FINANCIAL MANAGEMENT:FINANCIAL MANAGEMENT:IntroductionIntroduction

FINANCIAL MANAGEMENT:FINANCIAL MANAGEMENT:IntroductionIntroduction

BBA 2204 FINANCIAL MANAGEMENTBBA 2204 FINANCIAL MANAGEMENT

byStephen Ong

Visiting Fellow, Birmingham City University Business School, UK

Visiting Professor, Shenzhen University

Today’s Overview Today’s Overview

Learning GoalsLearning Goals1.1. Define Define financefinance and the managerial finance function. and the managerial finance function.2.2. Describe the legal forms of business organization.Describe the legal forms of business organization.3.3. Describe the goal of the firm, and explain why Describe the goal of the firm, and explain why

maximizing the value of the firm is an appropriate goal maximizing the value of the firm is an appropriate goal for a business.for a business.

4.4. Describe how the managerial finance function is related Describe how the managerial finance function is related to economics and accounting.to economics and accounting.

5.5. Identify the primary activities of the financial manager.Identify the primary activities of the financial manager.6.6. Describe the nature of the principle-agent relationship Describe the nature of the principle-agent relationship

between the owners and managers of a corporation, and between the owners and managers of a corporation, and explain how various corporate governance mechanisms explain how various corporate governance mechanisms attempt to manage agency problems.attempt to manage agency problems.

What is Finance?What is Finance? Finance can be defined as the science and art of Finance can be defined as the science and art of

managing money.managing money. At the personal level, finance is concerned with At the personal level, finance is concerned with

individuals’ decisions about how much of their individuals’ decisions about how much of their earnings they spend, how much they save, and earnings they spend, how much they save, and how they invest their savings. how they invest their savings.

In a business context, finance involves the same In a business context, finance involves the same types of decisions: how firms raise money from types of decisions: how firms raise money from investors, how firms invest money in an attempt investors, how firms invest money in an attempt to earn a profit, and how they decide whether to to earn a profit, and how they decide whether to reinvest profits in the business or distribute reinvest profits in the business or distribute them back to investors. them back to investors.

Career Opportunities in Career Opportunities in Finance: Financial ServicesFinance: Financial Services

Financial Services is the area of finance Financial Services is the area of finance concerned with the design and delivery concerned with the design and delivery of advice and financial products to of advice and financial products to individuals, businesses, and individuals, businesses, and governments. governments.

Career opportunities include banking, Career opportunities include banking, personal financial planning, personal financial planning, investments, real estate, and insurance.investments, real estate, and insurance.

Career Opportunities in Career Opportunities in Finance: Managerial FinanceFinance: Managerial Finance

Managerial finance is concerned with the Managerial finance is concerned with the duties of the financial manager working in a duties of the financial manager working in a business.business.

Financial managers administer the financial Financial managers administer the financial affairs of all types of businesses—private affairs of all types of businesses—private and public, large and small, profit-seeking and public, large and small, profit-seeking and not-for-profit.and not-for-profit.

They perform such varied tasks as They perform such varied tasks as developing a financial plan or budget, developing a financial plan or budget, extending credit to customers, evaluating extending credit to customers, evaluating proposed large expenditures, and raising proposed large expenditures, and raising money to fund the firm’s operations. money to fund the firm’s operations.

Career Opportunities in Finance: Managerial Career Opportunities in Finance: Managerial Finance (cont.)Finance (cont.)

• The recent global financial crisis and The recent global financial crisis and subsequent responses by governmental subsequent responses by governmental regulators, increased global competition, and regulators, increased global competition, and rapid technological change also increase the rapid technological change also increase the importance and complexity of the financial importance and complexity of the financial manager’s duties.manager’s duties.

• Increasing globalization has increased demand Increasing globalization has increased demand for financial experts who can manage cash for financial experts who can manage cash flows in different currencies and protect flows in different currencies and protect against the risks that naturally arise from against the risks that naturally arise from international transactions.international transactions.

Focus on PracticeFocus on Practice

Professional Certifications in Finance:Professional Certifications in Finance: Chartered Financial Analyst (CFA)Chartered Financial Analyst (CFA) – Offered by – Offered by

the CFA Institute, the CFA program is a graduate-the CFA Institute, the CFA program is a graduate-level course of study focused primarily on the level course of study focused primarily on the investments side of finance. investments side of finance.

Certified Treasury Professional (CTP)Certified Treasury Professional (CTP) – The CTP – The CTP program requires students to pass a single exam program requires students to pass a single exam that is focused on the knowledge and skills that is focused on the knowledge and skills needed for those working in a corporate treasury needed for those working in a corporate treasury department. department.

Certified Financial Planner (CFP)Certified Financial Planner (CFP) – To obtain CFP – To obtain CFP status, students must pass a ten-hour exam status, students must pass a ten-hour exam covering a wide range of topics related to covering a wide range of topics related to personal financial planning. personal financial planning.

Focus on Practice (cont.)Focus on Practice (cont.) Professional Certifications in Finance:Professional Certifications in Finance:

American Academy of Financial Management (AAFM)American Academy of Financial Management (AAFM) – The AAFM administers a host of certification – The AAFM administers a host of certification programs for financial professionals in a wide range programs for financial professionals in a wide range of fields. Their certifications include the Charter of fields. Their certifications include the Charter Portfolio Manager, Chartered Asset Manager, Certified Portfolio Manager, Chartered Asset Manager, Certified Risk Analyst, Certified Cost Accountant, Certified Risk Analyst, Certified Cost Accountant, Certified Credit Analyst, and many other programmes. Credit Analyst, and many other programmes.

Professional Certifications in AccountingProfessional Certifications in Accounting – Most – Most professionals in the field of managerial finance need professionals in the field of managerial finance need to know a great deal about accounting to succeed in to know a great deal about accounting to succeed in their jobs. Professional certifications in accounting their jobs. Professional certifications in accounting include the include the Certified Public Accountant (CPA), Certified Public Accountant (CPA), Certified Management Accountant (CMA), Certified Certified Management Accountant (CMA), Certified Internal Auditor (CIA), Internal Auditor (CIA), and many programmes.and many programmes.

Legal Forms of Business Legal Forms of Business OrganizationOrganization

• A sole proprietorship is a business owned by A sole proprietorship is a business owned by one person and operated for his or her own one person and operated for his or her own profit.profit.

• A partnership is a business owned by two or A partnership is a business owned by two or more people and operated for profit.more people and operated for profit.

• A corporation is an entity created by law. A corporation is an entity created by law. Corporations have the legal powers of an Corporations have the legal powers of an individual in that it can sue and be sued, individual in that it can sue and be sued, make and be party to contracts, and acquire make and be party to contracts, and acquire property in its own name.property in its own name.

Table 1.1 Strengths and Weaknesses of the Table 1.1 Strengths and Weaknesses of the Common Legal Forms of Business OrganizationCommon Legal Forms of Business Organization

Matter of FactMatter of Fact

Figure 1.1 Corporate Figure 1.1 Corporate OrganizationOrganization

Table 1.2 Career Opportunities Table 1.2 Career Opportunities in Managerial Financein Managerial Finance

Goal of the Firm: Goal of the Firm: Maximize Shareholder WealthMaximize Shareholder Wealth

Decision rule for managers: only take actions Decision rule for managers: only take actions that are expected to increase the share price.that are expected to increase the share price.

Goal of the Firm: Goal of the Firm: Maximize Profit?Maximize Profit?

Profit maximization may not lead to the highest Profit maximization may not lead to the highest possible share price for at least three reasons:possible share price for at least three reasons:

1.1. Timing is important—the receipt of funds sooner Timing is important—the receipt of funds sooner rather than later is preferredrather than later is preferred

2.2. Profits do not necessarily result in cash flows Profits do not necessarily result in cash flows available to stockholdersavailable to stockholders

3.3. Profit maximization fails to account for riskProfit maximization fails to account for risk

Which Investment is Preferred?Which Investment is Preferred?

Goal of the Firm: Goal of the Firm: What About Stakeholders?What About Stakeholders?

• Stakeholders are groups such as employees, Stakeholders are groups such as employees, customers, suppliers, creditors, owners, and customers, suppliers, creditors, owners, and others who have a direct economic link to the others who have a direct economic link to the firm. firm.

• A firm with a A firm with a stakeholder focusstakeholder focus consciously consciously avoids actions that would prove detrimental to avoids actions that would prove detrimental to stakeholders. The goal is not to maximize stakeholders. The goal is not to maximize stakeholder well-being but to preserve it.stakeholder well-being but to preserve it.

• Such a view is considered to be "socially Such a view is considered to be "socially responsible."responsible."

The Role of Business EthicsThe Role of Business Ethics

• Business ethics are the standards of conduct Business ethics are the standards of conduct or moral judgment that apply to persons or moral judgment that apply to persons engaged in commerce.engaged in commerce.

• Violations of these standards in finance Violations of these standards in finance involve a variety of actions: “creative involve a variety of actions: “creative accounting,” earnings management, accounting,” earnings management, misleading financial forecasts, insider trading, misleading financial forecasts, insider trading, fraud, excessive executive compensation, fraud, excessive executive compensation, options backdating, bribery, and kickbacks. options backdating, bribery, and kickbacks.

• Negative publicity often leads to negative Negative publicity often leads to negative impacts on a firmimpacts on a firm

The Role of Business Ethics: The Role of Business Ethics: Considering EthicsConsidering Ethics

Robert A. Cooke, a noted ethicist, suggests Robert A. Cooke, a noted ethicist, suggests that the following questions be used to assess that the following questions be used to assess the ethical viability of a proposed action:the ethical viability of a proposed action:

Is the action arbitrary or capricious? Does the Is the action arbitrary or capricious? Does the action unfairly single out an individual or group?action unfairly single out an individual or group?

Does the action affect the morals, or legal rights Does the action affect the morals, or legal rights of any individual or group?of any individual or group?

Does the action conform to accepted moral Does the action conform to accepted moral standards?standards?

Are there alternative courses of action that are Are there alternative courses of action that are less likely to cause actual or potential harm?less likely to cause actual or potential harm?

The Role of Business Ethics: The Role of Business Ethics: Ethics and Share PriceEthics and Share Price

Ethics programs seek to:Ethics programs seek to: reduce litigation and judgment costsreduce litigation and judgment costs maintain a positive corporate imagemaintain a positive corporate image build shareholder confidencebuild shareholder confidence gain the loyalty and respect of all gain the loyalty and respect of all

stakeholdersstakeholdersThe expected result of such The expected result of such programs is to positively affect the programs is to positively affect the firm’s share price.firm’s share price.

Focus on EthicsFocus on Ethics Will Google Live Up to Its Motto?Will Google Live Up to Its Motto?

In January 2010, Google announced that In January 2010, Google announced that the Gmail accounts of Chinese human-the Gmail accounts of Chinese human-rights activists and a number of rights activists and a number of technology, financial, and defense technology, financial, and defense companies had been hacked. companies had been hacked.

The company threatened to pull out of The company threatened to pull out of China unless an agreement on uncensored China unless an agreement on uncensored search results could be reached. search results could be reached.

Is the goal of maximization of shareholder Is the goal of maximization of shareholder wealth necessarily ethical or unethical?wealth necessarily ethical or unethical?

How can Google justify its actions in the How can Google justify its actions in the short run to its long run investors?short run to its long run investors?

Managerial Finance FunctionManagerial Finance Function

• The size and importance of the managerial The size and importance of the managerial finance function depends on the size of the finance function depends on the size of the firm.firm.

• In small firms, the finance function is generally In small firms, the finance function is generally performed by the accounting department.performed by the accounting department.

• As a firm grows, the finance function typically As a firm grows, the finance function typically evolves into a separate department linked evolves into a separate department linked directly to the company president or CEO directly to the company president or CEO through the chief financial officer (CFO) (see through the chief financial officer (CFO) (see Figure 1.1)Figure 1.1)

Managerial Finance Function: Managerial Finance Function: Relationship to EconomicsRelationship to Economics

• The field of finance is closely related to The field of finance is closely related to economics.economics.

• Financial managers must understand the Financial managers must understand the economic framework and be alert to the economic framework and be alert to the consequences of varying levels of economic consequences of varying levels of economic activity and changes in economic policy. activity and changes in economic policy.

• They must also be able to use economic They must also be able to use economic theories as guidelines for efficient business theories as guidelines for efficient business operation.operation.

Managerial Finance Function: Relationship Managerial Finance Function: Relationship to Economics (cont.)to Economics (cont.)

• Marginal cost–benefit analysis is the Marginal cost–benefit analysis is the economic principle that states that economic principle that states that financial decisions should be made and financial decisions should be made and actions taken only when the added actions taken only when the added benefits exceed the added costsbenefits exceed the added costs

• Marginal cost-benefit analysis can be Marginal cost-benefit analysis can be illustrated using the following simple illustrated using the following simple example.example.

Managerial Finance Function: Relationship Managerial Finance Function: Relationship to Economics (cont.)to Economics (cont.)

Nord Department Stores is applying marginal-Nord Department Stores is applying marginal-cost benefit analysis to decide whether to cost benefit analysis to decide whether to replace a computer:replace a computer:

Managerial Finance Function: Managerial Finance Function: Relationship to AccountingRelationship to Accounting

• The firm’s finance and accounting activities The firm’s finance and accounting activities are closely-related and generally overlap.are closely-related and generally overlap.

• In small firms accountants often carry out In small firms accountants often carry out the finance function, and in large firms the finance function, and in large firms financial analysts often help compile financial analysts often help compile accounting information.accounting information.

• One major difference in perspective and One major difference in perspective and emphasis between finance and accounting is emphasis between finance and accounting is that accountants generally use the accrual that accountants generally use the accrual method while in finance, the focus is on cash method while in finance, the focus is on cash flows.flows.

Managerial Finance Function: Relationship Managerial Finance Function: Relationship to Accounting (cont.)to Accounting (cont.)

• Whether a firm earns a profit or Whether a firm earns a profit or experiences a loss, experiences a loss, it must have a it must have a sufficient flow of cash to meet its sufficient flow of cash to meet its obligations as they come due.obligations as they come due.

• The significance of this difference The significance of this difference can be illustrated using the can be illustrated using the following simple example.following simple example.

Managerial Finance Function: Relationship Managerial Finance Function: Relationship to Accounting (cont.)to Accounting (cont.)

The Nassau Corporation experienced The Nassau Corporation experienced the following activity last year:the following activity last year:

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

Costs $ 80,000 (all paid in full under supplier terms)

Managerial Finance Function: Relationship Managerial Finance Function: Relationship to Accounting (cont.)to Accounting (cont.)

Now contrast the differences in performance Now contrast the differences in performance under the accounting method (accrual basis) under the accounting method (accrual basis) versus the financial view (cash basis):versus the financial view (cash basis):

Income Statement SummaryIncome Statement Summary

Accrual basisAccrual basis Cash basis Cash basis

Sales Sales $100,000 $100,000 $ 0 $ 0

Less: Costs Less: Costs ( (80,00080,000) () (80,00080,000))

Net Profit/(Loss)Net Profit/(Loss) $ 20,000 $ 20,000 $(80,000)$(80,000)

Managerial Finance Function: Relationship Managerial Finance Function: Relationship to Accounting (cont.)to Accounting (cont.)

Finance and accounting also differ with Finance and accounting also differ with respect to decision-making:respect to decision-making:

Accountants devote most of their attention Accountants devote most of their attention to the to the collection and presentation of collection and presentation of financial data.financial data.

Financial managers evaluate the Financial managers evaluate the accounting statements, develop additional accounting statements, develop additional data, and data, and make decisionsmake decisions on the basis of on the basis of their assessment of the associated returns their assessment of the associated returns and risks.and risks.

Personal Finance ExamplePersonal Finance Example

Figure 1.3 Financial ActivitiesFigure 1.3 Financial Activities

Governance and Agency: Governance and Agency: Corporate GovernanceCorporate Governance

• Corporate governance refers to the rules, Corporate governance refers to the rules, processes, and laws by which companies are processes, and laws by which companies are operated, controlled, and regulated. operated, controlled, and regulated.

• It defines the rights and responsibilities of the It defines the rights and responsibilities of the corporate participants such as the corporate participants such as the shareholders, board of directors, officers and shareholders, board of directors, officers and managers, and other stakeholders, as well as managers, and other stakeholders, as well as the rules and procedures for making corporate the rules and procedures for making corporate decisions. decisions.

• The structure of corporate governance was The structure of corporate governance was previously described in Figure 1.1.previously described in Figure 1.1.

Governance and Agency: Governance and Agency: Individual versus Institutional InvestorsIndividual versus Institutional Investors

• Individual investors are investors who own relatively Individual investors are investors who own relatively small quantities of shares so as to meet personal small quantities of shares so as to meet personal investment goals. investment goals.

• Institutional investors are investment professionals, Institutional investors are investment professionals, such as banks, insurance companies, mutual funds, and such as banks, insurance companies, mutual funds, and pension funds, that are paid to manage and hold large pension funds, that are paid to manage and hold large quantities of securities on behalf of others.quantities of securities on behalf of others.

• Unlike individual investors, institutional investors often Unlike individual investors, institutional investors often monitor and directly influence a firm’s corporate monitor and directly influence a firm’s corporate governance by exerting pressure on management to governance by exerting pressure on management to perform or communicating their concerns to the firm’s perform or communicating their concerns to the firm’s board.board.

Governance and Agency: Governance and Agency: Government RegulationGovernment Regulation

• Government regulation generally shapes the Government regulation generally shapes the corporate governance of all firms. corporate governance of all firms.

• During the recent decade, corporate During the recent decade, corporate governance has received increased attention governance has received increased attention due to several high-profile corporate due to several high-profile corporate scandals involving abuse of corporate power scandals involving abuse of corporate power and, in some cases, alleged criminal activity and, in some cases, alleged criminal activity by corporate officers.by corporate officers.

Governance and Agency: Governance and Agency: Government RegulationGovernment Regulation

The Sarbanes-Oxley Act of 2002: The Sarbanes-Oxley Act of 2002: • established an oversight board to monitor the established an oversight board to monitor the

accounting industry;accounting industry;• tightened audit regulations and controls; tightened audit regulations and controls; • toughened penalties against executives who commit toughened penalties against executives who commit

corporate fraud; corporate fraud; • strengthened accounting disclosure requirements and strengthened accounting disclosure requirements and

ethical guidelines for corporate officers; ethical guidelines for corporate officers; • established corporate board structure and membership established corporate board structure and membership

guidelines;guidelines;• established guidelines with regard to analyst conflicts of established guidelines with regard to analyst conflicts of

interest;interest;• mandated instant disclosure of stock sales by corporate mandated instant disclosure of stock sales by corporate

executives;executives;• increased securities regulation authority and budgets for increased securities regulation authority and budgets for

auditors and investigators.auditors and investigators.

Governance and Agency: Governance and Agency: The Agency IssueThe Agency Issue

• A principal-agent relationship is an A principal-agent relationship is an arrangement in which an agent acts on the arrangement in which an agent acts on the behalf of a principal. For example, behalf of a principal. For example, shareholders of a company (principals) elect shareholders of a company (principals) elect management (agents) to act on their behalf.management (agents) to act on their behalf.

• Agency problems arise when managers place Agency problems arise when managers place personal goals ahead of the goals of personal goals ahead of the goals of shareholders.shareholders.

• Agency costs arise from agency problems that Agency costs arise from agency problems that are borne by shareholders and represent a loss are borne by shareholders and represent a loss of shareholder wealth.of shareholder wealth.

The Agency Issue: The Agency Issue: Management Compensation PlansManagement Compensation Plans

• In addition to the roles played by corporate In addition to the roles played by corporate boards, institutional investors, and boards, institutional investors, and government regulations, corporate government regulations, corporate governance can be strengthened by ensuring governance can be strengthened by ensuring that managers’ interests are aligned with that managers’ interests are aligned with those of shareholders. those of shareholders.

• A common approach is to structure A common approach is to structure management compensation to correspond management compensation to correspond with firm performance.with firm performance.

The Agency Issue: The Agency Issue: Management Compensation PlansManagement Compensation Plans

• Incentive plans are management Incentive plans are management compensation plans that tie compensation plans that tie management compensation to share management compensation to share price; one example involves the price; one example involves the granting of stock options.granting of stock options.

• Performance plans tie management Performance plans tie management compensation to measures such as compensation to measures such as EPS or growth in EPS. Performance EPS or growth in EPS. Performance shares and/or cash bonuses are used shares and/or cash bonuses are used as compensation under these plans.as compensation under these plans.

Matter of Fact—Forbes.com Matter of Fact—Forbes.com CEO Performance vs. PayCEO Performance vs. Pay

The Agency Issue: The Threat of The Agency Issue: The Threat of TakeoverTakeover

• When a firm’s internal corporate governance When a firm’s internal corporate governance structure is unable to keep agency problems structure is unable to keep agency problems in check, it is likely that rival managers will in check, it is likely that rival managers will try to gain control of the firm. try to gain control of the firm.

• The threat of takeover by another firm, which The threat of takeover by another firm, which believes it can enhance the troubled firm’s believes it can enhance the troubled firm’s value by restructuring its management, value by restructuring its management, operations, and financing, can provide a operations, and financing, can provide a strong source of external corporate strong source of external corporate governance. governance.

Review of Learning GoalsReview of Learning Goals Define Define financefinance and the managerial finance function. and the managerial finance function.

Finance is the science and art of managing money. Managerial Finance is the science and art of managing money. Managerial finance is concerned with the duties of the financial manager finance is concerned with the duties of the financial manager working in a business.working in a business.

Describe the legal forms of business organization.Describe the legal forms of business organization. The legal forms of business organization are the sole The legal forms of business organization are the sole

proprietorship, the partnership, and the corporation.proprietorship, the partnership, and the corporation. Describe the goal of the firm, and explain why Describe the goal of the firm, and explain why

maximizing the value of the firm is an appropriate maximizing the value of the firm is an appropriate goal for a business.goal for a business. The goal of the firm is maximize its value, and therefore the The goal of the firm is maximize its value, and therefore the

wealth of its shareholders. Maximizing the value of the firm wealth of its shareholders. Maximizing the value of the firm means running the business in the interest of those who own itmeans running the business in the interest of those who own it——the shareholders.the shareholders.

Review of Learning Goals Review of Learning Goals (cont.)(cont.)

Describe how the managerial finance function Describe how the managerial finance function is related to economics and accounting.is related to economics and accounting.

The financial manager must understand the economic The financial manager must understand the economic environment and rely heavily on the economic principle environment and rely heavily on the economic principle of marginal cost–benefit analysis to make financial of marginal cost–benefit analysis to make financial decisions. Financial managers use accounting but decisions. Financial managers use accounting but concentrate on cash flows and decision making.concentrate on cash flows and decision making.

Identify the primary activities of the financial Identify the primary activities of the financial manager.manager.

The primary activities of the financial manager, in The primary activities of the financial manager, in addition to ongoing involvement in financial analysis addition to ongoing involvement in financial analysis and planning, are making investment decisions and and planning, are making investment decisions and making financing decisions.making financing decisions.

Review of Learning Goals Review of Learning Goals (cont.)(cont.)

Describe the nature of the principle-agent Describe the nature of the principle-agent relationship between the owners and managers relationship between the owners and managers of a corporation, and explain how various of a corporation, and explain how various corporate governance mechanisms attempt to corporate governance mechanisms attempt to manage agency problems.manage agency problems. This separation of owners and managers of the typical This separation of owners and managers of the typical

firm is representative of the classic principal-agent firm is representative of the classic principal-agent relationship, where the shareholders are the principles relationship, where the shareholders are the principles and mangers are the agents. A firm’s corporate and mangers are the agents. A firm’s corporate governance structure is intended to help ensure that governance structure is intended to help ensure that managers act in the best interests of the firm’s managers act in the best interests of the firm’s shareholders, and other stakeholders, and it is usually shareholders, and other stakeholders, and it is usually influenced by both internal and external factors.influenced by both internal and external factors.

QUESTIONS?QUESTIONS?