CHAPTER 1

An Overview of Financial
Management
 Meaning of Finance and Financial
Management
 Corporate Finance and its scope
 Relation between Finance and other
fields of study
 Goals of the Corporation
 Forms of Businesses
 Agency Relationships
 Career Opportunities
 Issues of the New Millennium 1-1
 Finance and Financial
Management
 What is Financial management?
 Financial Management is the management of financial
activities of all sort (individuals, firms of any kind,
public)
 What is Finance?
 Finance is a field that is concerned with the
allocation (investment) of assets/liabilities, the
sources of the resources, and management of its
other financial activities. Finance can be defined
as the art of money management.
 Finance can be classified in to three categories
 Personal Finance
 Public Finance
 Corporate Finance (differs from managerial finance
because corporate finance is about big public
corporations having share equities publicly traded;1-2
 Corporate Finance and its Scope
 Corporate Finance (according to Ross, westerfield and Jordan)
is the study of ways to answer the following three questions:
What investments should a firm take on? Where will the firm
get the finance to pay for investments it decided to take on?
How will the firm manage its daily financial activities?
 Investing Decision
 Is deploying resources on long term assets
 The decision involves analysis of the return (the expected
profitability) and the underlying uncertainty (risk)
 The required return can be in the form of regular income or capital
gain
 Investors have their required return from their investment which is
considered a cut-off (mainly the opportunity cost of the fund)
 Financing Decision
 Is determining the source of fund and its timing (for the investment)
 It commonly refers to making proper mix between the two basic
financing sources, Debt and Equity, and this is called capital structure
decision.
 Also involves decision of how much internal financing to use 1-3 , and
intern decision on dividend policy
 Corporate Finance and its Scope…
 Working capital Management
 Is management of firm’s short-tem assets and short term liabilities
 It is about management of day-to-day activities to ensure
uninterrupted smooth operations.
 It involves management of cash, debtors (receivables), inventory,
amount owed to suppliers (A/Payables)
 Whether to borrow in short tem or long term?
 Whether to extend credit sales or not?
 Whether to order inventory or not?

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 Relation to Other Fields
 Corporate Finance (Financial management of a firm in general)
is an integral to the firm’s management function
 It is related to:
 Economics ( FM needs analysis of issues of demand and
supply, understanding of economic policies, theories of
profit maximization, pricing theories, marginal-cost
benefit analysis)
 Accounting ( FM needs financial information of
accounting for analysis and decision making purposes.
But two basic differences: Corporate finance relies on
cash-flow not accrual and corporate finance specialists
(CFOs) decision making while accountants emphasize on
information provision)
 Marketing: Promotion, Branding, new product
development have to do with Financial manager’s
function of cashflow projection and capital
invesment/fianacing decisions)
 Mathematics and statistics: many financial decisions
involve mathematical models and statistical analysis 1-5
 Goals of Financial Management
 In corporate Finance the goal of financial managers is
adding value to the owners or enhancing shareholders’
wealth.
 What is adding value/Wealth to the owners? Is it survival
by enhancing revenue or market share? Is it avoiding
financial distress and bankruptcy through cost
minimization? Is it beating the competition through profit
maximization?
 Maximizing profit is not maximization of shareholders’
wealth. Because it fails in three parameters: doesn't show
timing (may resulted at the expense of the future like
cutting R &D cost), doesn't show risk, and doesn't show
cash available to shareholders.
 Shareholder wealth maximization is, therefore, translated
maximizing stock price.
 In a way of achieving the firm’s objective of maximizing
wealth of shareholders, Financial managers should act in a
socially responsible way. Acting Ethically and responsibly
will make the wealth maximization objective sustainable.
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Is stock price maximization
the same as profit
maximization?
 No, despite a generally high
correlation amongst stock price, EPS,
and cash flow.
 Current stock price relies upon
current earnings, as well as future
earnings and cash flow.
 Some actions may cause an increase
in earnings, yet cause the stock price
to decrease (and vice versa).
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Factors that affect stock
price
 Projected cash
flows to
shareholders
 Timing of the
cash flow stream
 Riskiness of the
cash flows

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 Basic Valuation Model
CF1 CF2 CFn
Value 1
 2
 
(1  k) (1  k) (1  k)n
n
CFt
 t
.
t 1 (1  k)

 To estimate an asset’s value, one estimates the

cash flow for each period t (CFt), the life of the
asset (n), and the appropriate discount rate (k)
 Throughout the course, we discuss how to
estimate the inputs and how financial
management is used to improve them and thus
maximize a firm’s value.
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Factors that Affect the
Level and Riskiness of
Cash Flows
 Decisions made by financial
managers:
 Investment decisions
 Financing decisions (the relative use
of debt financing)
 Dividend policy decisions
 The external environment

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 Agency relationships
 An agency relationship exists whenever a
principal hires an agent to act on its behalf.
 Within a corporation, agency relationships
exist between:

Shareholders and managers

Shareholders and creditors
 Agency Problem arises when the agent does
not act in the best interest of the principal.
 Avoiding or minimizing agency problem
has a cost ( lost profit i.e. opportunity
cost, audit fee, high incentive etc)
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 Shareholders versus Managers
 Managers are naturally inclined to act in their own
best interests (leisure, chauffeured car, going to risky
investment, less time to work cause of opportunity
cost, lack of ownership filling etc) which are against
shareholders interest of wealth maximization.
 But the following factors affect managerial behavior so
should be used to tackle the agency problem :
 Managerial compensation plans ( good annual

salary, bonus on profit, stock options or actual

shares)
 Direct intervention by shareholders ( by making voted

decisions at GA by raising proposals dictating the firm’s

direction)
 The threat of firing ( by using lobbyists shareholders can
vote to fire)
 The threat of takeover ( hostile takeover is most likely to
occur when a firms share is undervalued because of poor
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management performance)
 Shareholders versus
Creditors
 Shareholders (through managers) could take actions
to maximize stock price that are detrimental to
creditors (the shareholders decision may be against
debt covenants: changing capital structure, going to
risky investment projects, disposing crown jewels
etc)affect the capital structure already agreed up on.
 Creditors minimize this problems by: setting very
restrictive covenants or/and charging high required
return for firm manager assessed for the agency
problem
 Note that in the long run, such actions will raise the
cost of debt and ultimately lower stock price. 1-13
 Role of Finance in a Typical
Business Organization
Board of Directors

President

VP: Sales VP: Finance VP: Operations

Treasurer Controller

Credit Manager Cost Accounting

Inventory Manager Financial Accounting

Capital Budgeting Director Tax Department

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Responsibility of the Financial Staff
 Maximize stock value by:
 Forecasting and planning: by interacting with others
set the firm’s future
 Investment and financing decisions: finance people
should help in deciding optimal sales growth, viable
investment, proper means of financing the investments
 Coordination and control: interact with others in
promoting financial efficiency and operational
efficiency so that the firm can achieve its objectives. In
doing so they should work with marketing, production
and others
 Transactions in the financial markets: shall engage and
be active on the financial markets and transactions
thereon
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
Career Opportunities in
Finance
 Money and capital markets
 Investments
 Financial management

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Financial Management
Issues of the New
Millennium
 The effect of
changing
technology
 The
globalization of
business

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Percentage of Revenue and Net
Income from Overseas Operations
for 10 Well-Known Corporations,
2001
Company % of Revenue % of Net Income
from overseas from overseas
Coca-Cola 60.8 35.9
Exxon Mobil 69.4 60.2
General Electric 32.6 25.2
General Motors 26.1 60.6
IBM 57.9 48.4
JP Morgan Chase & 35.5 51.7
Co.
McDonald’s 63.1 61.7
Merck 18.3 58.1
3M 52.9 47.0
Sears, Roebuck 10.5 7.8 1-18
ANNEX

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Alternative Forms of
Business Organization
 Sole proprietorship
 Partnership
 Corporation

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Sole proprietorships &
Partnerships
 Advantages
 Ease of formation
 Subject to few regulations
 No corporate income taxes
 Disadvantages
 Difficult to raise capital
 Unlimited liability
 Limited life

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Corporation
 Advantages
 Unlimited life
 Easy transfer of ownership
 Limited liability
 Ease of raising capital
 Disadvantages
 Double taxation
 Cost of set-up and report filing

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