Course Name: Principles of Finance
Chapter 1: Overview of Financial Management
TABLE OF CONTENTS
LEARNING OBJECTIVES ................................................................................... 2
ABSTRACT .......................................................................................................... 2
1.1 INTRODUCTION ............................................................................................ 3
1.2 THE EVOLUTION OF FINANCE .................................................................... 4
1.3 THE FINANCIAL MANAGER’S FUNCTIONS ................................................ 5
1.3.1 Forecasting and Planning ........................................................................................ 5
1.3.2 Investment and Financing Decisions ...................................................................... 5
1.3.3 Coordination and Control ....................................................................................... 5
1.3.4 Dealing with Financial Markets ............................................................................. 5
1.3.5. Risk Management ................................................................................................... 6
1.4 FORMS OF BUSINESS ORGANIZATION ..................................................... 7
1.5 THE GOALS OF THE CORPORATION ......................................................... 8
1.6 AGENCY RELATIONSHIP ............................................................................. 9
1.6.1 Primary Agency Relationship ................................................................................. 9
1.6.2 Mechanisms to Motivate Managers To Act in Shareholder’s Best Interests ... 10
ADDITIONAL MATERIALS ................................................................................ 11
QUESTIONS ....................................................................................................... 11
Page 1 of 12
Course Name: Principles of Finance
Chapter 1: Overview of Financial Management
LEARNING OBJECTIVES
At the end of this chapter, you will be able to:




Introduce the three interrelated areas of finance to students
Describe the responsibilities of the financial manager
Describe the advantages and disadvantages of alternative forms of business organization
State the primary goal of a corporation, and agency relationship.
ABSTRACT
This chapter provides an overview of financial management. The three interrelated areas of
finance will be discussed and so as the functions of financial manager. Besides, students are
exposed to alternative forms of business organization. The concentration will be on corporation.
The goal of a corporation and how financial managers can contribute to the attainment of these
goals will be discussed in this chapter.
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Course Name: Principles of Finance
Chapter 1: Overview of Financial Management
1.1 INTRODUCTION
The field of finance is broad and dynamic. It directly affects every person and every organization,
financial or non-financial institution, private or public, large or small, profit seeking or not-for-profit.
Finance can be defined as the art and science of managing money. Virtually all individuals and
organizations raise money and spend or invest the money. Finance is more concern with the
process, institutions, markets, and instruments involved in the transfer of money among and
between individuals, businesses, and governments.
Finance consists of three interrelated areas:

Money and Capital markets
Money markets are the financial markets in which funds are borrowed or loaned
for short periods (less than one year). In other words, money market is where
you put your cash if you have surplus funds.
On the other hand, capital markets are the financial markets for stocks and for
intermediate-or-long-term debt (one year or longer). In other words, capital
market is where you sell or buy financial instruments.

Investments
Investment area focuses on the decisions made by both individual and
institutional investors as they choose securities for their investment portfolio. The
three main functions in the investments area are sales, analyzing individual
securities, and determining the optimal mix of securities for a given investor.

Financial Management
Financial management is the broadest of the three areas and is important in all
types of businesses including banks, financial institutions, industrial, retail firms
as well as governmental operations.
Financial management involves various decision-making ranging from how to
finance the company operation, determine the most appropriate types of
financing for the specific projects, and costs of each type of financing. It also
involves management of current asset such as cash, account receivables, and
inventories as well.
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Course Name: Principles of Finance
Chapter 1: Overview of Financial Management
1.2 THE EVOLUTION OF FINANCE
Similar to other functional areas like accounting, marketing, and production, to name a few,
finance has also undergone some kind of evolution. This is due to the fact that business itself has
evolved from purely an entity with a single objective such as profit maximization into an entity,
which has to accept multiple objectives.
The evolution of finance can be divided into six eras, as explained below.

1900s
Emphasis on the legal aspects of merger, formation of new firms, and the various types
of securities the firm can issue as new capital.

1930s
Legalistic and descriptive emphasizing on bankruptcy and reorganization, corporate
liquidity, and the regulation of security markets.

1940s
Descriptive, institutional subject viewed more from the standpoint of outsider rather than
from internal management.

1950s
Movement towards theoretical analysis focusing on the choice of assets to maximize the
value of the firm.

1960s
Important advances in the pricing of risky assets and in valuing contingent claims.

1990s
Continuation of the valuation process expanded to include inflation, deregulation,
computer analysis and electronic transfer of information and globalization. On the local
fronts, introduction of Islamic Bank and Islamic counters in conventional banks and the
uses of Islamic financial instruments as another alternative of financing captured most of
the academic discussions.
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Course Name: Principles of Finance
Chapter 1: Overview of Financial Management
1.3 THE FINANCIAL MANAGER’S FUNCTIONS
The financial managers are responsible to the financial activities in a company and help to
employ resources so as to maximize the value of the firm.
Activities performed by financial manager can be grouped into five categories:
1.
2.
3.
4.
5.
Forecasting and Planning
Investment and Financing Decisions
Coordination and Control
Dealing with Financial Markets
Risk Management
1.3.1 Forecasting and Planning
Financial data is analyzed and transformed into a form that can be used to monitor and forecast
the firm's financial condition. The firm position in the market is evaluated and financial analysis is
carried out to determine whether additional or reduced financing is required. The managers
concerned must interact with people from other departments as they look ahead and lay the plans
that will shape the firm's future.
1.3.2 Investment and Financing Decisions
A successful firm normally has a high volume of sales shown in financial statements. An increase
in sales requires additional investments in plant, equipment and inventory. In this case, the
managers concerned need to determine the optimum sales growth rate, decide what specific
assets to acquire, and then choose the best way to finance those assets according to the firm's
financial position.
1.3.3 Coordination and Control
The managers concerned must interact with other personnel to ensure that the firm is operated
as efficiently as possible. Coordination of different activities in the firm is important to produce the
required results, for example the preparation of financial statements.
All business decisions have financial implications, and all managers need to take this into
account.
1.3.4 Dealing with Financial Markets
Financial managers deal with the money and capital markets for investments and raising capital
expenditures. This is the result of the firm's activities and objectives that has to be satisfied. The
financial markets where funds are raised affect the firm, securities are traded, and where
investors either make or lose money.
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Course Name: Principles of Finance
Chapter 1: Overview of Financial Management
1.3.5. Risk Management
All businesses face certain kind of risks such as natural disasters, uncertainties in commodity and
security market, volatile interest rates, and fluctuating foreign exchange rates. Financial manager
analyzes and evaluates the business activities and the risks associated with it.
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Course Name: Principles of Finance
Chapter 1: Overview of Financial Management
1.4 FORMS OF BUSINESS ORGANIZATION
There are basically three forms of business organizations: sole proprietorship, partnership, and
corporation.
Sole proprietorship is a business legally owned by a person who operates it for his or her own
profit. Generally, this type of business is the most common form of organization.
A partnership consists of two or more owners, operating the business together for profit.
Basically, partnership is typically larger than sole proprietorships.
A corporation is an artificially being created by law. It is also known as 'legal entity'. It is separate
and distinct from its owners and managers.
The advantages and disadvantages of sole proprietorship, partnership and corporation shown in
Figure 1.
Figure 1: Advantages and Disadvantages of Sole Proprietorship, Partnership and Corporation
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Course Name: Principles of Finance
Chapter 1: Overview of Financial Management
1.5 THE GOALS OF THE CORPORATION
Shareholders are the owners of a corporation and they elect directors, who then hire managers to
run the corporation on a daily basis. Since managers are working on behalf of shareholders, they
should pursue policies that enhance shareholder value. Consequently, the primary goal of a
corporation is stockholder wealth maximization.
This is the primary goal for a corporation. Stockholders own the corporation; elect the board of
directors who then elect the management team. Management, in turn is supposed to operate in
the best interest of the stockholders. Managers should consider the risk and timing associated
with expected earnings per share in order to maximize the price of the firm's common stock.
Besides stockholder wealth maximization, there are other objectives that a corporation would
pursue such as personal satisfaction, employee welfare and good of community. It relates to the
concept of social responsibility.
Social responsibility is the concept that businesses should be actively concerned with the welfare
of society at large. It raises the question whether businesses should operate strictly in their
stockholders' best interests or also be responsible for the welfare of their employee, customer,
and the communities in which they operate. The costs of socially responsible actions play the
roles here. Corporations and government should cooperate in establishing the rules of corporate
behavior, and the costs as well as the benefits of such actions must be estimated accurately and
then taken into account.
It is believed that if a corporation attempts to maximize its stock price, the same action will also
benefit the society. To maximize stock price, a firm must provide a low-cost, high quality product
to consumers. This, in itself, is a benefit to society.
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Course Name: Principles of Finance
Chapter 1: Overview of Financial Management
1.6 AGENCY RELATIONSHIP
When the owners such as the shareholders appoint themselves as the member of the board
and/or the management, there is no agency relationship. But when the shareholders such as the
principals appoint another individuals, or agents on his behalf to run the company, then the
agency-principals relationship exists. The managers are the agents of the company holding the
management position on behalf of the shareholders.
The graphic below shows the agency relationship.
Figure 2: Agency Relationship
1.6.1 Primary Agency Relationship
In financial management, the primary agency relationships are those between:


Stockholders and managers
Managers and creditor
Stockholders and Managers
A potential agency problem arises when the manager of a firm owns less than 100% of the
firm's common stock. Conflict of interest arises when the owner-manager incorporates and then
sells some of the stock to outsiders. In this situation, the owner-manager may not work as
strenuously to maximize shareholder wealth, as less of this wealth will affect him or her. In
addition, the fact that the owner-manager will neither gain all the benefits nor bear all the costs
will increase the incentives to take actions that are not in the best interests of other shareholders.
In order to encourage managers to maximize the firm's stock price, the shareholders have to bear
all the costs incurred. This is also called agency costs. There are three major categories of
agency costs, which are:
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Course Name: Principles of Finance
Chapter 1: Overview of Financial Management
1. Expenditure to monitor managerial actions such as audit costs.
2. Expenditures to structure the organization in a way that will limit undesirable managerial
behavior.
3. Opportunity costs which are incurred when shareholders imposed restriction.
Managers and Creditors
Creditors have a claim on part of the firm's earnings stream for payment of interest and principal
on the debt. Creditors also have the right to claim on the firm's assets in the event of bankruptcy.
Conflicts arise if management acting for the stockholders takes on risky projects that are not
anticipated by creditors or the firm increases debt to a level higher than was anticipated.
Therefore, to best serve the shareholders in the long run, managers must play fairly with
creditors. Managers as agents of both shareholders and creditors must act in a manner that is
fairly balance between the interests of two classes of security holders.
As managers do not own 100 percent of a corporation's common stock, sometimes they may not
act in the best interest of shareholders. Managers can be encouraged to act in stockholders' best
interests through incentives and rewards for their good performance.
1.6.2 Mechanisms to Motivate Managers To Act in Shareholder’s Best Interests
Some specific mechanisms used to motivate managers to act in shareholders' best interests are:

Managerial compensation
The compensation package should be designed to cater these two objectives:
1. To attract and retain able managers
2. To align managers' actions as closely as possible with the interest of shareholders.
Normally, different compensation package is different from one company to another.

Direct intervention by shareholders
Today, institutional investors such as mutual funds, insurance companies, and pension
funds own majority of the stock. Therefore, the institutional money managers have the
clout if they decide to exercise considerably influence over most of the firms' operations.
They can propose to the management and institutional investors will acts as lobbyists for
the body of shareholders.

The threat of firing
The probability of a large firm's management being dismissed by its stockholder was so
remote that it posed little threat. This is because of the firm's shares are so widely
distributed, and management's control over the voting mechanism was so strong.
However, this situation is changing nowadays.

The threat of takeover
Hostile takeovers are most likely to occur when a firm's stock is undervalued relative to its
potential because of poor management. Normally, the managers of the acquired firm are
fired. Those who manage to stay on would lose their status and authority. Thus,
managers have a strong incentive to take actions designed to maximize stock prices.
Page 10 of 12
Course Name: Principles of Finance
Chapter 1: Overview of Financial Management
ADDITIONAL MATERIALS
Hyperlinks

Mutual Fund Basics
http://www.investopedia.com/university/mutualfunds/default.asp

The Encyclopedia About Corporate Governance
http://www.investopedia.com/university/mutualfunds/default.asp
QUESTIONS
1.
The primary goal of a publicly-owned firm interested in serving its stockholders should be to
_________________.
a.
b.
c.
d.
2.
Which of the following factors tend to encourage management to pursue stock price
maximization as a goal?
a.
b.
c.
d.
3.
Maximize expected total corporate profit.
Maximize expected earning per share.
Maximize expected net income
Maximize the stock price per share
Shareholders link management’s compensation to company performance.
Managers’ reaction to the threat of firing and hostile takeovers.
Managers do not have goals other than stock price maximization.
Statement a and b are correct.
Which of the following actions are likely to reduce agency conflicts between stockholders a
and managers?
a.
b.
c.
d.
Paying managers a large fixed salary.
Increasing the threat of corporate takeover.
Placing restrictive covenants in debt agreements
Statement b and c are correct.
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Course Name: Principles of Finance
Chapter 1: Overview of Financial Management
Answer:
1. d
2.d
3.b
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