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Lecture 1

1.1 What is finance?
1.2 General areas of finance.
1.3 The importance of finance in non-finance areas.
1.4 Increasing importance of managerial finance.
1.5 What goals should businesses pursue?
Learning Objectives
The purpose of Topic 1 is to provide an overview of managerial finance. On
successful completion of this topic you should be able to answer the following
 What is finance, and why it is important to understand basic financial
 What goal(s) should firms pursue? Do firms always pursue appropriate goals?
 What is the role of ethics in successful businesses?
What is Finance?
In simple terms, finance is concerned with decisions about money, or more
appropriately, cash flows. Finance decisions deal with how money is raised and used
by businesses, governments and individuals. Thus, finance is the art and science of
managing money, that is, the process, institutions, markets and instruments involved in the
transfer of money between individuals, businesses and government.
General Areas of Finance
The study of finance consists of four interrelated areas:
1. Financial Markets and Institutions
Financial institutions, which include banks, insurance companies, savings and loans,
and credit unions, are an integral part of the general financial services marketplace.
The success of these organisations requires an understanding of factors that cause
interest rates to rise and fall, regulations to which financial institutions are subject,
and the various types of financial instruments, such as mortgage, loans and
certificates of deposits, that financial institution offer.
2. Investments
This area of finance focusses on the decisions made by businesses and individuals as
they choose securities for their investment portfolios. The major functions in the
investments area are (1) determining the values, risks and returns associated with
such financial assets as stocks and bonds and (2) determining the optimal mix of
securities that should be held in a portfolio of investments.
3. Financial Services
Financial services refer to functions provided by organisations that operate in the
finance industry. In general, financial services organisations deal with the
management of money. People who work in these organisations, which include
banks, insurance companies, brokerage firms, and other similar companies, provide
services that help individuals (and companies) determine how to invest money to
achieve such goals as home purchase, retirement, financial stability and
sustainability, budgeting, and related activities. The financial services industry is one
of the largest in the world.
4. Managerial (Business) Finance
Managerial finance deals with decisions that all firms make concerning their cash
flows. As a consequence, managerial finance is important in all types of businesses,
whether they are public or private, deal with financial services, or manufacture
products. The types of duties encountered in managerial finance range from making
decisions about plant expansions to choosing what types of securities to issue to
finance such expansions. Financial managers also have the responsibility for
deciding the credit terms under which customers can buy, how much inventory the
firm should carry, how much cash to keep on hand, whether to acquire other firms
(merger analysis), and how much of the firm’s earnings to reinvest in the business
and how much to pay out as dividends.
The Importance of Finance in Non-finance Areas
Everyone is exposed to finance concepts almost every day. Thus, even if you do not
intend to pursue a career in a finance-related position, it is important that you do
have some basic understanding of finance concepts. Let’s consider how finance
relates to some of the non- finance areas in a business.
1. Accounting
In many firms (especially small ones), it is difficult to distinguish between the
finance function and the accounting function. Often, accountants make financial
decisions, and vice versa, because the two disciplines are closely related. Financial
managers rely heavily on accounting information because making decisions about
the future requires information about the past. As a result, accountants must
understand how financial managers use accounting information in planning and
decision making so that it can provide in an accurate and timely fashion. Similarly,
accountants must understand how accounting data are viewed (used) by investors,
creditors, and other outsiders who are interested in the firm’s operations.
Emphasis on cash flows
The accountant’s primary function is to develop and provide data for measuring the
performance of the firm, assessing its financial position and paying taxes. Using
certain standardized and generally accepted principles, the accountant prepares
financial statements that recognize revenue at the point of sale and expenses when
incurred. This approach is referred to as the accrual basis.
The financial manager, on the other hand, places primary emphasis on cash flow –
the intake and outflow of cash. He/she maintain the firm’s solvency by analyzing and
planning the cash flows necessary to satisfy its obligations and to acquire assets
needed to achieve its goals. The financial manager uses this cash basis to recognize
the revenues and expenses only with respect to actual inflows and outflows of cash.
Regardless of its profit or loss, a firm must have a sufficient flow of cash to meet its
obligations as they come due.
A small yacht dealer, in the calendar year just ended sold one yacht for $100,000, the
yacht was purchased during the year at a total cost of $80,000. Although the firm
paid in full for the yacht during the year, at the end of the year it has yet to collect
the $100,000 from the customer to whom the sale was made. The accounting view
and the financial view of the firm’s performance during the year are given by the
following income (profit and loss) and cash flow statements, respectively.
Accounting view
Income Statement
Sales revenue
Less: Costs
Net profit
Financial view
Cash Flow Statement
Cash flow
Less: Cash outflow
Net cash flow
In an accounting sense the firm is profitable, but in terms of actual cash flow it is a
financial failure. The firm’s lack of cash flow resulted from the uncollected account
receivable of $100,000. Without adequate cash inflows to meet its obligations the
firm will not survive, regardless of its level of profits.
2. Management
When we think of management, we often think of personal decisions and employee
relations, strategic planning, and the general operations of the firm. Strategic
planning, which is one of the most important activities of management, cannot be
accomplished without considering how such plans impact the overall financial wellbeing of the firm. Such personal decisions as setting salaries, hiring new staff, and
paying bonuses must be coordinated with financial decisions to ensure that any
needed funds are available. For these reasons, managers must have at least a general
understanding of financial management concepts to make informed decisions in
their areas.
3. Marketing
If you have taken basic marketing course, probably one of the first things you
learned was the four Ps of marketing – product, price, place and promotion –
determine the success of products that are manufactured and sold by companies.
Clearly, the price that should be charged for a product and the amount of
advertising a firm can afford for the product must be determined in consultation
with financial managers because the firm will lose money if the price of the product
is too low or too much is spent on advertising. Coordination of the finance function
and the marketing function is critical to the success of a company, especially for a
small, newly formed firm, because it is necessary to ensure that sufficient cash is
generated to survive. For these reasons, people in marketing must understand how
marketing decisions affect and are affected by such issues as funds availability,
inventory levels, and excess plant capacity.
4. Information Systems
Businesses thrive by effectively collecting and using information, which must be
reliable and available when needed for making decisions. The process by which the
delivery of such information is planned, developed and implemented is costly, so are
the problems caused by a lack of good information. Without appropriate
information, decisions relating to finance, management, marketing and accounting
could prove disastrous.
5. Economics
The field of finance is related to economics. Since every business firm operates
within the economy, the financial manager must understand the economic
framework and be alert to the consequences of varying levels of economic activity
and changes in economic policy. The finance manager must also be able to use
economic theories as guidelines for efficient business operation. Examples include
supply and demand analysis, profit maximizing strategies and price theory.
The primary economic principle used in managerial finance is marginal cost-benefit
analysis, the principle that financial decisions should be made and actions taken only
when the added benefits exceed the added costs. Thus, nearly all financial decisions
ultimately come down to an assessment of their marginal benefits and marginal
If for illustration purpose, Joan the financial manager for Bulk Shop – a chain of
department stores operating in Solomon Islands, is currently trying to decide
whether to replace one of the firm’s online computers with a new, more
sophisticated one that would both speed process time and handle a larger volume of
transactions. The new computer would require a cash outlay of $80,000, and the old
computer could be sold to net $28,000. The total benefits from the new computer
(measured in today’s dollars) would be $100,000, and the benefits over a smaller
time period from the old computer (measured in today’s dollars) would be $35,000.
Applying the marginal cost-benefit analysis to the data, is as follows:
Benefits with new computer
Less: benefits with old computer
Marginal (added) benefits
Cost of new computer
Less: proceeds from sale of old computer
Marginal (added) costs
Net benefits
Since the marginal (added) benefits of $65,000 exceed the marginal (added) costs of
$52,000, the purchase of the new computer to replace the old one is recommended.
The company will experience a net gain of $13,000 as a result of this action.
6. Finance in the Organizational Structure of the Firm
The importance of the managerial finance function depend on the size of the
company. In small businesses, the finance function is generally performed by the
accounting department. As the firm grows, the importance of the finance function
typically results in the evolution of a separate department linked directly to the CEO
through a finance director, sometimes called the chief financial officer (CFO)
Increasing Importance of Managerial Finance
The historical trends have greatly increased the importance of managerial finance. In
earlier times the marketing manager would project sales, the engineering and
production staffs would determine the assets necessary to meet those demands, and
the financial manager’s job was simply to raise the money needed to purchase the
required plant, equipment and inventories. The situation no longer exists, decisions
now are made in a much more coordinated manner, and the financial manager
generally has direct responsibility for the control process.
It is also becoming increasingly important for people in marketing, accounting,
production, personnel, and other areas to understand finance in order to do a good
job in their own fields. People in marketing for instance, must understand how
marketing decisions affect and are affected by funds availability, by inventory levels,
by excess plant capacity, and so on. Similarly, accountants must understand how
accounting data are used in corporate planning and are viewed by investors. As well,
financial managers must have an understanding of marketing, accounting, and so
forth to make more informed decisions about replacement or expansion of plant
and equipment and how to best finance their firms.
Thus, there are financial implications in virtually all business decisions, and
nonfinancial executives simply must know enough finance to work these
implications into their own specialised analysis.
What Goals Should Businesses Pursue?
As noted earlier, the owners of a corporation are normally distinct from its
managers. Actions of the financial manager relating to financial analysis and
planning, and investment and financing decisions, should be guided by the
objectives of the firm’s owners: its shareholders. In most cases, if the financial
managers are successful in this endeavour, they will also achieve their own financial
and professional objectives. Thus financial managers need to know what the
objectives of the firm’s owners are.
1. Managerial Actions to Maximise Shareholder Wealth
The general assumption is that owner’s objective is always to maximise profits. To
achieve the goal of profit maximisation, the financial manager takes only those
actions that are expected to make a major contribution to the firm’s overall profits.
For each alternative being considered, the financial manager would choose the one
expected to result in the highest monetary return.
Firms commonly measure profits in terms of earning per share (EPS), which
represent the amount earned during the period – typically a quarter or a year – on
each issue share. EPS are calculated by dividing the period’s total earnings available
for the firm’s ordinary shareholders – the firm’s owners – by the number of shares
But is profit maximisation a reasonable goal? No. It fails for a number of reasons. It
ignores the following:
 Timing of returns
Since the firm can earn a return on the funds it receives, the receipt of funds
sooner as opposed to later is preferred.
John, the financial manager of a particular manufacturing firm is attempting
to choose between two investments: Investment A or Investment B. Each is
expected to have the following effects over its three-year life.
Earnings per share
Year 1
Year 2
Year 3
Total for years
1, 2 and 3
Based on the profit-maximisation goal, investment B would be preferred
over Investment A since it results in higher EPS over the three-year period.
However, Investment A provides greater EPS in the first year and this earlier
returns could be re-invested to provide greater future earnings.
 Cash flows available to shareholders
Profits do not represent cash flows available to the shareholders. Owners
receive returns earlier through cash dividends paid or by selling their shares
for a higher price than initially paid. A greater EPS does not necessary mean
that a firm’s board of directors will vote to increase dividend payments.
Further, a higher EPS does not necessary translate into higher share price.
Firms sometimes experience earnings increases without any corresponding
favourable change in share price. Only when earnings increases are
accompanied by increased future cash flows would a higher share price be
A firm in a highly competitive technology-driven business could increase its
earnings by significantly reducing its research and development expenditures.
As a result, the firm’s expenses would be reduced, thereby increasing its
profits. But, because of its lessened competitive position, the firm’s share
price would drop, as many well-informed investors sell shares in recognition
of lower future cash flows. In this case, the earnings increase was
accompanied by lower future cash flows and therefore a lower share price.
 Risk
Profit maximisation also disregard risk – the chance that actual outcomes
may differ from those expected. A basic premise in managerial finance is that
a trade-off exists between return (cash flow) and risk. Return and risk are in fact
the key determinants of share price, which represents the wealth of the owners in the firm.
Cash flow and risk affect share price differently: higher cash flow is generally
associated with a higher share price. Higher risk tends to result in a lower share
price, because the shareholder must be compensated for the greater risk. For
example, if a legal action claiming significant damages is filed against a
company, its share price will typically immediately drop. This occurs not
because of any near-term cash flow reduction, but rather in response to the
firm’s increased risk – there is a chance that the firm will have to pay out a large
amount of cash sometime in the future to eliminate or fully satisfy the claim (i.e., increased
risk reduces firm’s share price).
Shareholders generally are risk-averse – they want to avoid risk. When risk is
involved, shareholders expect to earn higher rates of return on investments
of higher risk and lower rates of return on lower-risk investments.
Differences in risk can significantly affect the value of an investment.
Profit maximisation does not achieve the objectives of the firm’s owners,
thus it should not be the goal of the financial manager.
It is the shareholders who own the firm and elect the management team.
Management in turn, is supposed to operate in the best interests of the
shareholders. As noted above, the wealth of the owners is measured by the share
price, which in turn is based on the timing of returns (cash flows), their magnitude
and their risk.
Share price represents the owner’s wealth in the firm, therefore share price
maximisation is consistent with owner wealth maximisation.
2. Corporate Governance
The system used to direct and control a corporation is referred to as corporate
governance. It defines the rights and responsibilities of key corporate participants
such as shareholders, board of directors, officers, managers and other stakeholders,
and the rules and procedures for making corporate decisions. Typically, it also
specifies the structure through which the company sets objectives, develops plans
for achieving them and establishing procedures for monitoring performance.
Companies listed on the Australian Securities Exchange (ASX) now have guidance
on good governance practices. The ASX has issued corporate governance principles
which companies can address when framing their standards of corporate
governance. The core eight principles to guide a sound governance policy and
practice are listed below. Further details are on the ASX website.
Principle 1: Lay solid foundations for management and oversight
Principle 2: Structure the board to add value
Principle 3: Promote ethical and responsibility decision-making
Principle 4: Safeguard integrity in financial reporting
Principle 5: Make timely and balanced disclosure
Principle 6: Respect the rights of shareholders
Principle 7: Recognise and manage risk
Principle 8: Renumerate fairly and responsibly
Individual versus institutional investors
It is also worth noting that there are two classes of owners – individuals and
institutions. Individual investors are investors who buy relatively small quantities of
shares so as to earn a return on idle funds, build a source of retirement income or
provide financial security. Institutional investors are investment professionals that
are paid to manage other people’s money. They hold and trade large quantities of
securities for individuals, businesses and governments. Examples include banks,
insurance companies and pension funds.
Because they hold and trade large blocks of shares, institutional investors tend to
have a much greater influence on corporate governance than do individual
Corporate misdeeds
Numerous corporate misdeeds are uncovered by journalists and by various
regulatory bodies. The misdeeds derive from two main types of issues: (1) false
disclosure in financial reporting and other information releases, and (2) undisclosed
conflicts of interest between corporations and their analysts, auditors and lawyers.
3. Business Ethics
Business ethics are the standards of conduct or moral judgement that apply to
persons engaged in commerce. Violation of these standards in finance involves a
variety of actions: creative accounting, earnings management, misleading financial
forecasts, insider trading, fraud, excessive executive compensation, and bribery and
so on. Examples include directors and other statutory officers of major corporations
whose actions were deemed unethical and, in some cases, criminal.
Today, society in general and the financial community in particular are developing
and enforcing ethical standards. The goal of these standards is to motivate business
and market participants to adhere to both, and laws and regulations concerned with
all aspects of business practice. Most business leaders believe businesses actually
strengthen their competitive position by manipulating high ethical standards. And all
companies operating on the ASX are expected to promote ethical and responsible
Ethics and share price
An ethical program is believed to enhance corporate value. It can produce a number
of positive benefits: reduce potential litigation and judgement costs, maintain a
positive corporate image, build shareholder confidence and gain the loyalty,
commitment and respect of all the firm’s constituents. Such actions are expected to
impact positively on the firm’s share price. Ethical behaviour is therefore view as
necessary for the achievement of the firm’s goal of owner maximisation.
4. Manager’s Roles as Agents of Stockholder
We have seen that the goal of the financial manager should be to maximise the
wealth of the owners of the firm. Thus, managers can be viewed as agents of the
owners who have hired them and given them decision-making authority to manage
the firm for the owner’s benefit.
In theory, most financial managers would agree with the goal of owner wealth
maximisation. In practice, however, managers are also concerned with their personal
wealth, job security, lifestyle and perquisites (benefits such as golf club
memberships, company vehicles and impressive offices, all provided at company
expense). Such concerns may make managers reluctant or unwilling to take more
than moderate risk if they perceive that too much risk might result in the loss of
their job and damage to their personal wealth. The result of such a ‘satisfying’
approach (a compromise between satisfaction and maximisation) is a less-thanmaximum return and a potential loss of wealth for the owners.
The conflict between owner and managers is called the agency problem – the likelihood
that managers may place personal goals ahead of corporate goals.
Two factors act to prevent or minimize agency problems:
i. Market forces
- One market force is major shareholders, particularly large institutional
investors. These holders of large blocks of a firm’s shares exert pressure on
management to perform. When necessary, they exercise their voting rights as
shareholders to replace underperforming management.
- Another market force is the threat of takeover by another firm that believe it
can enhance the firm’s value by restructuring its management, operations and
financing. The constant threat of a takeover tends to motivate management to
act in the best interest of the firm’s owners.
Agency costs
To minimize agency problems and contribute to the maximisation of owners’
wealth, shareholders incur agency costs. These are costs of monitoring
management behaviour, ensuring against dishonest acts of management, and
giving managers the financial incentive to maximise share price. An example
is to structure management compensation to correspond with share price
maximisation through incentive plans – tie management compensation to share
price, e.g. granting share options to management, and performance plans – tie
management compensation to measures such as EPS, growth in EPS and
other ratios of return, e.g. performance shares and cash bonuses.
1. Would the role of the financial manager be likely to increase or increase in
importance relative to other executives if the rate of inflation increased?
2. Should stockholder wealth maximisation be thought of as a long-term or
short-term goal? For instance, if one action would probably increase the
firm’s stock price from a current level of $20 to $25 in six months and then
to $30 in five years, but another action would probably keep the stock at $20
for several years but then increase it to $40 in five years, which action would
be better? Can you think of some specific corporate actions that might have
these general tendencies?
3. Drawing on your background in accounting, can you think of any accounting
procedure differences that might make it difficult to compare the relative
performance of different firms?
4. Would the management of a firm in an oligopolistic or in a competitive
industry be more likely to engage in what might be called ‘socially conscious’
practices? Explain your reasoning.
5. If you were the president of a large, publicly owned corporation, would you
make decisions to maximise stockholders’ welfare or your own personal
interests? What are some actions stockholders could take to ensure that
management’s interests and those of stockholders coincided? What are some
other factors that might influence management’s actions?