Financial management

Chapter 1
 Learning outcomes
By the end of this chapter you should be able to:
• Explain and reflect on the meaning of the terms ‘corporate finance’ and ‘financial management’;
• Explain the role and responsibilities of the financial manager;
• Discuss three types of financial-management decisions and identify the main goals of financial
management;
• Discuss the agency problem and agency costs;
• Understand the functions of financial markets and institutions; and
• Explain the role of business ethics and corporate governance in the field of financial
management.
 Introduction
• Both big and small businesses are guided by the same corporate
financial principles
What are the three financial management principles?
 Defining financial management
• Planning, organizing, directing and controlling financial activities
of business
• Ultimate measure – to increase the wealth of the shareholders
(creating value for the shareholders)
• Financial management ≠ Accounting
• Accounting: a historical perspective (report)
• Financial managers: use information from accountants to make decisions
Position of the financial manager in the
corporate structure
Corporate financial management decisions

3 basic decisions:
• What should the business invest in?

• Where will the business get long-term financing to pay for the new investment?

• How will the business manage its day-to-day financial activities?

 1. Capital budgeting
• Financial manager should aim to create value
• Will do that by identifying investments that will create value (Net Present
Value)
• Determine cash flows
 Size – how much initial investment is needed and how much income will be received
 Timing – when and for how long income will be received
 Risk – the likelihood of receiving the income
• Will income from investment exceed the cost?
 2. Capital structure
• The mix of debt and equity a company uses to fund new investments/projects
• Three choices available:
 Borrow long-term funds (debt) – risk increase
 Use savings of the company (retained earnings)
 Issue more shares (equity) – ownership declines
• Whichever option will have an effect (risk and value)
• Which form of financing is the cheapest?
 3. Working-capital management
• Working capital = short-term assets and liabilities
• How will you approach the day-to-day financial management?
 Will you sell new product for cash, credit or both?
 Who will receive credit and who won’t?
 How many days until debtors have to pay?
 Will you pay expenses in cash or on credit?
• All these decisions are important to ensure business functions efficiently
• There must be sufficient resources for adequate liquidity
 The goals of financial management
• Profit maximisation:
 Increasing sales
 Increasing market share
 Minimising costs
 Increasing growth in profits
 Avoiding insolvency
 Surviving
(BUT focusing on profitability ignores risk)
• Maximising the rate of return
• Main goal is maximisation of the shareholders’ wealth.
 Shareholders’ wealth maximisation
• Number one goal = increase the wealth of the shareholders
• How can that be done?
 Shareholders can receive dividends
 Increase in the share price
• If a financial manager focuses on shareholders’ wealth maximisation, then both risk and
return are taken into account
• Profit maximisation: short-term goal not looking at long-term effects
• Share price maximisation: short-term and long-term
• Every decision in the best interest of the shareholders
 The corporate forms of business
(not for exam)
• Sole proprietorship
• Partnership
• Companies
 Non-profit companies
 For-profit companies
• Close corporations
 The agency problem
• Goal of financial management: increase shareholders’ wealth
• Sole proprietorship = easy; owners are generally also the managers of the business
• Big companies = difficult; owners/shareholders not directly involved in business
• The shareholders (principals) appoint managers (agents) to look after their interest
• Agency relationship: the relationship between the principal and the agent
• Agency problem: when the agent does not make decisions in the best interest of the
principal
 Agency problem cont…
• Management and shareholders goals can differ
• Agency cost: Any costs (both direct and indirect) that can arise due to the
agency problem
• Direct agency cost: measurable amount
• Indirect agency cost: not physical, lost opportunity
• Control agency cost:
 Incentive plans
 Performance plans
 Financial markets and institutions
Financial market: place where anyone with funds can transact with anyone in need of funds
• Money Market: short-term debt securities (no physical location)
• Capital Market: long-term debt securities (stock and bond exchanges)
 Primary market: sell securities for the first time
 Secondary market: securities traded after being sold in the primary market
 Auction market: broker brings buyer and seller together (NYSE)
 Dealer market: traders offer to buy or sell securities (JSE)
Financial institutions: bring savers and lenders together to efficiently allocate funds
(financial intermediary
 Business ethics
• “Ethics” is derived from the Greek word “ethos”
• Ethos refers to the character and guiding beliefs of a person, group or institution
• Ethical decisions refer to decisions on what is good, right, just and fair when
interacting with others (others = humans, animals or nature).
• Therefore, individuals, group and institutions should refrain from harming others.
• In the context of business world: example of unethical behaviours could include theft
of asset and intellectual property, fraud, creating accounting and insider trading.
 Corporate governance
• Corporate governance = framework of rules and practices used by a company’s board of
directors to ensure:
• Accountability, fairness, and transparency

• in the company’s dealings with its shareholders, creditors and other stakeholders.

• The framework should ensure that management practices are:

• Legitimate, objective, transparent and honourable.

• King III report

End
Thank you