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Lecture 1

Lecture 1

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Chapter 1

An Introduction to Financial Management

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Learning Goals
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.
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What is Finance?
‡ 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.

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businesses. and insurance.Major Areas & Opportunities in Finance: Financial Services ‡ Financial Services is the area of finance concerned with the design and delivery of advice and financial products to individuals. and government. real estate. personal financial planning. 1-4 . investments. ‡ Career opportunities include banking.

Major Areas & Opportunities in Finance: Managerial Finance ‡ Managerial finance is concerned with the duties of the financial manager in the business firm. whether private or public. profit-seeking or not-for-profit. ‡ They are also more involved in developing corporate strategy and improving the firm¶s competitive position. ‡ The financial manager actively manages the financial affairs of any type of business. 1-5 . large or small.

‡ Changing economic and regulatory conditions also complicate the financial management function.Major Areas & Opportunities in Finance: Managerial Finance (cont.) ‡ Increasing globalization has complicated the financial management function by requiring them to be proficient in managing cash flows in different currencies and protecting against the risks inherent in international transactions. 1-6 .

Legal status Owner Liabilities of owner Ownership of properties Management No legal status One Unlimited liabilities Partnerships No legal status Minimum 2. max 50 Public Co: min 2. 5. Owned by the soleproprietor Managed by the soleproprietor Jointly owned by the partners Every partner is entitled to participate 6. maximum20 Unlimited liabilities Corporation Separate legal entity Private Co: min2. Termination Occurs on the owner¶s death or by the owner¶s choice When any one of the partner: -passed away. Perpetual succession unless the company is liquidated. Director may or may not be the shareholder of the company By undergoing legal windingup. no max Limited to the amount of shares subscribed by the shareholders Owned by the company Managed by the Board of directors. -becomes a bankrupt -withdraws. 2. or becomes insane 1-7 .Legal Forms of Business Sole Proprietorship 1. 3. 4.

Limited Liability Company (LLC) Cross between a partnership and a corporation. Owners have limited liability. 1-8 . Limited Partnership Consists of one or more general partners.Other Forms of Business General Partnership All partners have unlimited liability. One or more limited partners (investors) whose liability is limited to the amount of their investment in the business. who have unlimited liability. but the firm runs and is taxed like a partnership.

and more secrecy Low organisation cost Maintain complete and ultimate control The proprietor is entitled to all the profits Unlimited liabilities Limited fund raising Proprietor must be jack-of-all trades The firm is terminate when the proprietor dies Partnership Ease of formation and dissolution then corporation Raise more funds than the sole proprietorship the limited partnership permits some of the partners the privilege of limited liability Corporation Limited liabilities Ease in raising capital Continuity of the business regardless of an owner's withdrawal or death Ease of ownership transferability Manage by the professional Complicated to form. y y y 1-9 .Strengths and weaknesses Sole Proprietorship Strengths Ease of formation and dissolution Minimize regulations. May need professional assistant High organisation cost Greater regulation and lack of secrecy y y y y y y y y y y y y y Weaknesses y y y y y y y y Unlimited liabilities Each partner is liable for the actions of the other partners Difficult of partnership transferability Terminated upon a partner's death.

Corporate Organization 1-10 .

‡ As the business expands. finance typically evolves into a separate department linked to the president as was previously described in Figure 1. the finance function may be performed by the company president or accounting department. ‡ In small companies. 1-11 .The Managerial Finance Function ‡ The size and importance of the managerial finance function depends on the size of the firm.1.

‡ Financial managers must understand the economic framework within which they operate in order to react or anticipate to changes in conditions. 1-12 . finance is sometimes referred to as financial economics. ‡ In fact.The Managerial Finance Function: Relationship to Economics ‡ The field of finance is actually an outgrowth of economics.

1-13 .) ‡ The primary economic principal used by financial managers is marginal costbenefit analysis which says that financial decisions should be implemented only when added benefits exceed added costs.The Managerial Finance Function: Relationship to Economics (cont.

The Managerial Finance Function: Relationship to Accounting ‡ The firm¶s finance (treasurer) and accounting (controller) functions are closely-related and overlapping. the financial manager generally performs both functions. ‡ In smaller firms. 1-14 .

The Managerial Finance Function: Relationship to Accounting (cont. the focus is on cash flows. ‡ The significance of this difference can be illustrated using the following simple example. 1-15 .) ‡ One major difference in perspective and emphasis between finance and accounting is that accountants generally use the accrual method while in finance.

) ‡ UTAR Bhd experienced the following activity last year: Sales Costs RM100. 1-16 . 100% still uncollected) RM80.000 (all paid in full under supplier terms) ‡ Now contrast the differences in performance under the accounting method versus the cash method.The Managerial Finance Function: Relationship to Accounting (cont.000 (1 yacht sold.

) INCOME STATEMENT SUMMARY ACCRUAL Sales Less: Costs Net Profit/(Loss) RM100.000) RM20.000 (80.000) RM(80.The Managerial Finance Function: Relationship to Accounting (cont.000 CASH RM0 (80.000) 1-17 .

the financial manager is primarily concerned with analyzing and interpreting this information for decisionmaking purposes.The Managerial Finance Function: Relationship to Accounting (cont. 1-18 . ‡ While accounting is primarily concerned with the presentation of financial data.) ‡ Finance and accounting also differ with respect to decision-making. ‡ 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 1-19 .

and the risk of these cash flows.00 0 Year 2 0 0 Year 3 0 RM1.Goal of the Firm: Maximize Profit??? Which investment is preferred? Cash flow Year 1 Project A Project B RM1. 1-20 .00 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.50 Total RM1.

Basic Goal: Shareholder Wealth Maximization Primary objective for firm Shareholder Wealth Maximization Measured by the market value of shareholders¶ common stock holdings 1-21 .

the timing of these cash flows. ‡ This can be illustrated using the following simple stock valuation equation: level & timing of cash flows Share Price = Future Dividends Required Return risk of cash flows 1-22 .Goal of the Firm: Maximize Shareholder Wealth!!! ‡ Why? ‡ Because maximizing shareholder wealth properly considers cash flows. and the risk of these cash flows.

Goal of the Firm: Maximize Shareholder Wealth!!! (cont.) ‡ The process of shareholder wealth maximization can be described using the following flow chart: 1-23 .

) Shareholder Wealth Maximization is the same as: ‡ Maximizing Firm Value ‡ Maximizing Stock Price 1-24 .Goal of the Firm: Maximize Shareholder Wealth!!! (cont.

customers. ‡ Such a view is considered to be "socially responsible." 1-25 . and others who have a direct economic link to the firm. owners. creditors. ‡ 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.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. suppliers.

job security. managers would agree with shareholder wealth maximization. managers are also concerned with their personal wealth. a potential agency problem exists. ‡ In theory. ‡ This would cause managers to act in ways that do not always benefit the firm shareholders. 1-26 . ‡ However.The Agency Issue: The Agency Problem ‡ Whenever a manager owns less than 100% of the firm¶s equity. fringe benefits. and lifestyle.

‡ 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.The Agency Issue: Resolving the Problem ‡ Market Forces such as major shareholders and the threat of a hostile takeover act to keep managers in check. 1-27 .

‡ A stock option is an incentive allowing managers to purchase stock at the market price set at the time of the grant. and structuring management compensation to make shareholders interests their own.) ‡ Examples would include bonding or monitoring management behavior. 1-28 .The Agency Issue: Resolving the Problem (cont.

performance shares and/or cash bonuses are used as compensation under these plans.) ‡ Performance plans tie management compensation to measures such as EPS growth. ‡ Recent studies have failed to find a strong relationship between CEO compensation and share price. 1-29 .The Agency Issue: Resolving the Problem (cont.

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 1-30 .

‡ In general. businesses. and governments. businesses. 1-31 . while businesses and governments are net demanders of funds. ‡ The key suppliers and demanders of funds are individuals. and governments into loans or investments.Financial Institutions & Markets: Financial Institutions ‡ Financial institutions are intermediaries that channel the savings of individuals. individuals are net suppliers of funds.

1-32 . ‡ Transactions in short term marketable securities take place in the money market while transactions in long-term securities take place in the capital market.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.

‡ The primary market is the only one in which a corporation or government is directly involved in and receives the proceeds from the transaction. securities then trade on the secondary markets such as Bursa Malaysia or MESDAQ. securities are first issued through the primary market.) ‡ Whether subsequently traded in the money or capital market. ‡ Once issued. 1-33 .Financial Institutions & Markets: Financial Markets (cont.

Financial Institutions & Markets: Financial Markets (cont. directly to an investor or group of investors (insurance company.) ‡ Private Placement The sale of a new security issue. mutual fund) 1-34 . typically bond or preferred stock. pension fund.

The Relationship between Financial Institutions and Financial Markets (A) Securities (A) Cash (A) Securities (A) Cash Firms (C) Cash flow distribution Financial Markets (C) Cash flow distribution Investors (D) Reinvestment (D) Reinvestment (B) Corporate Taxes Government (B) Income Taxes Figure 1-1: Flows of funds between firms. government and investors in the financial markets 1-35 .

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