TOPIC 1

An Overview of Financial
Management
 Learning Goals
1. Define finance, its major areas and
opportunities available in this field, and the legal
forms of business organization.
2. Describe the managerial finance function and
its relationship to economics and accounting.
3. Identify the primary activities of the financial
manager.
4. Explain the goal of the firm, corporate
governance, and the agency theory.
What is Finance
 Finance can be defined as the art and science
of managing money.

 Finance is concerned with the process,

institutions, markets, and instruments involved
in the transfer of money among individuals,
businesses, and governments.
What is Finance
 At the personal level, finance is concerned with
individuals’ decisions about how much of their
earnings they spend, how much they save, and
how they invest their savings.

 In a business context, finance involves the

same types of decisions: how firms raise money
from investors, how firms invest money in an
attempt to earn a profit, and how they decide
whether to reinvest profits in the business or
distribute them back to investors.
What is Finance
 At the macro level, finance is the study of
financial institutions and financial markets and
how they operate within the financial system
globally.
 At the micro level, finance is the study of
financial planning, asset management, and
fund raising for businesses and financial
institutions. Managing both sides of balance
sheet.
 They are also more involved in developing
corporate strategy and improving the firm’s
competitive position.
 Increasing globalization has complicated the
financial management function by requiring
them to be proficient in managing cash flows in
different currencies and protecting against the
risks inherent in international transactions.
 Changing economic and regulatory conditions
also complicate the financial management
function.
Professional Certifications in Finance:
 Chartered Financial Analyst (CFA) – Offered by the
CFA Institute, the CFA program is a graduate-level
course of study focused primarily on the investments
side of finance.
 Certified Financial Planner (CFP) – To obtain CFP
status, students must pass a ten-hour exam
covering a wide range of topics related to personal
financial planning.
Legal Forms of Business

1) Sole Proprietorship
 A business owned by a single individual.
 Owner maintains title to the firm’s assets.
 Owner has unlimited liability.

2) Partnership
 Similar to a sole proprietorship, except that there
are two or more owners.
2a) General Partnership
 All partners have unlimited liability.
2b) Limited Partnership
 Consists of one or more general partners, who have
unlimited liability.
 One or more limited partners (investors) whose liability
is limited to the amount of their investment in the
business.
2c) Limited Liability Partnership (LLP)
 All partners have limited liability.
 They are liable for the own acts of malpractice, but not
for that of other partners. Common for law firms and
accounting firms.
3) Corporation
 A business entity that legally functions separate
and apart from its owners.
 Owners’ liability is limited to the amount of their
investment in the firm (the paid-up capital for
equity shares).
 Owners hold common stock certificates, and
ownership can be transferred by selling the
certificates.
 Private limited companies (Sdn. Bhd.) and Public
listed companies (Bhd.)
Strengths and Weaknesses of the Common
Legal Forms of Business Organization
 The Trade-offs: Corporate Form
12

 Benefits:
 Limited liability
 Easy to transfer ownership
 Unlimited life (unless the firm goes through
corporate restructuring such as mergers and
bankruptcies)

 Drawbacks:
 No secrecy of information
 Maybe delays in decision making
 Greater regulation
 Double taxation
Corporate Organization

13
The Financial Management Function
 The importance of the financial management
function depends on the size of the firm.
 In small companies, the finance function may be
performed by the company president or
accounting department.
 As the business expands, finance typically
evolves into a separate department linked to the
president as was previously described.
Financial Management Function:
Relationship to Economics
 The field of finance is actually an outgrowth of
economics. Finance is sometimes referred to as
financial economics.
 Finance managers must understand the economic
framework within which they operate in order to react
or anticipate to changes in economic conditions.
 The primary economic principal used by finance
managers is marginal cost-benefit analysis which
says that financial decisions should be implemented
only when added benefits exceed added costs.
 Financial Management Function:
Relationship to Accounting
 The firm’s finance (treasurer) and accounting (controller)
functions are closely-related and overlapping.
 In smaller firms, the financial manager generally
performs both functions.
 One major difference in perspective and emphasis
between finance and accounting is that accountants
generally use the accrual method while in finance, the
focus is on cash flows. Refer to following example.
 The A Berhad experienced the following activity last
year:

Sales RM100,000 (1 yacht sold, 100% still uncollected)

Costs RM80,000 (all paid in full under supplier terms)
 Contrast the differences in performance under the accrual
method (accounting) vs. the cash method (finance).

ACCRUAL CASH
Sales RM100,000 RM 0
Less: Costs (80,000) (80,000)
Net Profit/(Loss) RM20,000 RM(80,000)
 Finance and accounting also differ with respect to
decision-making.
 While accounting is primarily concerned with the
presentation of financial data, the financial manager
is primarily concerned with analysing and
interpreting this information for decision-making
purposes.
 The financial manager uses this data as a vital tool
for making decisions about the financial aspects of
the firm.
 Financial Management Decisions
Macro Finance
XYZ Berhad
Statement of Financial Position
As of December 31, 2022

Assets: Liabilities & Equity:

Current Assets Current Liabilities
Working Cash & M.S. Accounts payable Working
Capital Accounts receivable Notes Payable
Capital
Inventory Total Current Liabilities
Total Current Assets Long-Term Liabilities
Fixed Assets: Total Liabilities

Investment Gross fixed assets Equity:

Financing
Less: Accumulated dep. Common Stock
Decisions Decisions
Goodwill Paid-in-capital
Other long-term assets Retained Earnings
Total Fixed Assets Total Equity
Total Assets Total Liabilities & Equity
Financial Management Decisions
 There are 3 main types of decisions facing finance
managers: investment decisions, financing
decisions, and dividend decisions.
 Investment decisions involve committing funds to:
→ internal investment projects (and withdrawing from
such projects should they turn out to be unprofitable)
→ external investment decisions, involving takeover of
another company or a merger
→ divestment decisions, involving selling a part of the
business such as an unwanted subsidiary company
 Financing decisions: The assets of a company must be
financed by share capital and reserves, long-term liabilities
or short-term liabilities. When a company is growing, it will
need additional finance from one or more of these
sources. A finance manager must know:
→ where additional funds can be obtained and at what costs
→ the effect on a company’s profitability and value of using any
particular source of funds
→ the effect on financial risk
 A company ought to be profitable, but it must be ‘liquid’ too,
so that it always has enough cash to pay for creditors and to
hold inventories. Financing decisions therefore include cash
management.
 Ordinary shareholders expect to earn dividends, and that
the value of a company’s shares will be related to the
amount of dividends that a company has been paying,
and also related to prospects for future dividends.
 Dividend decisions are also directly related to financing
decisions, since retained profits are the most important
source of new funds for companies. What a company
pays as dividends out of profits cannot be retained in the
business to finance future growth.
 Dividend Payout ratio = 1 – Retention ratio
Goal of the Firm: Maximize Profit?
Which Investment is Preferred?

Profit maximization may not lead to the highest possible share

price for at least three reasons:
1. Timing is important—the receipt of funds sooner rather than later is
preferred
2. Profits do not necessarily result in cash flows available to stockholders
3. Profit maximization fails to account for risk
 Why is Profit Maximisation not the
appropriate goal?
24

 Profit maximisation goal is unclear about the time

frame over which profits are to be measured.

 It is easy to manipulate the profits through various

accounting policies.

 Profit maximisation goal ignores risk and timing of

cash flows.
Goal of the Firm:
Maximize Shareholder Wealth!!!
 Why? Because maximizing shareholder wealth
properly considers cash flows, the timing of these
cash flows, and the risk of these cash flows.
 This can be illustrated using the following simple
stock valuation equation:
level & timing of
cash flows
Share Price = Future Dividends
risk of cash
Required Return flows
Goal of the Firm:
Maximise Shareholder Wealth
 The goal of the firm is to maximise shareholder
wealth. Good corporate decisions are those that
create wealth for the shareholder.
 Shareholder wealth is measured by share prices.
Thus shareholder wealth maximisation would
imply maximising the price of common stock.
Goal of the Firm:
Maximise Shareholder Wealth
 Share Price Changes (during last two years as
of June 29, Year 7)
Google: Share price increased by nearly $200 or
around 67% (from around $300 to $500) … wealth
created.

Yahoo: Share price decreased by nearly $8 or around

23% (from around $35 to $27) … wealth destroyed.
Goal of the Firm:
Maximize Shareholder Wealth

 The objective of management is to maximise the market value of the

firm, i.e. maximise the wealth of its ordinary shareholders.
 A company is financed by ordinary shareholders, preferred
stockholders and other short-term and long-term creditors.
 All surplus funds and retained earnings are undistributed wealth of
its legal owners – ordinary equity shareholders.
Linking NPV to SHWM
How to measure wealth of shareholders
and the value of a company?
 For public listed companies, the market value of a
company can be measured by the price at which its
shares are currently being traded in the stock market,
such as Bursa Malaysia, NYSE etc.
 For private limited companies, their shares are not
traded on any stock market. Hence, there is no easy way
to measure their market value.
 A shareholder’s wealth comes from dividends received
and market value of the shares.
 Shareholder’s return = dividends + capital
gains/losses (increase/decrease in MV of shares)
Short-Term and Long-Term Financial
Objectives
 Maximization of shareholders’ wealth is a long-term
objectives. Daily fluctuations of share price in the market
due to pattern of demand and supply or other external
factors should be ignored by long-term shareholders.
 Only share traders/ margin traders focus on short-term
movements in share prices.
 Short term measure of return (profit for a year) can mislead
a company managers to pursue short-term objectives at
the expense of long-term ones. For example, spending a
small amount on R&D and training, delaying new capital
investments etc in order to report higher profits for current
financial year end.
Goal of the Firm:
What About Other Stakeholders?
 Stakeholders include all groups or individuals
whose interests are directly affected by activities of
the firm, including owners, employees, customers,
suppliers, creditors, government and local
community.
 The "Stakeholder View" prescribes that the firm
make a conscious effort to avoid actions that could
be detrimental to the wealth position of any of its
stakeholders.
 Such a view is considered to be "socially
responsible."
 Ordinary equity shareholders are the provider of risk capital
of a company and usually their goal will be to maximise their
wealth which they have as a result of the ownership of the
shares in the company.
 Employees usually want to maximise the rewards paid to
them in the form of salaries, bonuses or allowances
according to their skills, performance and rewards available
in alternative employment. Employees will also want
continuity of employment, safety and comfort workplace.
Also include managers.
 Trade creditors supplied goods and services to the firm.
Have objective of being paid the full amount by the due date
of invoice. Also would ensure continue trading relationship
with the firm. Sometimes prepared to accept later payment
to avoid jeopardizing that relationship.
 Long-term creditors, often include banks and other
holders of secured and unsecured debt securities.
Have the objective of receiving the payments of
interest and principal on the loan by the due date of
repayment. For secured loan, the lender will be able to
appoint a receiver to dispose off the company’s assets
if the company defaults. For unsecured loans, lenders
may apply for the company to be wound up if the
company defaults.
 Customers concerns about the quality, durability,
warranty, after sales service and safety of the products
sold by the firm. Also expect delivery of products on
time.
 Government agencies impinges on firm’s activities in
different ways including through taxation of firm’s profits,
the provision of grants and implementing policies to
achieve macroeconomic objectives such as reducing
unemployment and fostering growth in productivity and
national income.
 Local community concerns whether firms protect the
environment and take measures to reduce pollution from
the production process. Also hope firms will sponsor
some community events.
The agency problem
 Why does it arise?
 Divergence of ownership and control
 Managers’ goals differ from shareholders’

 Asymmetry of information

 What are the consequences?

 Managers will follow their own objectives, such as
increasing their power, job security, pay and
rewards
 Shareholder wealth is no longer maximised
Signs of an agency problem
 Managers mainly finance company with equity
finance.
 Managers accept low risk, short-payback
investment projects.
 Managers diversify business operations.
 Managers follow ‘pet projects’.
 Managers are rewarded for performance that is
‘below average’.
Options to mitigate agency problem
 Excessive Executive Compensation
 Conflict arises when managers negotiate high salaries,
bonuses, and stock options that may not be directly linked to
the company's long-term performance. This misalignment of
incentives can incentivise managers to prioritise short-term
gains over long-term value creation.
 To mitigate this conflict, companies can implement
performance-based compensation structures that tie
executive remuneration to key performance indicators (KPIs)
or the achievement of specific financial targets.
 This approach ensures that managers are rewarded for actions
that contribute to long-term shareholder wealth.
Options to mitigate agency problem
 Information Asymmetry
 Managers may possess more information about the
company's operations, financials, and prospects than
shareholders, leading to information asymmetry. This can
allow managers to manipulate or selectively disclose
information, potentially harming shareholders' interests.
 To address this conflict, companies can enhance
transparency and disclosure practices.
 Regular and comprehensive reporting of financial performance,
strategic initiatives, and risk factors can provide shareholders with
more accurate and timely information, reducing information
asymmetry and enabling better-informed investment decisions.
Options to mitigate agency problem
 Empire Building
 Managers may pursue projects or acquisitions that increase
the size and power of the organization but do not necessarily
create value for shareholders. This behavior, known as
empire building, can lead to inefficient allocation of resources
and suboptimal financial performance.
 To mitigate this conflict, companies can establish clear and
well-defined corporate governance structures.
 Independent boards of directors with diverse expertise can provide
oversight and challenge managerial decisions that are not aligned
with long-term shareholder interests. Additionally, regular evaluation
of investment projects based on their potential to generate
shareholder value can help prevent empire-building activities.
Options to mitigate agency problem
 Corporate governance is about promoting corporate fairness,
transparency and accountability.
 It can be seen as an attempt to solve agency problem using
externally imposed regulation.
 Market forces such as hostile corporate takeover could
also sometimes help to discipline managers to look after
benefits of shareholders. This is because the inefficient
management will often be replaced by the acquirer .
Financial MAXIMISE VALUE OF THE FIRM/
Objective
MAXIMIZE SHAREHOLDERS’ WEALTH
Investment Financing Dividend Decision
If there are not enough investments
Decision Decision that earn the hurdle rate, return
Invest in projects that yield a return Choose a financing mix that cash to owners
greater than the minimum maximizes the value of the projects
acceptable hurdle rate taken and matches the assets being
financed How much? What form?
Financing Excess cash after Whether the
Hurdle rate Returns Financing
meeting all cash should be
Should be higher Should be time- Mix Type business needs returned as
for riskier weighted, cash Includes Debt Should be as dividends or
projects and flow based, and Equity and close as possible stock buybacks
reflect financing incremental can affect both to the asset or spin offs will
mix uses returns, the hurdle rate being financed depend upon
reflecting all and the cash the stockholder
side costs and
benefits
flows Working capital preferences

decisions

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