CHAPTER 1

INTRODUCTION TO FINANCIAL MANAGEMENT

 OUTLINES

• Financial Markets and Business Organizations

• Goals of the Firm
• Functions of Financial Manager
• Risk and Return Relationship
 What is Finance?
“ the art and science of managing money and assets”

 Skills to obtain and allocate financial resources effectively and efficiently.

 Process to create, maintain and accumulate economic value and wealth.

 Integration with other departments (i.e.. Marketing, operations, HR).

 Focuses on the process, institutions, markets and instruments involved in

the transfer of money among individuals, businesses and governments.

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 WHAT IS FINANCIAL MANAGEMENT

“ A process involved in an attempt to obtain

and allocate financial resources effectively
and efficiently to achieve the firm’s goal that
is to maximize the shareholder’s wealth by
maximizing share price”
 What is Financial Market?

What is market?

 A pool of possible buyers (demanders) and sellers (suppliers) of goods.

What is financial market?

 A forum or place where suppliers of funds (surplus units) and demanders

of fund (deficit units) transacts business via e.g., borrowing, lending and
investment activities.
 Consist of institutions and procedures that facilitate transactions in all type
of securities (i.e. financial assets).
 To allocate financial resources within the economy by providing funds
from surplus units to deficit units.
 To set prices for trade, raise capital and transfer liquidity and risk.
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 FUNDS FLOW BETWEEN ORGANIZATION AND FINANCIAL
MARKETS

Financial markets

Corporations A. Firms issues securities Investors

(deficit units) (Surplus units)
B. Firms receive Funds (Cash)
D. Dividends
E. reinvest

C. Cash flow from firms’ assets

D. Tax

Firms invest in assets Short term debts

Current assets Long term debts
Fixed assets Equity assets
Government
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 Supplier & Demanders of Funds

• Also known as surplus & deficit units

• Consists of Households, Govt, Firms
• They are the provider of funds and
receiver of funds
• Provider of funds – purchasing financial
assets (i.e. financial instruments) offered
by deficit units or financial institutions
• Receiver of funds – issued financial
assets
 Relationship between Lenders and Borrowers

LENDERS FINANCIAL FINANCIAL BORROWERS

(Surplus INSTITUTIONS MARKETS (Deficit Units)
Units) (Intermediaries)

Individual Banks Interbank Individuals

Companies Insurance companies Stock exchange Companies
Pension funds Money market Central government
Mutual funds Bond market Municipalities
Foreign Public corporation
exchange

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 Major Components of a Financial Market
1. Capital Market
 A market in which long-term securities (i.e., maturity date of longer
than one year) are issued by firms and government.
 The financial securities or instruments involve Equity (stock) and Debt
(bond) (i.e. corporate and government ) instruments.
 Carries greater risks but higher in returns (i.e. market risk).
 To raise capital for long-term purposes, such as for a merger or
acquisition, to expand a line of business or enter into a new business, or
for other capital projects.

2. Money Market
 A market in which short-term debt instruments (i.e. maturity date of
lesser than one year) are issued by firms & government.
 The financial securities or instruments involve commercial paper, NCDs,
etc (also known as Marketable Securities).
 Carries low risk and liquidity.
 To cover operating expenses or working capital for firms or government.
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 Cont.
Money Market vs. Capital Market

 Transaction of long term

 Transaction of short term
securities (or no maturities)
securities
 Comprise of primary and
 The securities are very liquid
secondary market

Primary Market vs. Secondary Market

 Already issued securities and

 Newly issued securities need to raise some funds in order
to finance new investment
 Forms of Organization

Sole Proprietorship
“A business owned by single individual”

 Advantages:
 Ease of formation
 Belongs to only one person
 Manager and owner is the same person

 Disadvantages:
 Limited life- termination occurs on owner’s death or by owner’s
choice
 Unlimited liability- personally responsible for all the debts
 Difficult to raise capital
 Forms of Organization (cont..)
Partnership
“An association of two or more individuals joined as co-
owners of business for profit”

 Advantages:
 Ease of formation
 Belongs by more one person
 Share liabilities (i.e. bound by partnership agreement)- Profit and
loss sharing by mutual agreement

 Disadvantages:
 Limited life
 Unlimited liability
 Difficult to raise capital
 Forms of Organization (cont..)
• Corporation
“An entity that legally functions separate from its owner”

 Advantages:
 Ease of transfer of ownership (Life of corporation does not depend
on the status of its owners. Ownership can be easily transferred)
 Shareholders are co-owner
 Limited liability (shareholder’s liability is restricted to the amount of
investment in company)
 Ease of raising capital

Disadvantages:
 Double taxation
 Cost of set-up and report filing
 GOALS OF A FIRM

“To make and execute decisions that

provides maximum benefits to the owners or
shareholders by maximizing owners'
wealth through share price maximization.”
 Goals of profit maximization VS maximization of
shareholders wealth
1. Profit Maximization
 focuses to obtain profit as much as possible regardless of long-term
effects.
 Is argued as an inappropriate goal.

Purposes:
 Maintain its operating stability
 Maintain growth in operations
 Reward to stakeholders (i.e. contributors of idea, capital etc.)

Problems or Challenges:
 Time Horizon (i.e. focus only on short-term profit),
 Timing of returns and time value of money (i.e. ignore future project).
 Distributions of returns (i.e. ignore a portion of earnings in the form of
dividends to be distributed to shareholders).
 Risk (i.e. ignore risk factor), higher return will associate with higher
risk.
 Goals of profit maximization VS maximization of
shareholders wealth (cont..)

2. Wealth maximization
Shareholders’ wealth maximization translates to maximizing stock price.
Good corporate decisions are those that create wealth for the shareholders.

Mediums of Application:
Maximization of profits
Maximization of sales ( sales volume,  market control and thus, 
profit.
Minimization of risk (firms involve in activities that have lesser risks).
Maximization of share price ( profits, associated risk, thus  market
value of the firm’s stocks.

3. Benefits to society (i.e. social responsibilities)

Efficient and low cost operations (i.e. low price)
New product development (i.e. consumer choice)
Provide efficient and courteous service
 THE GOAL OF A FIRM

 MAXimization of Profit
 MAXimization of Sales
 MAXimization of Share Price
 MINimization of Risk
 FUNCTIONS OF A FINANCIAL MANAGER

 Planning
 Involves the development, refinement & evaluations of the firm goals
& strategies.
 Deciding what the firm is aiming to do, how it proposes to do it, when
to do it.
 Forecast the outcomes of the strategies implemented.

 Controlling
 Analysis of causes and responsibilities.
 Reinforce current performance that conforms to the original plans.
 Modify & develop new strategies for future use.

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 FUNCTIONS OF A FINANCIAL MANAGER (cont.)

 Investment Decisions
 Determining the appropriate mix in the asset portfolio.
 Determining the appropriate RM to be invested in current assets versus
fixed assets.
 Determining the optimal level of investment.
 Recommending the best fixed asset to acquire and when to replace the
existing assets.

 Financing Decisions
 Determining the appropriate mix of short term and long term source of
financing.
 Choosing the appropriate source of funds for investment in asset
portfolio.
 Determining the appropriate dividend policy.

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 RISK AND RETURN RELATIONSHIP

Returns
 A measure of growth rate of an investment.
 Investment returns measure the financial results of an investment (i.e. ROI).
 Returns may be historical or prospective (anticipated).
 Return is defined as the profit per ringgit invested over a definite period of
time
 Components of total return
a) Yield : income return on a security. It is the periodic cash flows of interest

or dividends
b) Capital Gain/Loss : refers to the amount by which the selling price of a
security higher/lowers

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 RISK AND RETURN RELATIONSHIP (cont.)

Risk

 A measure of uncertainty.
 Typically, investment returns are not known with certainty.
 Investment risk pertains to the probability of earning a return less than that
expected.
 The greater the chance of a return far below the expected return, the greater
the risk.
 RISK is the chance of loss, RISK is the possibility of loss.
 RISK is an uncertainty.
 RISK is the chance that the actual outcome will differ from the expected
outcome.

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 RISK AND RETURN RELATIONSHIP (cont.)

 Systematic Risk (i.e. Market risk)

 Risk that is unavoidable and cannot be eliminated by
diversification (e.g. inflation, interest rate, political etc).

 Unsystematic Risk (i.e. Firm specific risk)

 Risk that can be eliminated by diversification (e.g. management,
operations, profit etc).

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 CLASSIFICATION OF RISK

SYSTEMATIC RISK UNSYSTEMATIC RISK

(Market Risk) (Non-Market Risk)
 The systematic risk is a non-  Unsystematic risk is a diversifiable
diversifiable risks that cannot be risk that is unique only to a
eliminated no matter how many particular company
securities are held in investment  These are the risks that occur
portfolio inside or within the company, and
 The risks occur outside the thus within the financial manager's
company and beyond the financial control
manager's control  Factors: New competition,
 Factors: inflation, recessions, lawsuits, etc
interest rate, political attitudes, etc
 RISK AND RETURN RELATIONSHIP (cont.)

Risk-Return Tradeoff
“The relationship between risk and return, in which
investments with more risk should provide higher
returns, and vice versa”

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RISK-RETURN TRADEOFF

EXPECTED
RETURN
RETURN

Y1

0
RISK
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