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An Introduction To The

Financial Management

Topic 1
Learning Objectives
1. Explain the definition of financial management.
2. Identify the roles of financial manager.
3. Determine the basic forms of business as well as the
advantages and disadvantages of each form of business.
4. Identify and explain the aims of a company.
5. Market and financial institutions.

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THE GOAL OF THE FIRM
The goal of the firm is to create value for the firms owners
(shareholders) Maximize shareholder wealth.
Shareholder wealth is measured by share prices. Thus,
This is equivalent to saying the goal is to maximize the price of
common stock!
Good financial decisions will increase stock price and poor
financial decisions will lead to a decline in stock price.

WRMAS 3
Why is Shareholder Maximization
NOT Profit Maximization?
Many people think the goal is to maximize profits.

However, profit maximization goal is unclear about the time


frame over which profits are to be measured. Would this
mean short-term profit, or long-term profit?

It is easy to manipulate the profits through various


accounting policies.

Profit maximization goal ignores risk and timing of cash


flows.

WRMAS 4
WHAT IS FINANCE?
A branch of economics concerned with resource allocation
as well as resource management, acquisition and
investment. Simply finance deals with matters related to
money and the markets (Investorword.com).

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 (Gitman).

Is concerned with the maintenance and creation of


economic value or wealth (Keown).
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FOUNDATIONAL PRINCIPLES OF FINANCE
Principle 1: Cash flow is what matters
Accounting profits are not equal to cash flows.
Cash flow drives the value of a business.
We must determine incremental cash flows (ICFs) when making
financial decisions.
(ICF = Accepted Projected CFs if the project is selected - if the
project is not selected)

Principle 2: Money has a time value


A dollar received today is worth more than a dollar received in
the future.
Since we can earn interest on money received today, it is better
to receive money earlier rather than later.

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Foundational Principles Of Finance
Principle 3: Risk requires a Reward
We wont take on additional risk unless we expect to be
compensated with additional reward or return.
Investors expect to be compensated for delaying consumption
and taking on risk.

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Foundational Principles Of Finance
Principle 4: Market Prices are generally Right
In an efficient market, the prices of all traded assets (such as stocks
and bonds) is fully reflect all available information.
Thus stock prices are a useful indicator of the value of the firm.
Good decisions Increase stock prices Increase expected CFs
Note there are inefficiencies in the market that may distort the prices.

Principle 5: Conflicts Of interest cause agency problems


Agency problem conflicts of interest between principal (owners)
and agents (managers) due to the separation of management and the
ownership.
Managers may make decisions that are not consistent with the goal of
the company.
Agency conflict is reduced through monitoring (ex. Annual reports),
compensation schemes (ex. stock options), and market mechanisms
(ex. Takeovers)
WRMAS 8
ROLES OF FINANCIAL MANAGERS
Actively manages the financial affairs of any type of business,
whether private or public, large or small, profit-seeking or not-for-
profit.

Important roles in making decision in a company such as:


Where to invest? (Capital budgeting)
How to raise money to fund the investment? (Capital structure)
How to manage cash flows from daily operations? (Working
capital)

The responsibilities of a financial managers including:


Planning and forecasting
Investment and financing decisions
Controlling and coordinating
Transaction in the financial markets
Risk management

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WRMAS 10
BASIC FORMS OF BUSINESS ORGANISATION

Business Forms

Sole
Partnership Corporation
Proprietorship

WRMAS 11
The Role of Finance in Business
Three basic issues addressed by the study of finance:
1. What long-term investments should the firm undertake?
(Capital budgeting decision)
2. How should the firm raise money to fund these investments?
(Capital structure decision)
3. How to manage cash flows arising from day-to-day operations?
(Working capital decision)
Knowledge of financial tools is relevant for decision making in all
areas of business (be it marketing, production etc)
Decisions involve an element of time and uncertainty financial
tools help adjust for time and risk.
Decisions taken in business should be financially viable financial
tools help determine the financial viability of decisions.

WRMAS
Sole Proprietorship
A business owned by a single individual.
Advantages:
Ease of formation
Few regulations
No corporate tax
Complete control and decision-making power
Retention of all profits and assets
Disadvantages:
Financing limitations
Unlimited liability (Incur all losses and debts)
Lacks continuity when proprietor dies

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Partnerships
Co-owned by 2 or more individuals agreed to form a business in
order to get profit based on agreement.
2 types:
General partnership
All partners have unlimited liability-fully liable for the
indebtedness incurred by the partnership.
Limited partnership
Some partners can have limited liability to cash/property
they invested in the firm.
There must be at least one general partner with unlimited
liability-actively manage the business, receive a salary, share
in profits and losses.
Limited partners (investors) cannot participate in the
business management and their names cannot appear in the
name of the firm.
WRMAS 14
Partnerships
Advantages:
More available brain power and managerial skill
Easy to form
Able to raise capital

Disadvantages:
Unlimited liability
Difficult to transfer ownership
Partnership is dissolved by the death or withdraw of
partners

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Corporation
Legally functions separate and apart from its owners
Co. can sue, be sued, purchase, sell, and own property
Owners (shareholders) dictate direction and policies of the company.
Life of company does not depend on the status of its owners.
Advantages:
Limited liability for shareholders
Ownership can be easily transferred
Unlimited life (unless the firm goes through corporate restructuring
such as mergers and bankruptcies)
Easy to raise capital
Disadvantages:
No secrecy of information
Maybe delays in decision making
Greater regulation therefore expensive and complex to form
Double taxation
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WRMAS 17
FINANCIAL MARKETS & INSTITUTION
Financial markets play a critical role in capitalist economy. Financial
markets help facilitate the transfer of funds from saving surplus
units to saving deficit units i.e. transfer money from those who
have the money to those who need it.
Three ways to transfer capital in the economy:

WRMAS 18
FINANCIAL MARKETS: TRANSFER OF CAPITAL
Direct Transfer
Firm seeking funds directly approaches a wealthy investor.
Indirect Transfer (using investment banks)
Here the investment bank acts as a link between the firm
(needing funds) and the investors (with surplus funds)
Indirect Transfer (using financial intermediary)
Here the financial intermediary (such as mutual funds)
collects funds from savers in exchange of its own securities
(indirect). The collected funds are then used to acquire
securities (such as stocks and bonds) from firm.

WRMAS 19
Money Market Vs. Capital Market
The 2 key financial markets are the MONEY MARKET and the
CAPITAL MARKET.
Money Market
Market for short-term debt instruments (maturity < 1 year).
Money market is typically a telephone and computer market
(rather than a physical building)
Examples: Treasury bills (issued by federal government),
commercial paper, negotiable CDs, bankers acceptances.
Capital Market
Market for long-term financial securities (maturity > 1 year).
Examples: Corporate Bonds, Common stocks, Treasury Bonds,
term loans and financial leases.

WRMAS 20
Primary Market Vs. Secondary Market
Primary Market (initial issue)
Market in which new issues of a securities are sold to initial
buyers. This is the only time the issuing firm ever gets any money
for the securities.
Example: Google raised $1.76 billion through sale of shares to
public in August 2004.
Seasoned Equity Offering: Sale of additional shares by a company
whose shares are already traded in the secondary market.
Example: Google raised $4.18 billion in September 2005.
Secondary Market (subsequent trading)
Market in which previously issued securities are traded. The
issuing corporation does not get any money for stocks traded on
the secondary market.
Example: Trading among investors today of Google stocks.

WRMAS 21
FINANCIAL MARKETS & INSTITUTION
Public Offering Both individuals and institutional investors
have the opportunity to purchase securities. The securities
are initially sold by the managing investment bank firm. The
issuing firm never actually meets the ultimate purchaser of
securities.
Initial Public Offering It is a type of public offering. The first
time a company issues its stock.
Private Placement The securities are offered and sold to a
limited number of investors.

WRMAS 22