CHAPTER 1(FIN 242)

Introduction of Financial Management

 Financial markets and business

organization
 Goals of the firm
 Functions of the financial
manager
 Risks and return relationship
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What is Finance?
 Is an art and science of management of money and
other asset.
 To obtained and allocated financial resources
effectively and efficiently
 Deal with financial decision (e.g. new product, new
asset, borrowing, issue stocks & debts)

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Financial Market
Capital Market
 Deals with transaction of long term securities( more than 1-year)
 Equity and Debt (i.e. corporate and govt ) instruments traded
in capital market
 Eg; bonds, common stock

Money Market
 Market short-term debt instruments (i.e. less than 1-year)
 Issued by firms, & govt
 Low risk and liquid
 Instruments such as commercial paper, NCDs, etc (also known
as Marketable Securities)
 Forms of Organization

 Sole proprietorship
 Partnership
 Corporation

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 Forms of Organization (cont..)

Sole Proprietorship
“A business owned by single individual”
 Advantages:
 Ease of formation
 Belongs to only one person
 Manager and owner is the same person
 Disadvantages:
 Limited life
 Unlimited liability
 Difficult to raise capital

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 Forms of Organization (cont..)
Partnership
“An association of two or more individuals joined as
co-owners of business for profit”
 Advantages
 Belongs by more one person
 Share liabilities (i.e. bound by partnership agreement)
 Disadvantages:
 If one partner died, other partner will held responsible to the business
liabilities and profit

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 Forms of Organization (cont..)
Corporation
“An entity that legally functions separate from its
owner”
 Advantages:
 Ease of transfer of ownership
 Shareholders are co-owner
 Limited liability
 Ease of raising capital
 Disadvantages:
 Double taxation
 Cost of set-up and report filing

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 Goals of the Corporation

 Profit Maximization
To obtain Profit as much as possible
Reasons:
 Maintain its operating stability
 Maintain growth
 Reward to stakeholders (i.e. contributors of idea,
capital,bonus etc)
 Maximization of Shareholder Value
The primary goal is shareholder wealth maximization, which
translates to maximizing stock price.
Higher share price will lead to higher profit to the shareholder 8
 Goals of the Corporation (cont..)

 Benefits to society (i.e. social

responsibilities)
 Efficient and low cost operations (i.e. low price)
 New product development (i.e. consumer choice)
 Provide efficient service

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The Financial Management Function
 Planning
 Involves the development, refinement & evaluations of the firm
goals & strategies
 Deciding what the firm is aiming to do, how it proposes to do it,
when to do it
 Forecast the outcomes of the strategies implemented
 Controlling
 Analysis of causes and responsibilities
 Reinforce current performance that conforms to the original
plans
 Modify & develop new strategies for future use
 The Financial Management
Function (cont..)
 Investment Decisions
 Determining the appropriate mix in the asset portfolio
 Determining the appropriate RM to be invested in current assets
versus fixed assets
 Determining the optimal level of investment
 Recommending the best fixed asset to acquire and when to replace
the existing assets

 Financing Decisions
 Determining the appropriate mix of short term and long term source
of financing
 Choosing the appropriate source of funds for investment in asset
portfolio
 Determining the appropriate dividend policy
 Risk and Return Relationship

Returns
 Payoff from an investment
 Investment returns measure the financial results
of an investment (i.e. ROI).
 Returns can be expressed in:
 Dollar terms
 Percentage terms

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Risk and Return Relationship (cont..)

Risk
 Is the chances that real outcome not in line with
expectation
 Investment risk pertains to the probability of
earning a return less than that expected.
 The greater the chance of a return far below the
expected return, the greater the risk.

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Risk and Return Relationship (cont..)
 Risk and return trade – offs play a major role in influencing
the investment decision made.
 The basic rule states that; higher risk associates with higher
returns and vice versa
 Risk is unavoidable, thus, the key strategy is seek
investment opportunities that offer the highest return with the
least risk

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 Risk and Return Relationship
(cont..)
Systematic Risk (i.e. Market risk)
Risk that is unavoidable and cannot be
eliminated by diversification (e.g. inflation,
interest rate, political havoc,etc)
Unsystematic Risk (i.e. Firm specific risk)
Risk that can be eliminated by diversification
and proper management (e.g. new
competition, high cost of operations,etc)
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 Risk and Return Relationship
(cont..)
Common
Risk Stocks
SML
Fixed Bond
deposit

Risk Free Asset

Return 16
How To Manage Risk
Diversification
 Diversification means reducing risk by investing in a
variety of assets 
 Can reduce unsystematic risk to some extend, dependent
upon the correlation coefficient that exists between the
securities held in the portfolio (i.e. stocks, corporate
bonds, government bonds)
 Correlation coefficient describes how much linear co –
movement exists between two random variables or
between two securities.

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 The possible correlation is:
1. Positive correlation;
 The securities involved has a direct relationship; an increase
risk in one security, tend to increase risk in another
2. Negative correlation;
 The securities involved has an inverse relationship; an
increase risk in one security, tends to reduce risk in another
3. Zero correlation;
 The securities involved has no relationships with one another
The END

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