Unit 1

INTRODUCTION TO FINANCIAL
MANAGEMENT

- Chapter 1 & 6 (p.182-p.194 only)

What is Finance?
• Finance applies specific value to
• things we owned,
• services we used,
• decisions we made.

• Financial management
• organization’s approach to valuation of
things, services and decisions.
Economic Participants
• Type 1 Participants (no money and no
business ideas)
• Do not lend or spend in business context.
• No direct role in financial markets.
• Indirect role to provide labor and consume
products.
Economic Participants
• Type 4 Participants (have both money
and business ideas)
• Use financial tools to
• evaluate own businesses.
• choose highest-potential ideas.
• Are self-funded, so no need for financial
markets.
Economic Participants
• Types 2 and 3 Participants
• Use financial institutions and financial markets for
mutually beneficial exchange.
• Type 2 (lenders) (have money but no business ideas)
:
• makes temporary loans to Type 3 participants.
• Type 3 (borrowers) (no money but have business
ideas):
• typically consists of companies engaging in
Research & Development (R&D) etc. They need
capital or funds from Type 2 participants.
Economic Participants
• Two dimensions
• Participants with “extra” investment money.
• Participants with economically viable ideas.
Where Does the Cash / Fund Go ?
• Economically successful projects
repay money (plus profit) to investors.
• But, friction occurs when not all cash
is returned to investors.
• Retained Earnings (funds the firm keeps for its
ongoing operations)
• Taxes (funds that go to the Government)
Sub-areas of Finance
• Investments
• Involve methods and techniques for making
decisions about what kinds of securities (e.g.
stocks, bonds) to own.
Sub-areas of Finance
• Financial Management
• Decisions about acquiring and using cash.
• Examples include :
• Organizing and raising capital/funds
(Financing decisions).
• Tax decisions.
• Projects to fund (Capital Budgeting decisions
to be discussed in the future).
Sub-areas of Finance
• Financial Institutions and Markets
• Facilitate flow of capital between investors and
companies.
• International Finance
• Finance theory used in global business
environment.
• Involves foreign exchange risk and political risk.
Financial Decision Application & Theory
• Risk
• Uncertainty of future cash flows due to timing
and size.
• Financial Asset
• Ownership in cash flow represented by
securities like stocks, bonds, and other assets.
• These assets may provide regular or irregular,
constant or non-constant cash flows to the
investors.
Financial Decision Application & Theory
• Real Assets
• Physical properties like gold, machinery,
equipment, real estate.
• Real Markets
• Places / processes that facilitate trading of real
assets.
• Time Value of Money (TVM)
• Theory and application of valuing cash flows at
various points in time.
Finance vs. Accounting
• Accounting
• Tracks what happened to firm’s money in the
past (based on historical records or figures).
• Financial Management
• Combines historical figures and current
information (includes updated information or
figures).
• Determines what should happen with firm’s
money now and in the future.
The Financial Managers
• Chief Financial Officer (CFO)
• Highest level financial officer
CFO

• Controller
Controller Treasurer
• Oversees accounting function

• Treasurer
• Responsible for managing cash, credit,
financing, capital budgeting, risk management
Finance in Other Business Functions
• CFO and Treasurer
• Most visible finance-related positions in the firm.

• Finance permeates the organization

• Provide guidance to develop and manage
strategy and day-to-day business operations.
• Operations
• Marketing
• Human Resources
Finance in Your Personal Life
• Help you make good personal
financial decisions such as :
• Borrowing money for a new car.
• Refinancing home mortgage at lower rate.
• Making credit card or student loan payments.
• Saving for retirement.
Business Organizations
• Single Owners, Partners, and
Corporations operate businesses.
• Advantages and disadvantages
related to :
• Controls and ownership of firm
• Owners’ risks
• Access to capital and tax ramifications
Business Form Types
Sole Proprietorships
General Partnerships
Corporations / Companies
Private Companies
Public / Listed Companies

Hybrids
Sole Proprietorships
• Not legally separate from the owner.
• Advantages
• Easy to start.
• Light regulatory and paperwork burden.
• Single taxation at the personal tax rate.
• Disadvantages
• Unlimited liability.
• Limited access to capital.
General Partnerships
• Partners own the business together.
• Advantages
• Relatively easy to start.
• Single taxation.
• Disadvantages
• Partners jointly share unlimited liability.
• Personally liable for legal actions and debts of
firm.
• Difficult to raise large amounts of capital.
Corporations / Companies
• Legally independent entity entirely separate
from its owners.
• Advantages
• Limited liability for owners.
• Can raise large amounts of capital.
• Easy to transfer ownership (buying and selling
shares).
• Disadvantages
• Double taxation (taxable at both corporate and
personal levels).
Hybrid Organizations
• Combine attributes of several forms –
have some forms of corporations and
some forms of proprietors or
partnerships.
• Advantages
• Offer single taxation and limited liability to
most partners. Examples :
• Limited Liability Partnerships (LLPs)
Business Form Types
Firm Goals
• Owners seek to maximize their wealth and
the firm’s value through
• Maximizing present value (PV) of future cash flows.
• Maximizing owners’ equity.
• Decisions about:
• attracting additional funds (e.g. raising funds for
business expansion).
• projects in which to invest (Capital Budgeting
decisions).
• returning profits to owners over time.
Corporate / Listed Company Goals
• Maximize Value of Owners’ Equity
• Increase current value per share (stock price) of
existing shares.
• Common methods:
• Maximize net income or profit.
• Minimize costs.
• Maximize market share.
Agency Theory
• Problems arise when principal
(shareholder) hires agent (manager) to
operate firm but cannot monitor the
agent’s actions. (Principal-Agent problem)
• Manager’s interest may not be aligned
with shareholder goals.
• E.g. Managers may pursue short-term goals such as
promoting sales to increase their commission
incomes at the expense of long-term benefits to the
firm.
Agency Theory
• Three approaches to minimizing this
conflict of interest :
• Ignore if effect is minimal.
• Use accountants, debt holders to monitor
managers (can be very costly).
• Provide incentives to managers
• Equity stakes (make them owners) through :
• Direct grant of stock options
• Employee Stock Option Plan (ESOP)
Corporate Governance
• The process of monitoring managers
and aligning their incentives with
shareholder goals.
• Includes set of laws, policies,
incentives, and monitors designed to
handle issues arising from the
separation of ownership and control.
Corporate Governance
• Inside Monitors
• Board of Directors
• Hires the CEO
• Evaluates management
• Designs compensation plans
Corporate Governance
• Outside Monitors
• Auditors
• Analysts
• Banks
• Credit rating agencies (e.g. Standard & Poor’s,
Moody’s, Fitch Ratings etc.)
• Government (e.g. HKMA, SFC etc.)
• Laws (e.g. Companies, Banking, Insurance or
securities ordinances etc.)
Corporate Governance Monitors
Business Ethics
• Financial professionals manage other
people’s money or provide advices on
financial matters.
• Corporate managers
• Bankers
• Investment advisors

• Ethical dilemmas of corporate agency

relationship
• Stealing from firms = stealing from shareholders
Financial Markets
• Manage flow of funds
• Two major market dimensions
• Primary versus secondary markets
• Money versus capital markets
Primary Markets
• Used by corporations and
governments
• Used to issue new financial
instruments such as initial public
offerings (IPOs)
• Stocks
• Bonds
Primary Market Transfer of Funds
Secondary Markets
• Benefit investors and issuers
• Securities traded after issue between buyers
and sellers
• Provide liquidity and diversification benefits for
investors
• Security valuation information for issuers
Secondary Market Transfer of Funds
Money Markets vs. Capital Markets
• Money markets trade debt securities or
instruments with maturities of one year or
less e.g. US Treasury bills, Commercial
paper etc.
• Capital markets trade stocks and long-
term debt with maturities greater than one
year e.g. US Treasury notes and bonds,
local government bonds, corporate bonds
or stocks etc.
Money Market vs. Capital Market Maturities
Other Types of Markets

• Foreign Exchange Markets

• Trade currency for immediate delivery (spot) or
for some future delivery
• Subject to foreign exchange risk due to
currency fluctuations
Other Types of Markets

• Derivatives
• Highly leveraged financial securities linked to
underlying security
• Potentially high-risk
• Used for hedging and speculating
• e.g. futures, options, warrants etc.
Financial Markets and Intermediaries
• Financial intermediaries i.e. financial
institutions
• Facilitate flow of capital from investors to firms
and back to investors.
• Earn very high profits (from fees, commissions
and interests) because of their specialized
expertise and assets.
Financial Institutions
• 3 pillars of a financial centre:
• Banks
• Commercial Banks
• Thrifts i.e. depository institutions including savings associations,
savings banks, credit union etc.
• Insurance companies
• Securities firms and Assets management
companies
• Securities firms (brokers) and/or investment banks
• Mutual funds and/or Assets management companies
• Pension funds e.g. MPF
Funds Flow with Financial Institutions
Financial Institutions
• Perform vital economic functions
• Monitoring costs: lower the costs of fund suppliers to
explore investment opportunities or to locate fund
demanders
• Liquidity: provide liquidity by channeling funds from
fund suppliers (with surplus funds) to fund demanders
(shortage of funds)
• Price risk: spreading risk by pooling funds together
from individual investors for investments. By do this,
individual investors can diversify their holding risks
into appropriate portfolios
End of Lecture 1