Chapter 1

An Overview of
Financial Management
To Thi Thanh Truc
Faculty of Finance and Banking
University of Economics and Law

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 Learning outcomes
After finishing this chapter you should be able to:
 Explain the basic types of financial management decisions
and the role of the financial manager.
 Explain the goal of financial management.

 Explain the determinants of stock price

 Identify the conflicts of interest that can arise between

owners and managers, and discuss the techniques that
firms can use to mitigate these potential conflicts.
 Identify the advantages and disadvantages of different

forms of business organization.

 Discuss the importance of business ethics and the

consequences of unethical behavior.

Concept of Corporate finance,
Financial Management

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 What is Financial Management?
(Houston & Brigham)

Financial management (corporate finance)

focuses on decisions relating to how much
and what types of assets to acquire, how
to raise the capital needed to purchase
assets, and how to run the firm so as to
maximize its value.

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What is Financial Management?
(James C. Van Horne)

Concerns the acquisition,

financing, and management of
assets with some overall goal
in mind.

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 Investment Decisions
Most important of the three
decisions.
 What is the optimal firm size?
 What specific assets should be
acquired?
 What assets (if any) should be reduced
or eliminated?

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 Financing Decisions
Determine how the assets will be
financed

 What is the best type of financing?

 What is the best financing mix?
 What is the best dividend policy?
 How will the funds be physically acquired?

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 Asset Management
Decisions
 How do we manage existing assets
efficiently?
 Financial Manager has varying
degrees of operating responsibility
over assets.
 Greater emphasis on current asset
management than fixed asset
management.
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Corporate Finance
(Stephen A. Ross)
Some important questions that are
answered using finance
 What long-term investments should the
firm take on?
 Where will we get the long-term financing
to pay for the investment?
 How will we manage the everyday financial
activities of the firm?

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Financial Management
Decisions
 Capital budgeting
 What long-term investments or projects
should the business take on?
 Capital structure
 How should we pay for our assets?
 Should we use debt or equity?
 Working capital management
 How do we manage the day-to-day
finances of the firm?
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 Investment Decision (Capital
Budgeting)

 The process of planning and

management of long-term investments
of the company.
 Financial managements identify
investment opportunities that are worth
more to the firm than they cost to
acquire.

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Three important questions that
managers should be concerned.

 How much cash they expect to

receive?
 When they expect to receive it?
 How likely they are to receive it?

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 Financing Decision (Capital
Structure)
 Ways in which the firm obtains and manages
the long-term financing it needs to support its
long term investments?

 A firm’s capital structure is the specific

mixture of long-term debt and equity the
firm uses to finance its operations.

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Important questions
 How much should the firm borrow?
That is, what mixture of debt and
equity is best?
 What are the least expensive sources
of funds for the firm?
 How and where to raise the money?

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 Working Capital Management
 The term working capital refers to a firm’s
short-term assets, such as inventory, and its
short-term liabilities.
 Managing the firm’s working capital is a day-
to-day activity that ensures that the firm has
sufficient resources to continue its operations
and avoid costly interruptions.

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 Some questions about working
capital that must be answered
 (1) How much cash and inventory should we
keep on hand?
 (2) Should we sell on credit? If so, what terms
will we offer, and to whom will we extend them?
 (3) How will we obtain any needed short-term
financing? Will we purchase on credit, or will we
borrow in the short term and pay cash? If we
borrow in the short term, how and where should
we do it?

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Financial Manager
 Financial managers try to answer some or all of
these questions
 The top financial manager within a firm is usually
the Chief Financial Officer (CFO)
 Treasurer – oversees cash management,

credit management, capital expenditures, and

financial planning
 Controller – oversees taxes, cost accounting,

financial accounting and data processing

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 Typical Corporate Organizational
Structure

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 Organization of the Financial
Management Function

VP of Finance (CFO)
Treasurer Controller
Capital Budgeting Cost Accounting
Cash Management Cost Management
Credit Management Data Processing
Dividend Disbursement General Ledger
Fin Analysis/Planning Government Reporting
Pension Management Internal Control
Insurance/Risk Mngmt Preparing Fin Stmts
Tax Analysis/Planning Preparing Budgets
Preparing Forecasts
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Firm and Financial Market
The Market The Firm
Capital Structure Capital Budgeting

Dividends
Stockholders Cash flow

Equity
Financial
Projects
Debt Manager

Bondholders Investments
Interest

Corporate
Personal Taxes
Taxes

Government
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 Firm and Financial Market
The Market The Firm
Capital Structure Capital Budgeting

Dividends
Stockholders Cash flow

Equity
Financial
Projects
Debt Manager

Bondholders Investments
Interest

Corporate Ethical Ethical

Taxes Cooperation vs. Pressures
Personal Social Costs
Taxes
Government Society
Politics

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Goal of Financial Management

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Goal Of Financial Management
 What should be the goal of a corporation?
 Maximize profit?
 Minimize costs?
 Maximize market share?
 Maximize the current value of the company’s
stock?
 Does this mean we should do anything
and everything to maximize owner wealth?

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Goal Of Financial Management
Maximization of Owner Wealth!

Value creation occurs when we

maximize the share price for
current shareholders.

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 Shortcomings of Alternative
Perspectives

Profit Maximization
 Maximizing a firm’s earnings after taxes.
Problems
 Could increase current profits while harming
firm (e.g., defer maintenance, issue common
stock to buy T-bills, etc.).
 Ignores changes in the risk level of the firm.

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 Shortcomings of Alternative
Perspectives

Earnings per Share Maximization

 Maximizing earnings after taxes divided by
shares outstanding.
Problems
 Does not specify timing or duration of expected
returns.
 Ignores changes in the risk level of the firm.
 Calls for a zero payout dividend policy.
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 Strengths of Shareholder
Wealth Maximization

 Takes account of: current and future profits

and EPS; the timing, duration, and risk of
profits and EPS; dividend policy; and all
other relevant factors.
 Thus, share price serves as a barometer for
business performance.

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Framework for Financial
Management

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Determinants of a Firm’s Value

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Determinants of Stock Price
 Projected cash
flows to
shareholders
 Timing of the
cash flow stream
 Riskiness of the
cash flows

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 Risk – Return Tradeoff
 The greater of risk a firm has, the lower its
stock price will be.
 The more profitable a firm is, the higher its
stock price will be.
 Greater the rate of return pursued by the
company, the more risk to which it exposes
itself.
 In order to maximize the firm’s value,
managers should orient activities toward the
optimal balance between risk and return.
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Intrinsic Value versus Market Value

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Intrinsic Value versus Market Value

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 Stock Prices and Intrinsic Value
 In equilibrium, a stock’s price should equal its
“true” or intrinsic value.
 To the extent that investor perceptions are
incorrect, a stock’s price in the short run may
deviate from its intrinsic value.
 Ideally, managers should avoid actions that
reduce intrinsic value, even if those decisions
increase the stock price in the short run.

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Agency Problem

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The Modern Corporation

Modern Corporation

Shareholders Management

There exists a SEPARATION between

owners and managers.
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Agency Problem

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 Role of Management

Management acts as an agent for

the owners (shareholders) of the
firm.
 An agent is an individual authorized
by another person, called the
principal, to act in the latter’s behalf.

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The Agency Problem
 Agency relationship
 Principal hires an agent to represent his/her
interests
 Stockholders (principals) hire managers
(agents) to run the company
 Agency problem
 Conflict of interest between principal and
agent
 Management goals and agency costs
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Conflicts Between Managers and
Stockholders
 Managers are naturally inclined to act in their
own best interests (which are not always the
same as the interest of stockholders).
 But the following factors affect managerial
behavior:
 Managerial compensation plans
 Direct intervention by shareholders
 The threat of firing
 The threat of takeover

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Managing Managers
 Managerial compensation
 Incentives can be used to align management
and stockholder interests
 The incentives need to be structured
carefully to make sure that they achieve
their goal
 Corporate control
 The threat of a takeover may result in better
management
 Other stakeholders
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Forms of Business
Organization

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 Forms of Business Organization

 Sole Proprietorship

 Partnership

 Limited Liability company

 Corporation

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 Sole Proprietorship
 Advantages  Disadvantages
 Limited to life of
 Easiest to start
owner
 Least regulated
 Equity capital limited
 Single owner keeps to owner’s personal
all the profits wealth
 Taxed once on the  Unlimited liability
business income
 Difficult to sell
(Vietnamese
ownership interest
regulation)

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 Partnership
 Advantages  Disadvantages
 Two or more owners  Unlimited liability

 More capital available  General partnership

 Relatively easy to start  Limited partnership

 Partnership dissolves

when one partner dies

or wishes to sell
 Difficult to transfer

ownership
 Double Income taxation

(Vietnamese regulation)

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Limited Liability Company (LLC)

• The owners’ Liability: Limited

liability
• Tax: double taxation
• Capital access: be able to issue
bonds to raise capital.

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 Corporation
 Advantages  Disadvantages
 Limited liability  Separation of
 Unlimited life ownership and
 Separation of management
ownership and  Double taxation
management (income taxed at the
 Transfer of corporate rate and
ownership is easy then dividends taxed
at the personal rate)
 Easier to raise capital

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