CHAPTER 1

INTRODUCTION TO CORPORATE
FINANCIAL MANAGEMENT
LECTURER: PROF O.A ONI
Chapter outline
• Introduction
• What is corporate finance?
• The goals of financial management
• The corporate forms of business
• The agency problem
• Financial markets and institutions
• Corporate governance and ethics
• Conclusion
Learning outcomes
By the end of this chapter you should be able to:
• Explain the role of corporate financial management and
the role and responsibilities of the financial manager
• Review the types of corporate financial management
decisions and identify the main goal of financial
management
• Describe the different corporate forms of business
• Describe the agency problem and agency cost
• Understand the functions of financial markets and
institutions and the role of corporate governance and
business ethics
Introduction
• Both big and small businesses are guided by
the same corporate financial principles
• Bigger businesses are run by managers
• These managers are selected by the
shareholders (owners of the business)
• It is important to increase the wealth of the
shareholders
The role of corporate financial
management
• The process of creating value in a business by
making the best decisions
• Ultimate measure – to increase the wealth of
the shareholders
• Financial management ≠ Accounting
• Accounting: a historical perspective (report)
• Financial managers: use information from
accountants to make decisions
Position of the financial manager
in the corporate structure
The Financial Manager
Responsible for:
• Managing the business’s cash and credit
• Financial planning
• Corporate expenditure
• Record-keeping
Corporate financial management
decisions
3 basic decisions:
• What should the business invest in?
CAPITAL-BUDGETING DECISION
• Where will the business get long-term
financing to pay for the new investment?
CAPITAL-STRUCTURE DECISION
• How will the business manage its day-to-day
financial activities?
WORKING-CAPITAL MANAGEMENT DECISION
Capital budgeting
• Financial manager should aim to create value
• Will do that by identifying investments that will
create value
• Determine cash flows
 Size – how much initial investment is needed and
how much income will be received
 Timing – when and for how long income will be
received
 Risk – the likelihood of receiving the income
• Will income from investment exceed the cost?
Capital structure
• The mix of debt and equity a company uses to
fund new investments/projects
• Three choices available:
 Borrow long-term funds (debt) – risk increase
 Use savings of the company (retained earnings)
 Issue more shares (equity) – ownership declines
• Whichever option will have an effect (risk and
value)
• Which form of financing is the cheapest?
Working-capital management
• Working capital = short-term assets and liabilities
• How will you approach the day-to-day financial
management?
 Will you sell new product for cash, credit or both?
 Who will receive credit and who won’t?
 How many days until debtors have to pay?
 Will you pay expenses in cash or on credit?
• All these decisions are important to ensure
business functions efficiently
• There must be sufficient resources for adequate
liquidity
Three financial management
decisions
The goals of financial
management
• Most people believe main goal is maximising profit:
 Increasing sales
 Increasing market share
 Minimising costs
 Increasing growth in profits
 Avoiding insolvency
 Surviving
• BUT focusing on profitability ignores risk
• Higher risk should correspond with higher return
• Need more basic goal – shareholders’ wealth
maximisation
Shareholders’ wealth maximisation
• Number one goal = increase the wealth of the
shareholders
• How can that be done?
 Shareholders can receive dividends
 Increase in the share price
• If a financial manager focuses on shareholders’ wealth
maximisation, then both risk and return are taken into
account
• Profit maximisation: short-term goal not looking at long-
term effects
• Share price maximisation: short-term and long-term
• Every decision in the best interest of the shareholders
The corporate forms of business
• Sole proprietorship
• Partnership
• Companies
 Private companies
 Public companies
• Close corporations
Sole proprietorship
• A single person has the controlling interest
(one-person business)
• Success/failure is entirely in the hand of one
person
• Main characteristics:
 Easy entry into the market
 Lifespan of business = owner’s lifespan
 Owner is generally also the manager (shareholders’
wealth maximisation)
 Business not a separate legal entity from owner
Partnership
• Private agreement between partners (max 20)
• All contribute to business with skills and equity
• Partners can raise more capital and have
greater creditworthiness
• Main characteristics:
 Easy entry into the market
 Lifespan of the business is limited
 Business not a separate legal entity from partners
 Profits and debts are the liability of the partners in
proportion to their contribution to capital
Companies
• Separate legal entity from the owners
• Owners (shareholders) have limited liability
• Company must comply with legislation
• Two kinds of companies:
 Private companies
 Public companies
PRIVATE COMPANIES PUBLIC COMPANIES
Must have between 1 and Minimum of 7 (unlimited
50 shareholders number of shareholders)
At least one director At least two directors
Transferability of shares is Transferability of shares
restricted. No offer can be not restricted. Public are
made to the public to buy. invited to purchase and
sell shares at any time
Financial statements only Financial statements are
available to the directors available to the public
and shareholders
Proprietary Limited - (Pty) Limited (Ltd) after the
Ltd after the name of the name of the company
company
Companies
• Main characteristics:
 Complicated entry into the market
 Lifespan of the company is unlimited
 Company is a separate legal entity from the owners
 Unlimited access to capital
 Separation of ownership and management
Close corporations
• Same advantages of a company, but simpler
and less expensive
• Between 1 - 10 members (not shareholders)
• Member’s interest (not shares) – percentage
share in the business
• Main characteristics:
 Less complicated market entry than a company
 A separate legal entity and limited liability to
members
 Transfer of interest uncomplicated and simple
The agency problem
• Goal of financial management: increase shareholders’
wealth
• Sole proprietorship = easy; owners are generally also
the managers of the business
• Big companies = difficult; owners/shareholders not
directly involved in business
• The shareholders (principals) appoint managers
(agents) to look after their interest
• Agency relationship: the relationship between the
principal and the agent
• Agency problem: when the agent does not make
decisions in the best interest of the principal
Agency costs
• Management and shareholders goals can differ
• Agency cost: Any costs (both direct and
indirect) that can arise due to the agency
problem
• Direct agency cost: measurable amount
• Indirect agency cost: not physical, lost
opportunity
• Control agency cost:
 Incentive plans
 Performance plans
Financial markets and institutions
Financial market: place where anyone with funds can
transact with anyone in need of funds
• Money Market: short-term debt securities (no physical location)
• Capital Market: long-term debt securities (stock and bond
exchanges)
 Primary market: sell securities for the first time
 Secondary market: securities traded after being sold in the
primary market
 Auction market: broker brings buyer and seller together
(NYSE)
 Dealer market: traders offer to buy or sell securities (JSE)
Financial institutions: bring savers and lenders together to
efficiently allocate funds (financial intermediary)
Flow of funds
Corporate governance
• Laws, policies, processes and organisations that
influence business and the business environment
• Ensures that needs of shareholders & stakeholders are
served
• Main role players: shareholders, board of directors,
management
• Other stakeholders: employees , creditors, customers,
community
• Accepted principles of corporate governance:
 Rights & equitable treatment of shareholders
 Interests of other stakeholders
 Role & responsibility of the board
 Integrity & ethical behaviour
 Disclosure & transparency
• King III Report
Business ethics
• Moral principles and values applied in a business
setting
• Ethical companies conduct themselves by
distinguishing between right and wrong
• Unethical behaviour: creative accounting, insider
trading, gender, race & religious discrimination, price
fixing
• Certain behaviour might be legal, but still unethical
• For example: child labour might be legal in certain
countries, but is it ethical to buy products from
companies using children as cheap labour?
Conclusion
• Corporate financial management is the process of
creating value in a business.

• The financial manager needs to make the following

three decisions to create value:
 What should a business invest in?
 Where will the business get the long-term financing to fund the
investment?
 How will the business manage its day-to-day financial
activities?

• The most important financial management goal is to

increase the wealth of the shareholders by increasing
the current share price.
Conclusion (cont.)

• The four forms of a business organisation are:

 Sole proprietorship
 Partnership
 Company
 Close corporation

• Shareholders are the owners of a business and they

appoint managers to act as their agents. If the
managers do not act in the shareholders’ best interests,
the business is faced with the problem of agency.
Conclusion (cont.)
• Financial markets act as a platform to bring together
buyers and sellers of securities. There are two forms of
financial markets, namely money and capital markets.
Capital markets are also divided into primary and
secondary markets.

• Financial institutions act as intermediaries to bring

together suppliers of funds (savers) and demanders of
funds (borrowers).

• Corporate governance and ethics are necessary to

manage a business in a moral and lawful manner.