Introduction to

Finance
Topic One
The Role of Financial
Management
Chapter Learning Outcomes
1. Define finance and financial management
2. Identify the goal of the firm.
3. Identify the main financial decisions.
4. Understand the basic principles of finance and
their importance.
5. Identify the agency problem and the governance
of the corporation.
6. Understand the ethics in finance field.

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What is FINANCE?
Finance is the art and science of managing wealth.
• At the personal level
➖It is about making decisions regarding what assets to buy/sell
and when to buy/sell these assets.
➖Its main objective is to make individuals and their businesses
better off.
• At the business level
1. What long-term investments should the firm undertake?
(capital budgeting decisions – how to spend the money?)
2. How should the firm fund these investments? (capital
structure decisions -- How to get the money?)
3. How can the firm best manage its cash flows as they arise in
its day-to-day operations? (working capital management
decisions – how to manage cash (liquid) money?)

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What is Financial Management?
• Financial management is generally defined as those
activities that create or preserve the economic value of the
assets of an individual, small business, or corporation.
➖Financial management comes down to making sound
financial decisions.

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Business Legal Forms
Business Forms

Sole
Proprietorship
General
Partnership
Limited
Corporation

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Business Legal Forms
• A sole proprietorship is a business owned by one person
and operated for his or her own profit.
• A partnership is a business owned by two or more people
and operated for profit.
• A corporation is an entity created by law. Corporations have
the legal powers of an individual in that it can sue and be
sued, make and be party to contracts, and acquire property in
its own name.

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Business Legal Forms
• Number of firms according to legal form in Egypt
Sole Proprietorships Partnerships Corporations
Number of firms 3,545,176 121,732 30,690
(thousands)
% of all firms 94.7% 3.3% 0.8%

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 The Goal of The Financial Manager
• Maximizing the shareholders’ wealth the same as
maximizing the share price.

Financial
Increase
Financial Decision Return
Share Yes Accept
Manager Alternatives Risk
Price
or Actions

No

Reject

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Main Finance Decisions

• Capital budgeting: the process of planning and

managing a firm’s long-term investments 
fixed assets.
• Capital structure: the mixture of debt and equity
maintained by the firm  L-T debt and equity.
• Working capital management: a firm’s short-term
assets and liabilities  current assets and current
liabilities.

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Main Finance Decisions

Working Current
Capital Liabilities
Current Assets

Long-term
Liabilities

Decisions
Financing
Fixed Assets
Decisions
Investment

1. Tangible
2. Intangible Equity

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Basic Finance Principles
1. Cash flows are the source of value.
2. Money has a time value.
3. There is a risk-return trade-off.
4. Market prices reflect information.

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Basic Finance Principles
1. Cash flows are the source of value.
• Profit is an accounting concept and measures a business’s
performance. Cash flow is the amount of cash that can
actually be taken out of the business.
• Accounting profits are not equal to cash flows. It is possible
for a firm to generate accounting profits but not have cash or
to generate cash flows but not report accounting profits in the
books.
• Cash flow, and not profits, drive the value of a business.
• We must determine incremental or marginal cash flows when
making financial decisions.

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Basic Finance Principles

2. Money has a time value

• A dollar received today is worth more valuable than a
dollar received in the future.
• We can invest the dollar received today to earn interest.
Thus, in the future, we will have more than one dollar, as
we will have earned interest on the investment.
• Since we can earn interest on money received today, it is
better to receive money sooner rather than later.

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Basic Finance Principles

3. There is a risk-return trade-off.

• Investors tend to be risk-averse and prefer certain return
to an uncertain return.
• Investors will not take on additional risk unless they
expect to be compensated with additional reward or
return.
• Higher the risk, higher will be the expected return. Note
expected return may not be equal to the realized rate of
return. Thus higher risk does not guarantee higher rate of
return.

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Basic Finance Principles
4. Market prices reflect information.
• In an efficient market, the market prices of all traded
assets (such as stocks and bonds) fully reflect all
available information at any instant in time.
• Investors respond to new information by buying and
selling their investments. The speed of investor reaction
and speed of price adjustment determines the efficiency
of market.
• Thus stock prices are a useful indicator of the value of
the firm. Price changes reflect changes in expected
future cash flows. Good decisions will tend to increase in
stock price and vice versa.
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Agency Problem and Corporate Governance

• Agency relationship:
• Principles (stockholders) hire agents (managers) to run
the company.
• Agency problem:
• Conflict of interest between principals and agents.
• This occurs in a corporate setting whenever the agents do
not hold 100% of the firm’s shares.
• The source of agency problems is the separation of
(owners’) control and management.

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Agency Problem and Corporate Governance

Agency costs
• Direct costs: (1) unnecessary expenses, such as a
corporate jet, and (2) monitoring costs.
• Indirect costs. For example, a manager may choose not to
take on the optimal investment. She/he may prefer a less
risky project so that she/he has a higher probability
keeping her/his tenure.

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Agency Problem and Corporate Governance

Agency Problem Solutions

• The manager can be motivated to act in the
shareholders’ best interest through incentives such
as:
• Performance-based compensation.
• Stock option.
• The threat of takeovers

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Agency Problem and Corporate Governance

Corporate Governance Definition

• internal means by which a corporations are operated and
controlled … which involve a set of relationships between a
company’s management, its board, its shareholders and other
stakeholders.”
- it influences how company objectives are set, how risk is
monitored and assessed, and how performance is optimised.

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Agency Problem and Corporate Governance

Why Corporate Governance

• The need for corporate governance is linked to the fact that
owners (i.e. the principal) and managers (i.e. the agent) are
different parties
• This separation gives rise to the agency problem, which
involves the issue of moral hazard
• Moral hazard exists when one party is responsible for the
interests of another, but has an incentive to put his/her own
interests first

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Agency Problem and Corporate Governance

Why Corporate Governance

• For example, a manager may invest in projects that involve
an excessive level of risk, knowing that it is shareholders
who will bear the risk
• A key role of corporate governance is to ensure that
contracts are set up to deal with the problem of moral hazard
- e.g. management remuneration might be based on corporate
earnings, or significant capital investments might require
shareholder approval

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Agency Problem and Corporate Governance

Why Corporate Governance

• A modern corporation is seen to have broader societal
responsibilities beyond that of the shareholder group
• This includes a commitment to a code of ethical behaviour
and good citizenship
• Therefore, corporate governance must ensure that a company
fulfils its commitments to stakeholders such as employees,
suppliers, conservationists and other interest groups

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Ethics in Finance
• Ethics in finance consists of the moral norms that apply to
financial activity broadly conceived. That finance be conducted
according to moral norms is of great importance, not only because
of the crucial role that financial activity plays in the personal,
economic, political, and social realms but also because of the
opportunities for large financial gains that may tempt people to act
unethically.
• Ethics plays a vital role, in addition to laws and regulations, first,
by guiding the formation of laws and regulations and, second, by
guiding conduct in areas not governed by laws and regulations. In
general, moral norms reflect the conduct in financial activity that
follows from fundamental ethical principles.

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Ethics in Finance
• Ethics in finance is one of the main things which everyone
has to follow from small, medium and big level company.
• It is considered important as without financial component no
business can run for a long time.
• Ethics in finance may vary from industry to industry but
everyone is liable to do their work at utmost good faith.

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Ethics in Finance

Code of Ethics in Finance

• Act with honesty and integrity avoiding conflicts of interest
in personal and professional relationship
• To provide information which is full, accurate, fair,
objective, timely and understandable.
• To promote ethical behavior among other associates
• Respect the confidentiality of info acquired in course of
business except authorized
• Adhere to and promote this Code of Ethics.

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CFA: THE CODE OF ETHICS
Members of CFA Institute (including CFA charterholders) and
candidates for the CFA designation must:
• Act with integrity, competence, diligence, respect and in an ethical
manner with the public, clients, prospective clients, employers,
employees, colleagues in the investment profession, and other
participants in the global capital markets.
• Place the integrity of the investment profession and the interests of
clients above their own personal interests.
• Use reasonable care and exercise independent professional
judgment when conducting investment analysis, making
investment recommendations, taking investment actions, and
engaging in other professional activities.
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CFA: THE CODE OF ETHICS
• Practice and encourage others to practice in a professional
and ethical manner that will reflect credit on themselves and
the profession.
• Promote the integrity and viability of the global capital
markets for the ultimate benefit of society.
• Maintain and improve their professional competence and
strive to maintain and improve the competence of other
investment professionals

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