CHAPTER 1

Introduction of Financial Management

 Financial markets and business

organization
 Goals of the firm
 Functions of the financial
manager
 Risks and return relationship
What is Finance?
 To obtain and allocate financial resources effectively
and efficiently
 Maintenance and creation of economic value and
wealth
 Integrate with other department (i.e.. Marketing,
operations)
 Deal with financial decision (e.g. new product, new
asset, borrowing, issue stocks & debts)
 Forms of Organization

 Sole proprietorship
 Partnership
 Corporation
 Forms of Organization (cont..)

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
◼ Unlimited liability
◼ 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)
 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
◼ Shareholders are co-owner
◼ Limited liability
◼ Ease of raising capital
 Disadvantages:
◼ Double taxation
◼ Cost of set-up and report filing
 Goals of the Corporation

 Profit Maximization
To obtain Profit as much as possible
Reasons:
◼ Maintain its operating stability
◼ Maintain growth
◼ Reward to stakeholders (i.e. contributors of idea,
capital etc)
 Goals of the Corporation (cont..)

 Maximization of Shareholder Value

The primary goal is shareholder wealth maximization,
which translates to maximizing stock price.

The Problems of Profit Maximization

◼ Time Horizon (i.e. short-term profit)
◼ Timing of Returns (i.e. ignore future project)
◼ Distributions of Returns (i.e. dividends)
◼ Risk (i.e. ignore risk factor)
 Goals of the Corporation (cont..)

 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
 Financial Management Framework

The Environment of Financial Management

 Internal Environment

factors exist within the firm, controllable

 External Environment
factors exist outside the firm, uncontrollable
 Financial Management Framework

Functions of Financial Management

To ensure the Maximization of Shareholder Value,
Financial Manager need to

 Planning (i.e. ways to achieve firms goals and

strategies)
 Controlling (i.e. to conform actual performance
with stated plan)
 Functions of Financial Manager
(cont..)
 Financial Decisions
◼ Investment Decision
Determine the appropriate investment to be
made (i.e. acquire new asset), ROI
◼ Financing Decision
How to finance the investment (i.e. Equity or
debts), To identify Risk exist in Financial
Market
“Both decision affect the Risk and Return”
 What is Financial Market?
❑ Institutions and procedures that facilitate transactions
in all type of securities (i.e. financial assets)
❑ To allocate financial resources within the economy
❑ Provide Sources of Funds to Deficit Units
❑ Firms receive money from it , while investors (i.e. Firms
or Individual) made investment (i.e. shares, bonds,
marketable securities, government securities)
 Flow of Funds Mechanism
FINANCIAL
INSTITUTIONS

Suppliers Demanders
of Funds (i.e. Of Funds
Surplus units) (i.e. Deficit Units)

FINANCIAL
MARKETS
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
Financial Market
Capital Market
◼ Market in which long-term securities issued by firms and
governments are exchanged
◼ Equity and Debt (i.e. corporate and govt ) instruments traded
in capital market
◼ Carries greater risks but higher in returns (i.e. market risk)
Money Market
◼ Market short-term debt instruments (i.e. less than 1-year)
◼ Issued by firms, & govt
◼ Low risk and liquid
◼ Instruments such as commercial paper, NCDs, etc (also known
as Marketable Securities)
 Risk and Return Relationship

Returns
Investment returns measure the financial results
of an investment (i.e. ROI).
Returns may be historical or prospective
(anticipated).
Returns can be expressed in:
◼Dollar terms
◼Percentage terms
Risk and Return Relationship (cont..)

Risk
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 and Return Relationship (cont..)
❑ Risk and return trade – offs play a major role in influencing
the investment decision made.
❑ The basic rule states that; higher risk associates with higher
returns and vice versa
❑ Risk is unavoidable, thus, the key strategy is seek
investment opportunities that offer the highest return with the
least risk
❑ Bonds and Equities are the instruments that pose Higher
Risks and gives Higher Returns, and there are Less Liquid
(i.e. long-term securities) while Marketable Securities pose
Lower Risk, result to Low in Returns, but High in
Liquidity
 Risk and Return Relationship
(cont..)
Common
Risk Stocks
SML
Preferred Stocks
Bonds

Risk Free Asset

Return
 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)
How To Manage Risk
Diversification
 Diversification in an investment portfolio can reduce
unsystematic risk to some extend, dependent upon the
correlation coefficient that exists between the securities
held in the portfolio (i.e. stocks, corporate bonds,
government bonds)

 Correlation coefficient describes how much linear co –

movement exists between two random variables or
between two securities.
 Market Portfolio (i.e. stocks portfolio)
Risk (%)
Unsystematic Risk
35 (i.e. related to company)

20

Systematic Risk (i.e. Market Risk)

0
10 20 30 40 2,000+

# Stocks in Portfolio
 The possible correlation is:
1. Positive correlation;
 The securities involved has a direct relationship;
an increase risk in one security, tend to increase
risk in another
2. Negative correlation;
 The securities involved has an inverse
relationship; an increase risk in one security, tends
to reduce risk in another
3. Zero correlation;
 The securities involved has no relationships with
one another
The End