Topic 1
An Introduction to
Financial Management
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Learning Goals & Objectives
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, the agency issue, and explain
why maximizing the value of the firm is an appropriate goal
for a business.
5. Understand financial institutions and markets, and the role
they play in managerial finance.
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Learning Objective
1
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What is Finance?
 Finance can be defined as the art and science of
managing money.
 At the personal level, finance is concerned with
individuals’ decisions about
 how much of their earnings they spend
 how much they save
 how they invest their savings
 In a business context, finance involves:
 how firms raise money from investors
 how firms invest money in an attempt to earn a profit
 how firms decide whether to reinvest profits in the business
or distribute them back to investors.
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Career 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, businesses, and
government.
 Career opportunities include





banking
personal financial planning
investments
real estate
and insurance
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Career Opportunities in Finance:
Managerial Finance
 Managerial Finance is concerned with
the duties of the financial manager in the
business firm.
 Financial Manager administer the financial affairs
of all types of businesses − private and public, large
and small, profit-seeking and not-for-profit. Tasks
include:




developing a financial plan or budget
extending credit to customers
evaluating proposed large expenditures
raising money to fund the firm’s operations.
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Legal Form of Business Organization
 A sole proprietorship is a business owned by one
person and operated for his or her own profit.
 A partnership is a business owned by two or more
people and operated for profit.
 A corporation is an entity created by law.
Corporations have the legal powers of an individual
in that it can sue and be sued, make and be party to
contracts, and acquire property in its own name.
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Legal Form of Business Organization
Legal status
Owner
Sole Proprietorship
Partnerships
Corporation
No legal status
No legal status
Separate legal entity
One
Minimum 2, Maximum 20
Private Co.: min 2, max 50
Public Co.: min 2
Liabilities of
owner
Unlimited liabilities
Unlimited liabilities
Limited to the amount of
shares subscribed by the
shareholders
Ownership of
properties
Owned by the soleproprietor
Jointly owned by the
partners
Owned by the company
Management
Managed by the soleproprietor
Every partner is entitled to
participate
Managed by the Board of
directors and the
management team
Occurs on the owner’s death
or by the owner’s choice
When any one of the partner:
- passed away;
- is bankrupt
- withdraws;
- or becomes insane
- By undergoing legal
winding-up.
- Perpetual succession
unless the company is
liquidated.
Termination
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Strengths and Weaknesses of the Common
Legal Forms of Business Organization
Sole Proprietorship:
Business owned by one person
Advantages
Disadvantages
– Easiest to start
– Least regulated
– Single owner keeps all of the
profits
– Taxed once as personal
income
– Limited to life of owner
– Equity capital limited to
owner’s personal wealth
– Unlimited liability
– Difficult to transfer
ownership interest
– Limited managerial capacity
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Strengths and Weaknesses of the Common
Legal Forms of Business Organization
Partnership:
Business owned by two or more persons
Advantages
Disadvantages
– More brain power (than sole
proprietorship)
– More capital available (than
sole proprietorship)
– Relatively easy to start (than
corporation)
– Income taxed once as
personal income
– Unlimited liability ( for
General partnership)
– Partnership dissolves when
one partner dies or wishes to
sell
– Difficult to transfer
ownership
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Strengths and Weaknesses of the Common
Legal Forms of Business Organization
Corporation:
A legal “person” distinct from owners
Advantages
Disadvantages
– Limited liability
– Separation of ownership and
management (agency
– Unlimited life
problem)
– Greater governance
– Transfer of ownership is easy – Double taxation (income
taxed at the corporate rate
– Easier to raise capital
and then dividends taxed at
personal rate)
– Greater and stricter
regulation
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– Costly to operate
Strengths and Weaknesses of the Common
Legal Forms of Business Organization
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Learning Objective
2
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The Managerial Finance Function
 The size and importance of the managerial finance
function depends on the size of the firm.
 In small companies, the finance function may
be performed by the company president or
accounting department.
 As the business expands, finance typically evolves
into a separate department linked to the president
as shown in Figure 1.1 below.
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Corporate Organization
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The Managerial Finance Function:
Relationship to Economics
 The field of finance is actually an outgrowth of
economics.
 In fact, finance is sometimes referred to as financial
economics.
 Financial managers must understand the economic
framework within which they operate in order to react
or anticipate to changes in conditions.
 The primary economic principal used by financial
managers is marginal cost-benefit analysis which says
that financial decisions should be implemented only
when added benefits exceed added costs (optimization).
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The Managerial Finance Function:
Relationship to Accounting
 The firm’s finance (treasurer) and accounting
(controller) functions are closely-related and
overlapping.
 In smaller firms, the financial manager generally performs
both functions.
 One major difference in perspective and emphasis
between finance and accounting is that accountants
generally use the accrual method while in finance, the
focus is on cash flows.
 Whether a firm earns a profit or experiences a loss, it
must have a sufficient flow of cash to meet its
obligations as they come due.
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The Managerial Finance Function:
Relationship to Accounting (Con’t)
 The significance of this difference between finance
and accounting principle can be illustrated using
the following simple example:
Suppose XYZ Bhd experienced the following activity in
2017:
Sales Revenue RM 1,000,000 (100% still uncollected)
Costs of Sales
RM 700,000 (fully paid due to supplier terms)
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The Managerial Finance Function:
Relationship to Accounting (Con’t)
Financial Statement of XYZ Bhd for year 2017:
Accrual
Sales
Less: Costs
Profit/(Loss)
RM 1,000,000
Cash
RM 0
(RM 700,000)
(RM 700,000)
RM 300,000
(RM 700,000)
Surplus in
Accounting Profit
Deficit in Actual
Cash flow
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The Managerial Finance Function:
Relationship to Accounting (Con’t)
 Finance and accounting also differ with respect to
decision-making.
 While accounting is primarily concerned with the
presentation of financial data, the financial manager
is primarily concerned with analyzing and
interpreting this information for decision-making
purposes.
 The financial manager uses this data as a vital tool for
making decisions about the financial aspects of the firm.
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Learning Objective
3
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Primary Activities of the Financial Manager
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Learning Objective
4
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Goal of the Firm:
Maximize Profit?
 Consider the following investment options, which
has different expected increases in EPS over a 3year period:
Investment
Project A
Project B
Increase in Earnings per share (RM)
Year 1
Year 2
Year 3
Total
3.00
2.00
1.50
RM6.50
1.00
0.50
5.50
RM7.00
 Which investment is preferred
 If your goal is to maximize profit?
 If your goal is to maximize share price?
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Goal of the Firm:
Maximize Profit?
The problem of Profit Maximization
 Timing: Since a firm can earn a return on funds it
receives, the receipt of funds sooner rather than
later is preferred.
 Cash Flows: Profits do not necessarily result in
cash flows. There is no guarantee that the BODs will
increase dividends when profits increase.
 Risk: Actual outcomes may differ from
expectations. There is always a trade-off between
risk and return.
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Goal of the Firm:
Shareholder Wealth Maximization
 In short: Profit maximization fails to account for
differences in the level of cash flows (as opposed to
profits), the timing of these cash flows, and the risk of
these cash flows
 In contrast, shareholder wealth maximization properly
considers the level of cash flows, the timing of these
cash flows, and the risk of these cash flows.
 This can be illustrated using the following simple stock
valuation equation:
level & timing
of cash flows
Future Dividends
Share Price =
Required rate of return
risk of cash
flows
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Goal of the Firm:
Shareholder Wealth Maximization
 Shareholder Wealth Maximization is the same as:
 Maximizing Firm’s Value
 Maximizing Share Price
 The process of shareholder wealth maximization
can be described using the following flow chart:
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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, customers, suppliers, creditors, owners,
government, and others.
 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. The goal is not to maximize
stakeholder wealth but to preserve it.
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Goal of the Firm:
What about other Stakeholders?
 The stakeholder view does not change the goal of
maximizing shareholder wealth.
 Such a view is considered to be "socially
responsible.“
 It is expected to provide long run benefit to
shareholders by maintaining positive relationships
with other stakeholders
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The Agency Issue:
The Agency Problem
 Manager: Agent of the company who is hired by
the shareholders (principal) to manage the
company (making decisions on behalf of
shareholders). Recall back the Organization structure in Figure
1.1 (Slide 13)
 Agency problem exists when managers place
personal interests (personal wealth, job security,
fringe benefits, and lifestyle) ahead of the goals of
shareholders (maximize shareholder wealth).
 This would cause managers to act in ways that do not
always benefit the firm shareholders.
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The Agency Issue:
The Agency Problem
Existence of agency problems in turn give rise to
agency cost.
 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 (ensuring the
managers’ interests are aligned with those of
shareholders).
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The Agency Issue:
Resolving the Problem
1. Management Compensation Plans:
Structure management compensation to correspond with
firm performance.
 Incentive plans tie management compensation to share
price. A stock option is an incentive allowing managers
to purchase stock at the market price set at the time of
the grant.
 Performance plans tie management compensation to
performance measures such as EPS or growth in EPS.
Compensation is often in the form of performance
shares or cash bonuses.
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The Agency Issue:
Resolving the Problem
2. Threat of Takeover
 As agency problem represent a misuse of firm’s
resources and impose agency costs on the firm’s
shareholders, the firm’s stock is generally
depressed.
 This makes the firm an attractive takeover target.
 External corporate governance: The constant
threat of a takeover tends to motivate management
to act in the best interest of the shareholders.
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Learning Objective
5
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Financial Institutions and 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
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Financial Institutions
 Financial institutions are intermediaries that
channel the savings of individuals, businesses, and
governments into loans or investments.
 The key suppliers and demanders of funds are
individuals, businesses, and governments.
 Supplier of funds: they lend
 Demander for funds: they borrow
 In general, individuals are net suppliers of funds,
while businesses and governments are net
demanders of funds.
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The Relationship between Financial
Institutions and Financial Markets
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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.
 Transactions of short term marketable securities
take place in the money market while transactions
of long-term securities take place in the capital
market.
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Financial Markets
 Whether subsequently traded in the money or
capital market, securities are first issued through
the primary 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.
 Once issued, securities then trade on the secondary
markets such as Bursa Malaysia or MESDAQ.
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Financial Markets
 Private Placement
 The sale of a new security issue, typically bond or
preferred stock, directly to an investor or group of
investors (insurance company, pension fund, mutual
fund)
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Learning Goals & Objectives
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, the agency issue, and explain
why maximizing the value of the firm is an appropriate goal
for a business.
5. Understand financial institutions and markets, and the role
they play in managerial finance.
1-41