Learning Goals

1.
2.
3.
4.
5.

Define finance and the managerial finance function.

Describe the role of finance in business.
Describe the legal forms of business organization.
The goal of financial management
The agency problem and control of the corporation

What is Finance?

What is Finance? (cont.)

(cont.)

Finance can be defined as the art and science 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 decisions
about 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 include banking, personal
financial planning, investments, real estate, and
insurance.

Finance is concerned with the processes, institutions,

markets, and instruments involved in the transfer of
money among individuals, businesses, and
governments.
Financial Services is the area of finance concerned with
the design and delivery of advice and financial products
to individuals, businesses, and government.

Managerial Finance
Managerial Finance or Corporate 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.

Other Forms of Business

Legal Forms of Business

Sole Proprietorship

Corporation

1.

Legal status

No legal status

No legal status

Separate legal entity

2.

Owner

One

Minimum 2,
maximum20

Private Co: min2, max 50

Public Co: min 2, no max

3.

Liabilities of
owner

Unlimited liabilities

Unlimited liabilities

Limited to the amount of shares

subscribed by the shareholders

4.

Ownership of
properties

Owned by the soleproprietor

Jointly owned by the

partners

Owned by the company

5.

Management

Managed by the soleproprietor

Every partner is
entitled to participate

Managed by the Board of

directors. Director may or may
not be the shareholder of the
company

6.

Termination

Occurs on the owners

death or by the
owners choice

When any one of the

partner:
-passed away;
-becomes bankrupt
-withdraws; or
becomes insane

By undergoing legal winding-up.

Perpetual succession unless the
company is liquidated.

Strengths and Weaknesses

General Partnership
All partners have unlimited liability.

Sole Proprietorship
Strengths

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.
Also known as Private Limited Company or Ltd.

Partnerships

Weaknesses

Partnership

Corporation

Ease of formation and

dissolution
Minimize regulations,
and more secrecy

Low organization cost

Maintain complete

and ultimate control

The proprietor is
entitled to all the
profits

Ease of formation and

dissolution than
corporation
Raise more funds than
the sole proprietorship
the limited partnership
permits some of the
partners the privilege of
limited liability

Unlimited liabilities
Limited fund raising
Proprietor must be
jack-of-all trades
The firm is
terminated when the
proprietor dies

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

Limited liabilities
Ease in raising capital
Continuity of the
business regardless of
an owner's withdrawal
or death
Ease of ownership
transferability
Managed by the
professional
Complicated to form.
May need professional
assistant
High organizational
cost
More regulations to
comply with and lack
of secrecy

The Managerial Finance Function

Corporate Organization

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
described in Figure 1.1.

The Managerial Finance Function:

Relationship to Economics

The Managerial Finance Function:

Relationship to Accounting

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.
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.

The firms finance (treasurer) and accounting

(controller) functions are closely-related and
overlapping.
In smaller 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 significance of this difference
can be illustrated using the following simple example.

The Managerial Finance Function:

Relationship to Accounting (cont.)

The Managerial Finance Function:

Relationship to Accounting (cont.)

ABC Bhd. experienced the following activity last year:

Sales

RM100,000 (1 car sold, 100% still uncollected)

Costs

RM80,000 (all paid in full under supplier terms)

Now contrast the differences in performance under the

accounting method versus the finance (cash) method.

INCOME STATEMENT SUMMARY

Sales
Less: Costs
Net Profit/(Loss)

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 decision-making purposes.
The financial manager uses this data as a vital tool for
making decisions about the financial aspects of the
firm.

ACCRUAL

CASH

RM100,000

RM0

(80,000)

(80,000)

RM20,000

RM(80,000)

Primary Activities of the Financial

Manager

Goals of a Firm

Goal of a Firm:
Firm: Maximize Profit?
Profit?

Profit Maximization
Shareholder Wealth Maximization
Stakeholder Interest Maximization

Which investment is preferred?

Cash flow
Year 1

Year 2

Year 3

Total

Project A

RM1.00

RM1.00

Project B

RM1.50

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.

Goal of a Firm:
Firm: Maximize Shareholder
Wealth

Goal of the Firm: Maximize

Shareholder Wealth (cont.)

Because maximizing shareholder wealth properly

considers the amount of 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:

Shareholder Wealth Maximization is the same as:

level & timing

of cash flows
  

   =   

risk of cash
flows

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 "Stakeholder View" prescribes that the firm make a
conscious effort to avoid actions that could be
detrimental to the wealth position of its stakeholders.
The goal is not to maximize stakeholder well-being but
to preserve it.

The Agency Problem

Agency relationship
Stockholders (principals) hire managers (agents) to
run the company
Agency problem
Conflict of interest between principal and agent
Agency costs arise from agency problems that are
borne by shareholders and represent a loss of
shareholder wealth.

Such a view is considered to be "socially responsible."

The Agency Problem (cont.)

(cont.)

Agency Costs

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.

The costs borne by stockholders to maintain a corporate

governance structure that minimizes agency problems
and contributes to the maximization of shareholder
wealth.
Strong and independent BODs can engage in hiring and
dismissing ineffective top management to deter
identified agency problems.

The Agency Issue:

Management Compensation Plans

The Agency Issue:

The Threat of Takeover

Incentive plans are management compensation plans

that tie management compensation to share price; one
example involves the granting of stock options.
Performance plans tie management compensation to
measures such as EPS or growth in EPS. Performance
shares and/or cash bonuses are used as compensation
under these plans.

When a firms internal corporate governance structure

is unable to keep agency problems in check, it is likely
that rival managers will try to gain control of the firm.
The threat of takeover by another firm, which is
believed to enhance the troubled firms value by
restructuring its management, operations, and
financing, can provide a strong source of external
corporate governance.

The Role of Business Ethics

The Role of Business Ethics

Business ethics are the standards of conduct or moral

judgment that apply to persons engaged in commerce.
Violations of these standards in finance involve a variety
of actions: misleading financial forecasts, insider trading,
fraud, excessive executive compensation, and bribery.
Negative publicity often leads to negative impacts on a
firm

Ethics programs seek to:

reduce litigation and judgment costs

maintain a positive corporate image
build shareholder confidence
gain the loyalty and respect of all stakeholders

The expected result of such programs is to positively

affect the firms share price.