Chapter 1
Overview of Financial
Management and the Financial
Environment
1
What is Finance
2
What is Finance?
Finance can be defined as the science and art 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, and
 how they invest their savings.
In a business context, finance involves the same types of decisions:
 how firms raise money from investors,
 how firms invest money in an attempt to earn a profit, and

how they decide whether to reinvest profits in the business or
distribute them back to investors.
1-3
What is Finance?
Finance is concerned with the process, institutions,
markets and instruments involved in the transfer of
money among and between individuals , business &
governments
 Financial markets and financial intermediaries facilitate the flow of funds
from savers to borrowers.
 Financial management involves the efficient use of financial resources in
the production of goods.

Finance goal …… make better personal finance
decisions
4
Financial Institutions &
Markets
Firms that require funds from external sources can
obtain them in three ways:
1. through a financial institution
2. through financial markets
3. through private placements
2-5
FIGURE 1 Flows of Funds
Through the Financial System
6
Financial Institutions &
Markets
Financial institutions: an intermediary that
channels the saving of individual, business &
government into loans or investment
 The major financial institutions are commercial banks,
investment banks & insurance companies
 The key supplier and demanders of fund in financial
institutions are:
 Individuals------ net supplier of funds (save more than
borrow)
 Business firm--- net demander of funds
 Government------net demander of funds
7
Commercial Banks, Investment Banks,
and the Shadow Banking System
• Commercial banks are institutions that provide
savers with a secure place to invest their funds and
that offer loans to individual and business
borrowers.
• Investment banks such as Merrill Lynch are
institutions that assist companies in raising
capital, advise firms on major transactions such as
mergers or financial restructurings, and engage in
trading and market making activities.
2-8
Financial Institutions &
Markets Cont.
Financial markets: provide a forum in
which supplier of funds and demanders
of funds can transact business directly


Whereas financial institutions, loans and
investments are made without the direct
knowledge of supplier of funds
The two key financial markets:
 Money market ( for short-term fund)
 Capital market ( for long-term fund)
9
Financial Institutions & Markets Cont.
1)The Money Market: a financial relationship
created between supplier & demanders of
short-term funds
 Most money market transactions are made in marketable
securities ( short –term debt instrument such as government
treasury bills and commercial paper).
Government Treasury bills are short-term instrument issued by government.
It is more secure than bank deposits or any other investment alternatives,
because the risk of the government being in default, not being able to re-pay
interest or principal, is very remote, almost negligible compared to the risk of
other borrowers.
In Egypt, there are three types of T-Bills i.e. 91 days, 182 days and 364days.
you pay a lower amount when you purchase T-bills compared to their par
value, which you will receive after a certain period i.e. 91 days. For example, I
pay LE 990 today for T-Bills 91 days and later receive LE 1000 after three
months.
The method of offering Treasury bills to the market is through auctions. The
entity or financial institution that pays more than the other entities will win the
bid, which is the same process as any other auction in the market.
10
Treasury Bills
11
Commercial paper
Commercial Paper is another short-term investment
tool is commercial paper, which is issued by well
established companies such as IBM, Procter &
Gamble etc. in order to finance their short-term or
working capital requirements.
Commercial paper is highly liquid and is traded on
the secondary market.
There are currently no commercial paper traded in
Egypt.
12
The Capital Market
2) The Capital Market: a financial relationship created
between supplier & demanders of long-term funds
• The key capital market securities are bonds (long-term
debt) and both common and preferred stock (equity, or
ownership).



Bonds are long-term debt instruments used by businesses and
government to raise large sums of money, generally from a diverse
group of lenders.
Common stock are units of ownership interest or equity in a
corporation.
Preferred stock is a special form of ownership that has features of
both a bond and common stock.
2-13
Financial Institutions &
Markets Cont.
To raise money, firms can use either
private placement or public offering


Private placement: the sale of a new
security issue, typically bonds or preferred
stock, directly to an investor or group of
investors such as insurance companies &
pension funds
Public offering: the nonexclusive sale of
either bonds or stocks to general public
14
Financial Institutions &
Markets Cont.
Primary market: financial markets in
which securities are initially issued
 The only market in which the issuer is directly
involved in the transaction
 This is done through an intermediate named
investment bank
Secondary market: financial markets in
which pre-owned securities ( those that
are not new issues) are traded
 The intermediate is the stock market
 Example: NASDAQ or New York stock exchange and EGX
15
The Relationship between Financial
Institutions and Financial Markets
16
Types of securities
Equity(my money)
Capital
Shares( both represent
the owned capital &
they have no maturity)

C.S.:
 Take variable
dividends depend on:
 The amount of
net earning
 The decision to
distribute or to
retain the earning
 Have the right to vote
(every share=one
vote)
Debt(borrowed)
Long –term debts
Bonds
Bondholders


Take interest on the
par value of the
bond
Has a maturity date
17
Types of securities
Equity(my money)

P.S.:
 Take fixed dividends
before common stock
 Preferred stock are
bought for the benefit
of its low risk as it
has a fixed dividends
regardless of


Amount of net
earning
The decision of
distributing or
retaining earnings
Debt(borrowed)
The shareholder’s
claim on firm value
is the residual
amount that remains
after the debt
holders are paid
18
Major Areas & Opportunities
in Finance
1. Financial service: concerned with the design
and delivery of advice and financial
products to individuals, business &
government

Financial analysis and Financial advisor

Career opportunities include banking, personal financial
planning, investments, real estate, and insurance.
19
Major Areas & Opportunities in
Finance (cont.)
2. Managerial finance is concerned with the duties
of the financial manager working in a business.


Financial managers administer the financial affairs of
all types of businesses—private and public, large and
small, profit-seeking and not-for-profit.
They perform such varied tasks as
 developing a financial plan or budget,
 extending credit to customers,


evaluating proposed large expenditures, and
raising money to fund the firm’s operations.
1-20
Corporate Finance
Addresses the Following
Three Questions
1. What long- term investments should the
firm engage in? ( Investment decision)
2. How the firm can raise the money for the
required investments? ( Financing
decision)
3. How much short- term cash flow does a
company need to pay its bills? ( Managing
the working capital)
21
Macro Finance
ABC Company
Balance Sheet
As of December 31, 19xx
Working
Capital
Assets:
Liabilities & Equity:
Current Assets
Current Liabilities
Cash & M.S.
Accounts payable
Accounts receivable
Notes Payable
Inventory
Total Current Assets
Fixed Assets:
Investment
Decisions
Gross fixed assets
Total Current Liabilities
Long-Term Liabilities
Total Liabilities
Equity:
Less: Accumulated dep.
Common Stock
Goodw ill
Paid-in-capital
Other long-term assets
Retained Earnings
Total Fixed Assets
Total Assets
Working
Capital
Financing
Decisions
Total Equity
Total Liabilities & Equity
22
The Financial Manager
To create value, the financial manager
should:


Try to make smart investment decisions
(Determine the mix and type of assets
found on the left-hand side of a firm
balance sheet)
Try to make smart financing decisions
( Deal with right- hand side of a firm
balance sheet)
23
Legal Forms of Business
Organization
1. The sole proprietorship: A business owned
by one person and operated for his or her
own profit (unlimited liability)



example: majority of Sole proprietorship are found in
the wholesale, retail, service and construction industry.
Limited sources of finance
Unlimited liability: allowing the owner’s total
wealth to be taken to satisfy creditors
24
Starting as a Proprietorship
Advantages:



Ease of formation
Subject to few regulations
No corporate income taxes
Disadvantages:



Limited life
Unlimited liability
Difficult to raise capital to support growth
25
Legal Forms of Business
Organization. Cont.
2. Partnership: A business owned by two
or more people and operated for profit

General partner ( unlimited liability)
Manage the company
 In case of liquidation, all the loans are their
responsibilities


Limited partner ( limited liability)
 He will lose only his capital under liquidation
26
Legal Forms of Business
Organization. Cont.
3. Corporation :
A corporation is a legal entity separate from its
owners and managers.
File papers of incorporation with state.





Charter
Bylaws
Owners have limited liability which guarantees that they
cannot lose more than they invested
Can achieve large size through sale of stock
Subject to greater government regulation
27
Advantages and Disadvantages
of a Corporation
Advantages:




Unlimited life
Easy transfer of ownership
Limited liability
Ease of raising capital
Disadvantages:


Double taxation
Cost of set-up and report filing
28
Basic Forms of Business Organization
29
Managerial Finance Function
• The size and importance of the managerial
finance function depends on the size of the firm.
• In small firms, the finance function is generally
performed by the accounting department.
• As a firm grows, the finance function typically
evolves into a separate department linked directly
to the company president or CEO through the
chief financial officer (CFO) (see Figure 1.1)
1-30
Corporate Organization
31
The Managerial Finance
Function
Treasurer : (the firm’s chief financial
manager) is responsible for the firm’s
financial activities such as financial
planning and fund raising
Controller : (the firm’s chief
accountant) is responsible for the firm’s
accounting activities, such as cost
accounting
32
The Managerial Finance
Function
Relationship to Economics:



The field of finance is closely related to
economics.
The primary economic principle used in
managerial finance is Marginal Analysis
Marginal Analysis: economic principle
that states that financial decision should be
made & actions taken only when added
benefit exceeds the added costs
33
Example on relationship
between Economics & Finance
A company is evaluating a decision to buy a
new production line that requires an
immediate cash investment of $ 5M. This
production line will have a useful life of 5
years. The net cash flow during this useful
life had been estimated and it has a net
present value of $ 8M. The company has an
existing production line that may be sold
today for $ 1M. It is expected that the
existing production line has 3 years left in its
useful life; the net cash flow during these 3
years are estimated & its NPV $ 3M.
34
Relationship Between
Accounting & Finance
Finance
Accounting
Future
Take the financial
decisions
Current market
value
Past
Record financial
transaction
Historical cost
Cash basis (recognizes
Accrual Basis
revenues & expenses only with
respect to actual inflows &
outflow of cash)
(recognizes revenues ay the
point of sale & recognizes
expenses when incurred)
35
Managerial Finance Function:
Relationship to Accounting (cont.)
Finance and accounting also differ with respect to
decision-making:
 Accountants devote most of their attention to
the collection and presentation of financial
data.
 Financial managers evaluate the accounting
statements, develop additional data, and make
decisions on the basis of their assessment of the
associated returns and risks.
1-36
Example
ABC company had sales account of $1 M
during last year; out of which 60% is cash.
The cost of good sold is $800,000 out of
which 80% is cash
Required:
a) What is the accounting net profit or
loss for the company?
b) What is the Net Cash Flow for the
company?
37
Example
The following data is extracted from XYZ
company for the last quarter of 2003
Oct.
Nov.
Dec
Sales
$1 M
800,000
$1 M
(-) Exp.
800,000 800,000 700,000
The company policy is to sell 40% cash, and
the rest is on credit to be collected after 2
months. The expenses are paid 70% cash,
and the rest is after 1 month. Calculate the
NCF during December
38
Goal of a Firm
Corporations commonly measure profits in terms of
Earnings per share (EPS)
Maximizing profit ; is it a correct goal????
No
Profit maximization may not lead to the highest possible
share price for at least three reasons:
1.
Profits do not necessarily result in cash flows available
to stockholders
2.
Timing is important—the receipt of funds sooner rather
than later is preferred
3.
Profit maximization fails to account for risk
39
Goal of a Firm
1)Ignores cash flow available for stockholders:
 Profits do not necessarily result in cash flow available
to the stockholders
 Owners receive cash flow in the form of: cash


dividends & capital gain.
High EPS do not necessarily mean that B.O.D will vote
to increase dividends payments.
High EPS do not necessarily translate into a higher
stock price; only when earnings increases are
accompanied by increased future cash flows would a
higher stock price be expected. (example: firm sold a
high-quality product= increase in earnings due to
reducing
it
equipment
maintenance
expenditures=expenses decrease ---- profits increased
BUT product quality decreased = losing competitive
position ; therefore stock price drop due to recognition
of LOWER FUTUR CASH FLOWS
40
Goal of the Firm Cont.
2) Profit maximization doesn't consider the timing of return ( time value
of money)
 The receipt of funds sooner rather than later is preferred ( the
larger returns in year 1 could be reinvested to provide greater future
earnings)
Which Investment is Preferred?
41
Goal of the Firm Cont.
3) Risk is also not considered
Risk: it means variation of the expected return from the
actual return
-- tradeoff between return ( cash flow) & risk
 Cash flow & Risk affect share price differently :

HIGH CASH FLOW LEAD TO HIGH SHARE PRICE
HIGH RISK LEAD TO LOWER SHARE PRICE (

In general , Stockholders are Risk-averse

ex. Death of highly successful CEO)
Therefore; The goal of the firm is TO MAXIMIZE THE WEALTH
OF THE OWNERS
 The wealth of corporate owners is measured by share
price of the stock
 Financial managers should accept only those actions that
are expected to increase share price
42
Goal of the Firm
Maximize Shareholder Wealth!!!

It can also be described using the following flow chart:
43
Goal of the Firm:
What About Stakeholders?
• Stakeholders are groups such as employees,
customers, suppliers, creditors, owners, and others
who have a direct economic link to the firm.
• A firm with a stakeholder focus consciously
avoids actions that would prove detrimental to
stakeholders. The goal is not to maximize
stakeholder well-being but to preserve it.
• Such a view is considered to be "socially
responsible."
1-44
Individual versus Institutional
Investors
Individual investors are investors who purchase
relatively small quantities of shares in order to earn a
return on idle funds, build a source of retirement
income, or provide financial security.
Institutional investors are investment professionals
who are paid to manage other people’s money.
They hold and trade large quantities of securities for
individuals, businesses, and governments and tend to
have a much greater impact on corporate
governance.
45
Governance and Agency:
Corporate Governance
• Corporate governance refers to the rules,
processes, and laws by which companies are
operated, controlled, and regulated.
• It defines the rights and responsibilities of the
corporate participants such as the shareholders,
board of directors, officers and managers, and
other stakeholders, as well as the rules and
procedures for making corporate decisions.
1-46
Governance and Agency:
The Agency Issue
A principal-agent relationship is an arrangement
in which an agent acts on the behalf of a principal.
For example, shareholders of a company
(principals) elect management (agents) to act on
their behalf.
• Agency problems arise when managers place
personal goals ahead of the goals of shareholders.
• Agency costs arise from agency problems that are
borne by shareholders and represent a loss of
shareholder wealth.
47
Governance and Agency:
The Agency Issue
Management of the company should
consider share price movement in their
decision (not concentrate only on profit)
The management compensation system
should be related to the share price &
not to annual profits; To reduce any
conflict of interest between shareholders
& the management which is called
agency problem -48