Chapter 1

Financial
Management
 Definition of Finance:

• Finance is the art and science of managing

wealth.
– It is about making decisions regarding what
assets to buy/sell and when to buy/sell these
assets.
– Its main objective is to make individuals and
their businesses better off.

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 Definition of financial
management
• Financial management is generally defined
as those activities that create or preserve
the economic value of the assets of an
individual, small business, or corporation.
– Financial management comes down to making
sound financial decisions.

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 • Finance is a Combination of Accounting and
Economics
• Finance examines the creation and management
of wealth. It is especially concerned with the
study of raising funds, deploying funds, and
managing liquidity in order to achieve a set of
objectives for individuals and businesses
• Finance: A discipline concerned with
determining value and making decisions. The
finance function allocates resources, which
includes acquiring, investing,and managing the
resources.

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 Relationship between Finance,
Economics and Accounting
• Economics provides structure for decision
making in many important areas.
− Provides a broad picture of economic
environment.
• Accounting provides financial data in various
forms.
– Income statements, balance sheets, and
statement of cash flows.
• Finance links economic theory with the
numbers of accounting.

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 1.1 The Cycle of Money

• Financial intermediaries assist in the

movement of money, from lenders to
borrowers and back again.
– This process is termed the cycle of money and its
main objective is to make all the participants
better off

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 Figure 1.1 The money cycle

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 Example 1: The Money Cycle

• Example: A mutual fund issues shares which are

bought by individuals
• The pooled funds are invested by the mutual fund
company in shares that are issued by firms
• The firms pay dividends periodically which are
received by the mutual fund and passed through to
their shareholders, or reinvested in additional
shares and the cycle of money starts again.
– The mutual fund managers earn fees;
– the firms whose securities are bought are able to raise
capital for growth and future returns; and
– the mutual fund shareholders earn dividends and capital
gains.
• Thus, all participants are generally better off.

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 1.2 Overview of Finance Areas

4 main interconnected and interrelated areas:

1. Corporate Finance
2. Investments
3. Financial Institutions and Markets
4. International Finance

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 1.3 The Finance Manager and
Financial Management

Finance manager
– Has to determine the best repayment structure for
borrowed funds
– Makes sure that debt obligations are met on time
– Ensures that sufficient funds are available for carrying out
daily operations.

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Role of The Financial Manager
borrow
(2) (1)

Firm's Financial Financial

(4a)
operations manager markets

(3) (4b)

(1) Cash raised from investors

(2) Cash invested in firm
(3) Cash generated by operations
(4a) Cash reinvested
(4b) Cash returned to investors
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 Functions of the Financial
Manager

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 1.4 The Finance Manager and
Financial Management (continued)
Financial management involves 3 main
functions:
• Capital Budgeting
• Capital Structure
• Working Capital Management

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 1.5 Objective of the Finance
Manager
To make investment and financing decisions
that increase the cash flow of the firm,
thereby maximizing the current stock price

Profit maximization vs. Stock price

maximization
Why are they not the same?
Which one is more important?

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 1.6 Financial Markets

• Forums where buyers and sellers of financial assets

and commodities meet.
• Financial markets can be classified by:
– Type of asset traded
– Maturity of the financial asset
• money market
• capital market

– Owner of the financial asset

• primary market
• secondary market

– Nature of transaction
• dealer markets
• auction markets

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 The Role of Financial Markets

• Financial markets are indicators of

maximization of shareholder value and the
ethical or the unethical behavior that may
influence the value of the company.
• Participants in the financial market range
over the public, private and government
institutions.
– Public financial markets
– Corporate financial markets

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 Stocks versus Bonds

• Stock = ownership or equity

− Stockholders own the company

• Bond = debt or IOU

− Bondholders are owed $ by company

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 Stocks vs. Bonds
Bond: A financial contract that typically has a stated maturity and
periodic interest payments.

Common Stock: An equity security representing the ownership interest

in a corporation.

Preferred Stock: An equity security with an intermediate claim

( between the bondholders and the stockholders) on a firm’s assets
and earnings.

Stock = ownership or equity

Stockholders own the company
Bond = debt or IOU
Bondholders are owed $ by company

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 The Financial Manager’s
Responsibilities
• Obtain and use funds in a way that will
maximize the value of the firm
– Forecasting and planning
– Major investment and financing decisions
– Coordination and control
– Dealing with financial markets

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 Goals of Financial Management

• Valuation Approach
• Maximizing shareholder wealth (shareholder
wealth maximization)
• Management and stockholder wealth

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 Social Responsibility

• Adoption of policies that maximize values in

the market attracts capital, provides
employment and offers benefits to the
society.
• Certain cost-increasing activities may have
to be mandatory rather than voluntary
initially, to ensure burden falls equally over
all business firms.

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 Ethical Behavior

• Ethical behavior creates invaluable

reputation.
• Insider trading
• Protected against by the Securities and
Exchange Commission (SEC).

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 1.7 Internal and External Players

• Financial managers have to interact with

various internal and external stakeholders
– Internal players include all the departmental
managers and other employees
– External parties include:
• Customers
• Suppliers
• Government
• Creditors

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 Figure 1.2 A Basic Organizational
Chart for a Company

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 1.8 The Legal Forms of Business

• There are three main legal categories of

business organizations:
1. Sole proprietorship
2. Partnership
3. Corporation

• Besides these 3 main forms some other

forms of business organizations include:
Hybrid Corporations
Not-for-Profit Corporations

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 1.8 The Legal Forms of Business
(continued)
Sole Proprietorship
•Advantages
1. Simplest and easiest form of business.
2. Least amount of legal documentation.
3. Least regulated.
4. Owner keeps all profits

•Disadvantages
1. Owner pays personal tax rate on profits
2. Obligations of the business are sole responsibility of owner, and
personal assets may be necessary to pay obligations (personal and
business assets are commingled).
3. Business entity limited to life of owner.
4. Can have limited access to outside funding for the business.

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 1.8 The Legal Forms of Business
(continued)
Partnership
• Advantages
1. Agreements between partners may be easily formed
2. Involves more individuals as owners and therefore usually
more expertise
3. Larger amount of capital usually available to the business
(compared to proprietorship)
• Disadvantages
1. Assets of general partners are commingled with assets of
the business
2. Profits treated as personal income for tax purposes
3. Difficult to transfer ownership

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 1.8 The Legal Forms of Business
(continued)

Corporation
• Advantages
1. Business is legal, separate entity from owners
2. Owners have limited liability to obligations of the
business
3. Easy to transfer ownership
4. Usually greater access to capital for business
5. Owners do not have any personal liability for default
• Disadvantages
1. Most difficult business operation to form
2. Double taxation of company profits
3. Most regulated.

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 1.9 The Financial Management
Setting: The Agency Model
• Agency relationship
• Agency conflict
– Why does it arise?
– How can it be minimized?
• Principal-agent problem
• Agency theory
• Agency costs

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 Corporate Governance

• Agency theory
– Examines the relationship between the owners
and managers of the firm.
• Institutional investors
– Have more to say about the way publicly owned
companies are managed.

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 Corporate governance

• Corporate governance is the process and

structure used to direct and manage the
business and affairs of the company towards
enhancing business prosperity and corporate
accountability with the ultimate objective of
realizing long term shareholder value, whilst
taking into account the interests of other
stakeholders.
•

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 1.9 Corporate Governance and
Business Ethics
• Corporate governance deals with….
– how a company conducts its business and implements
controls to ensure proper procedures and ethical behavior.
• The Sarbanes-Oxley Act, enacted in 2002, requires
that
– The CEO and CFO attest to the fairness of the financial
reports.
– The company maintains an effective internal control
structure around financial reporting.
– The company and its auditors assess the effectiveness of
the controls over the most recent fiscal year.

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 1.10 Why Study Finance?

• Understand how and why financial decisions are

made in large and small companies.
• Helps individuals increase their own compensations,
• Improves contributions to the success of the
companies that people work for.
• Understand the tradeoffs we face in making
personal financial choices and help us to select the
most appropriate action.

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