1. Acknowledgement Ross et al, 2011, Essentials of Corporate Finance, 7th Ed, McGraw-Hill Companies, Inc..
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Topic 1
Introduction to
Financial
Management
Taylor’s University
Dual Degree Program
Introduction
to Finance
2. 1-1 1-1
1
Learning Outcomes
At the end of the lesson, students should be
able to:
• describe the basic types of financial
management decisions and the role of the
financial manager
• explain the financial implications of the
different forms of business organization
• discuss the goal of financial management
• explain the conflicts of interest that can arise
between owners and managers
3. 1-2 1-2
2
Topic Outline
• Business Finance and The Financial
Manager
• Forms of Business Organization
• The Goal of Financial Management
• The Agency Problem and Control of the
Corporation
• Financial Markets and the Corporation
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Lecture 1 - Intro 3
What is Finance?
• Financial manager
– Important role in the operations of business
– Looking after the firm’s cash flows,
– Recording of the outcomes = Accounting,
– Management of cash flows =Treasury.
• What is Finance?
– Management of money and monetary affairs.
– Financial manager must allocate the funds
available to the firm in the most productive
way
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Lecture 1 - Intro 4
Goals
• Individual
– Maximise utility of life time consumption
– Satisfaction increases with higher
consumption
• eg better car, home, travel
• You are happier
• Firm
–maximise market value
– assume increases with share price
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Lecture 1 - Intro 5
Goals of the Firm
• Maximise shareholder’s wealth
– Increased share price
– Higher dividend payments
• Note: profit maximisation is not
shareholder wealth maximisation
– May have accounting policies that generate
profits but do not provide cash
– Amortisation of expenditures
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Lecture 1 - Intro 6
A Simplified Overview of
Finance
Firms
Goal: Max
Market Value
Financial
Markets
Individuals
Goal: Max Utility of
consumption
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Lecture 1 - Intro 7
Financial System
• role of financial system -allocate savings
efficiently to ultimate users of funds.
– Provision of credit or financial capital.
• Important contribution
– role played by financial intermediaries.
• Without efficient financial markets
substantial funds would lay idle and
profitable investment opportunities would
lapse
• efficiency -reflection of quality of products
offered and cost.
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Financial Management Decisions
• Capital budgeting (Investment
Decisions)
– What long-term investments or projects
should the business take on?
• Capital structure (Financing Decisions)
– How should we pay for our assets?
– Should we use debt or equity - Choice
between debt and equity financing
• Working capital management
– How do we manage the day-to-day
finances of the firm? Current Assets vs
Current Liabilities
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Statement of Financial Position
Asset Value 100 Debt (D) 40
Equity (E) 60
Asset Value 100 Firm Value (V) 100
Market Value Balance Sheet example
Investment Decision Financing Decision
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1-10
Lecture 1 - Intro 10
A Financial Manager’s Decisions
• The Investment Decision
• Most Important
– Incorporates cash, time and risk.
– Acquiring alternative assets/projects for a
firm.
– Choose the ones that produce highest
returns after considering return required by
investors
– Composition of assets which will best
facilitate the operations of the firm.
– Determines total amount of assets held by a
firm.
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1-11
Lecture 1 - Intro 11
The Investment Decision
cont.
– Hard to reverse if wrong
• Business risk is perceived by suppliers of
capital to the firm.
• Important: availability of cash
• Timing, degree of certainty.
• Cash pays the firms expenses,
–Profits do not.
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1-12
Lecture 1 - Intro 12
The Financing Decision
• Determines the best financing mix
between
– debt (loan funds) and
– equity (funds supplied by owners of the firm).
• Trade off between cost and risks
– Difference between equity and debt
• = gearing or leverage.
• How to finance the house?
– Use your money or ??
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1-13
Lecture 1 - Intro 13
Working Capital Management
• Net working capital = Current Assets –
Current Liabilities
• Managing liquidity by managing current
assets and current liabilities
• Need cash to pay operating expenses
• Need credit to attract customers
• Need inventory to support production
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Lecture 1 - Intro 14
Primary Market
• Security or instrument issued to an
investor for the first time.
• Funds are raised by the firm and flow to it.
• Public offering or private placement.
• Can be debt or equity funding.
• Fund raising between investors and firm.
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Lecture 1 - Intro 15
Secondary Market
• Financial securities (that are already
issued) are bought and sold.
• Way of transferring ownership.
• An example of a secondary market -
– stock exchange
• Investor to investor trading.
• No additional funds are raised by the firm.
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Forms of Business
Organization
• Three major forms
– Sole proprietorship (unlimited liability)
– Partnership
• General (all partners with equal responsibilities)
• Limited (two classes of partners – general and
limited)
– Corporation
• Stockholders have limited liability
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17
Sole Proprietorship
• Advantages
– Easiest to start
– Least regulated
– Single owner keeps
all of the profits
– Taxed once as
personal income
• Disadvantages
– Limited to life of owner
– Equity capital limited to
owner’s personal
wealth
– Unlimited liability
– Difficult to sell
ownership interest
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Partnership
• Advantages
– Two or more owners,
risk is shared
– More capital available
– Relatively easy to
start
– Income taxed once as
personal income
• Disadvantages
– Unlimited liability
• General partnership
– Partnership dissolves
when one partner dies
or wishes to sell
– Difficult to transfer
ownership
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Corporation
• Advantages
– Limited liability
– Unlimited life
– Separation of
ownership and
management (refer
notes)
– Transfer of ownership
is easy
– Easier to raise capital
• Disadvantages
– Separation of
ownership and
management (agency
problem)
– Double taxation
(income taxed at the
corporate rate and
then dividends taxed
at personal rate, while
dividends paid are not
tax deductible)
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The Agency Problem
• Agency relationship
– Principal / stockholder hires an agent to
represent its interests
– Stockholders (principals) hire managers
(agents) to run the company
• Agency problem
– Conflict of interest between principal and agent
• Management goals and stockholder
interests may differ → agency costs
• “Managers may be satisfiers rather than
maximisers”
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Managing Managers
• Management only make optimal decisions if
adequately compensated
– Incentive payments
– Share options & Bonuses
• Corporate control
– The threat of a takeover may result in better
management
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Self-test Questions
• What are the three types of financial
management decisions, and what questions
are they designed to answer?
• What are the three major forms of business
organization?
• What is the goal of financial management?
• What are agency problems, and why do they
exist within a corporation?
