is the area of finance concerned with the design and delivery of advice and financial products to individuals, businesses, and government. Career opportunities include banking, personal financial planning, investments, real estate, and insurance.

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Major Areas & Opportunities in Finance: Managerial Finance

Managerial finance is concerned with the duties of the financial manager in the business firm. The financial manager actively manages the financial affairs of any type of business, whether private or public, large or small, profit-seeking or not-for-profit. They are also more involved in developing corporate strategy and improving the firms competitive position.
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Major Areas & Opportunities in Finance: Managerial Finance (cont.)

Increasing globalization has complicated the financial management function by requiring them to be proficient in managing cash flows in different currencies and protecting against the risks inherent in international transactions. Changing economic and regulatory conditions also complicate the financial management function.
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Legal Forms of Business

Sole Proprietorship 1. 2. 3. Legal status Owner Liabilities of owner Ownership of properties Management No legal status One Unlimited liabilities Partnerships No legal status Minimum 2, maximum20 Unlimited liabilities Corporation Separate legal entity Private Co: min2, max 50 Public Co: min 2, no max Limited to the amount of shares subscribed by the shareholders Owned by the company Managed by the Board of directors. Director may or may not be the shareholder of the company By undergoing legal windingup. Perpetual succession unless the company is liquidated.

4. 5.

Owned by the soleproprietor Managed by the soleproprietor

Jointly owned by the partners Every partner is entitled to participate

6.

Termination

Occurs on the owners death or by the owners choice

When any one of the partner: -passed away; -becomes a bankrupt -withdraws; or becomes insane

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Other Forms of Business

General Partnership All partners have unlimited liability. Limited Partnership Consists of one or more general partners, who have unlimited liability. One or more limited partners (investors) whose liability is limited to the amount of their investment in the business. Limited Liability Company (LLC) Cross between a partnership and a corporation. Owners have limited liability, but the firm runs and is taxed like a partnership.
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Strengths and weaknesses

Sole Proprietorship Strengths Ease of formation and dissolution Minimize regulations, and more secrecy Low organisation cost Maintain complete and ultimate control The proprietor is entitled to all the profits Unlimited liabilities Limited fund raising Proprietor must be jack-of-all trades The firm is terminate when the proprietor dies Partnership Ease of formation and dissolution then corporation Raise more funds than the sole proprietorship the limited partnership permits some of the partners the privilege of limited liability Corporation Limited liabilities Ease in raising capital Continuity of the business regardless of an owner's withdrawal or death Ease of ownership transferability Manage by the professional Complicated to form. May need professional assistant High organisation cost Greater regulation and lack of secrecy
y y y y y y y y y

y y

y y

Weaknesses

y y y y

y y

y y

Unlimited liabilities Each partner is liable for the actions of the other partners Difficult of partnership transferability Terminated upon a partner's death.

y y

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Corporate Organization

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The Managerial Finance Function

The size and importance of the managerial finance function depends on the size of the firm. In small companies, the finance function may be performed by the company president or accounting department. As the business expands, finance typically evolves into a separate department linked to the president as was previously described in Figure 1.1.

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The Managerial Finance Function: Relationship to Economics

The field of finance is actually an outgrowth of economics. In fact, finance is sometimes referred to as financial economics. Financial managers must understand the economic framework within which they operate in order to react or anticipate to changes in conditions.
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The Managerial Finance Function: Relationship to Economics (cont.)

The primary economic principal used by financial managers is marginal costbenefit analysis which says that financial decisions should be implemented only when added benefits exceed added costs.

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The Managerial Finance Function: Relationship to Accounting

The firms finance (treasurer) and accounting (controller) functions are closely-related and overlapping. In smaller firms, the financial manager generally performs both functions.

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The Managerial Finance Function: Relationship to Accounting (cont.)

One major difference in perspective and emphasis between finance and accounting is that accountants generally use the accrual method while in finance, the focus is on cash flows. The significance of this difference can be illustrated using the following simple example.
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The Managerial Finance Function: Relationship to Accounting (cont.)

UTAR Bhd experienced the following activity last year:
Sales Costs RM100,000 (1 yacht sold, 100% still uncollected) RM80,000 (all paid in full under supplier terms)

Now contrast the differences in performance under the accounting method versus the cash method.
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The Managerial Finance Function: Relationship to Accounting (cont.)

INCOME STATEMENT SUMMARY ACCRUAL Sales Less: Costs Net Profit/(Loss) RM100,000 (80,000) RM20,000 CASH RM0 (80,000) RM(80,000)

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The Managerial Finance Function: Relationship to Accounting (cont.)

Finance and accounting also differ with respect to decision-making. While accounting is primarily concerned with the presentation of financial data, the financial manager is primarily concerned with analyzing and interpreting this information for decisionmaking purposes. The financial manager uses this data as a vital tool for making decisions about the financial aspects of the firm.
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Primary Activities of the Financial Manager

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Goal of the Firm: Maximize Profit???

Which investment is preferred?
Cash flow Year 1 Project A Project B RM1.00 0 Year 2 0 0 Year 3 0 RM1.50 Total RM1.00 RM1.50

Profit maximization fails to account for differences in the level of cash flows (as opposed to profits), the timing of these cash flows, and the risk of these cash flows. 1-20

Basic Goal: Shareholder Wealth Maximization

Primary objective for firm Shareholder Wealth Maximization Measured by the market value of shareholders common stock holdings
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Goal of the Firm: Maximize Shareholder Wealth!!!

Why? Because maximizing shareholder wealth properly considers cash flows, the timing of these cash flows, and the risk of these cash flows. This can be illustrated using the following simple stock valuation equation: level & timing of cash flows

Share Price = Future Dividends Required Return

risk of cash flows

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Goal of the Firm: Maximize Shareholder Wealth!!! (cont.)

The process of shareholder wealth maximization can be described using the following flow chart:

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Goal of the Firm: Maximize Shareholder Wealth!!! (cont.)

Shareholder Wealth Maximization is the same as: Maximizing Firm Value Maximizing Stock Price

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Goal of the Firm: What About Other Stakeholders?

Stakeholders include all groups of individuals who have a direct economic link to the firm including employees, customers, suppliers, creditors, owners, and others who have a direct economic link to the firm. The "Stakeholder View" prescribes that the firm make a conscious effort to avoid actions that could be detrimental to the wealth position of its stakeholders. Such a view is considered to be "socially responsible."

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The Agency Issue: The Agency Problem

Whenever a manager owns less than 100% of the firms equity, a potential agency problem exists. In theory, managers would agree with shareholder wealth maximization. However, managers are also concerned with their personal wealth, job security, fringe benefits, and lifestyle. This would cause managers to act in ways that do not always benefit the firm shareholders.

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The Agency Issue: Resolving the Problem

Market Forces such as major shareholders and the threat of a hostile takeover act to keep managers in check. Agency Costs are the costs borne by stockholders to maintain a corporate governance structure that minimizes agency problems and contributes to the maximization of shareholder wealth.

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The Agency Issue: Resolving the Problem (cont.)

Examples would include bonding or monitoring management behavior, and structuring management compensation to make shareholders interests their own. A stock option is an incentive allowing managers to purchase stock at the market price set at the time of the grant.

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The Agency Issue: Resolving the Problem (cont.)

Performance plans tie management compensation to measures such as EPS growth; performance shares and/or cash bonuses are used as compensation under these plans. Recent studies have failed to find a strong relationship between CEO compensation and share price.

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Financial Institutions & Markets

Firms that require funds from external sources can obtain them in three ways: through a bank or other financial institution through financial markets through private placements

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Financial Institutions & Markets: Financial Institutions

Financial institutions are intermediaries that channel the savings of individuals, businesses, and governments into loans or investments. The key suppliers and demanders of funds are individuals, businesses, and governments. In general, individuals are net suppliers of funds, while businesses and governments are net demanders of funds.
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Financial Institutions & Markets: Financial Markets

Financial markets provide a forum in which suppliers of funds and demanders of funds can transact business directly. The two key financial markets are the money market and the capital market. Transactions in short term marketable securities take place in the money market while transactions in long-term securities take place in the capital market.
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Financial Institutions & Markets: Financial Markets (cont.)

Whether subsequently traded in the money or capital market, securities are first issued through the primary market. The primary market is the only one in which a corporation or government is directly involved in and receives the proceeds from the transaction. Once issued, securities then trade on the secondary markets such as Bursa Malaysia or MESDAQ.
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Financial Institutions & Markets: Financial Markets (cont.)

Private Placement The sale of a new security issue, typically bond or preferred stock, directly to an investor or group of investors (insurance company, pension fund, mutual fund)

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The Relationship between Financial Institutions and Financial Markets

(A) Securities (A) Cash (A) Securities (A) Cash

Firms
(C) Cash flow distribution

Financial Markets
(C) Cash flow distribution

Investors

(D) Reinvestment

(D) Reinvestment

(B) Corporate Taxes

Government

(B) Income Taxes

Figure 1-1: Flows of funds between firms, government and investors in the financial markets

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