Chapter 1

An Introduction to Financial Management

Learning Goals & Objective
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.
What is Finance?
Finance can be defined as the science and art of
managing money.

• At the personal level, finance is concerned with

individuals’ decisions about how much of their
earnings they spend, how much they save, and
how they invest their savings.

• In a business context, finance involves the same

types of decisions: how firms raise money from
investors, how firms invest money in an attempt to
earn a profit, and how they decide whether to
reinvest profits in the business or distribute them
back to investors.
Career Opportunities in Finance
1) Financial Services

 The area of finance concerned with the design

and delivery of advice and financial products
to individuals, businesses, and government.

 Career opportunities: banking, personal

financial planning, investments, real estate,
and insurance.
Career Opportunities in Finance
2) 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 firm’s
competitive position.
Legal Forms of Business
Organization
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.
 Legal Forms of Business
Sole Proprietorship Partnerships Corporation

Legal status No legal status No legal status Separate legal entity

Minimum 2, Private Co: min2, max 50
Owner One
maximum20 Public Co: min 2, no max
Limited to the amount of
Liabilities of
Unlimited liabilities Unlimited liabilities shares subscribed by the
owner
shareholders
Ownership of Owned by the sole- Jointly owned by the
Owned by the company
properties proprietor partners
Managed by the Board of
Managed by the sole- Every partner is entitled directors. Director may or
Management
proprietor to participate may not be the shareholder of
the company

When any one

of the partner: •By undergoing legal
Occurs on the owner’s
-passed away; winding-up.
Termination death or by the
-becomes a bankrupt •Perpetual succession unless
owner’s choice
-withdraws; or becomes the company is liquidated.
insane
Strengths and Weaknesses of the Common
Legal Forms of Business Organization
Corporate Organization
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 previous slide.
The Managerial Finance Function:
Relationship to Economics

 The field of finance is actually an outgrowth of

economics.

 Infact, 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.
The Managerial Finance Function:
Relationship to Economics

The primary economic principal used by

financial managers is marginal cost-benefit
analysis which says that financial decisions
should be implemented only when added
benefits exceed added costs.
Example
Jamie Teng trying to make decision to replace
company’s computer with a new one. The new computer
would require a cash outlay of RM8,000 and the old
computer could be sold to net RM2,000. The total
benefit from new computer would be RM10,000. The
benefits over a similar time period from the old
computer would be RM3,000.

State your recommendation, should Jamie Teng replace

the old computer with a new one using marginal-cost-
benefit analysis.
The Managerial Finance Function:
Relationship to Accounting
The firm’s finance (treasurer) and accounting
(controller) functions are closely-related and
overlapping.
Insmaller firms, the financial manager generally
performs both functions.
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 Managerial Finance Function:
Relationship to Accounting
Whether a firm earns a profit or experiences a
loss, it must have a sufficient flow of cash to
meet its obligations as they come due.

The significance of this difference

can be illustrated using the following simple
example.
The Managerial Finance Function:
Relationship to Accounting
The ABC Corporation experienced the following activity last year:

Sales: $100,000 (100% still uncollected)

Costs: $80,000 (all paid in full under supplier terms)

Now contrast the differences in performance under the accounting

method (accrual basis) versus the financial view (cash basis):

Income Statement Summary

Accrual basis Cash basis
Sales $100,000 $ 0
Less: Costs (80,000) (80,000)
Net Profit/(Loss) $ 20,000 $ (80,000)
The Managerial Finance Function:
Relationship to Accounting
 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 decision-making
purposes.

 The financial manager uses this data as a vital tool

for making decisions about the financial aspects of
the firm.
Primary Activities of the Financial Manager
 Basic Goal:
Shareholder Wealth Maximization

Primary objective
for firm
Shareholder
Wealth
Maximization
Measured by the
market value of
shareholders’ common
stock holdings
 Basic Goal:
Shareholder Wealth Maximization
 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

risk of cash flows
Required Return
Basic Goal:
Shareholder Wealth Maximization

The process of shareholder wealth maximization

can be described using the following flow chart:
Basic Goal:
Shareholder Wealth Maximization

Shareholder Wealth Maximization is the same as:

Maximizing Firm Value

Maximizing Stock Price
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 Agency Issue:
The Agency Problem
Manager: Agent of the company who is hired by
the shareholders (principal) to manage the
company (making decisions on behalf of
shareholders).
Agency problem exists when mangers place
personal goals/ benefits/ interests (personal
wealth, job security, fringe benefits, and lifestyle)
ahead of the goals of shareholders (maximize
shareholder wealth).
The Agency Issue:
Resolving the Problem
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 (ensuring the managers’ interests are
aligned with those of shareholders).
The Agency Issue:
Resolving the Problem
1) Management Compensation Plans
 Structure management compensation to
correspond with firm performance.
 Incentive plans tie management compensation to
share price. A stock option is an incentive
allowing managers to purchase stock at the market
price set at the time of the grant.
 Performance plans tie management compensation
to performance measures such as EPS in the form
of performance shares or cash bonuses.
The Agency Issue:
Resolving the Problem
2) The Threat of Takeover
 When the agency problem (misuse of the firm’s
resources and impose agency costs) of a company
is getting worse, its stock is generally depressed,
making the firm an attractive takeover target.
 After takeover, the firm believes it can enhance
the troubled firm’s value by restructuring its
management, operations, and financing can
provide a strong source of external corporate
governance.
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
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.
Ingeneral, individuals are net suppliers of funds,
while businesses and governments are net
demanders of funds.
Example: Public Bank (commercial bank)
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.
 Money Market: A financial relationship created
between suppliers and demanders of short-term
funds(eg. 3-months deposit).
 Capital market: A market that enables suppliers and
demanders of long-term funds to make transactions
(10-years corporate bond).
Financial Institutions & Markets:
Financial Markets
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.
Financial Institutions & Markets:
Financial Markets
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)
The Relationship between Financial
Institutions and Financial Markets

(A) Securities (A) Securities

(A) Cash (A) Cash

Financial
Firms Investors
Markets
(C) Cash flow distribution (C) Cash flow distribution

(D) Reinvestment (D) Reinvestment

(B) Corporate Taxes Government (B) Income Taxes