Topic 1

AN INTRODUCTION TO THE FOUNDATIONS OF FINANCIAL

MANAGEMENT

Learning Objectives

1. Definition of finance.2. Roles of the financial manager. 3. Goals of the firm.4. Basic principles of finance.5. Basic forms of business 6. Financial institutions and markets.

1. 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

• Simply finance deals with matters related to money and the markets

2. The Role of a Financial Manager in a Firm

Three broad issues addressed by the financial manger: Where to Invest? (Capital budgeting

decision) How to raise money to fund the investment?

(Capital structure decision) How to manage cash flows from daily

operations? (Working capital decision)

The Role of a Financial Manager in a Firm (cont.)

3. The Goal of the Firm

The goal of the firm is to create value for the firm’s legal owners (that is, its shareholders). Thus the goal of the firm is to “maximize shareholder wealth” by maximizing the price of the existing common stock.

Share Price Maximization

•Why?•Because maximizing shareholder wealth properly considers cash flows, the timing of these cash flows, and the risk of these cash flows.

•It is easy to manipulate the profits through various accounting policies.

Maximize Shareholder Wealth not profit maximization!!!

4. Five Foundational Principles of Finance

Cash flow is what matters Money has a time value Risk requires a reward Market prices are generally right Conflicts of interest cause agency

problems

Principle 1: Cash flow is what matters

Accounting profits are not equal to cash flows. It is possible for a firm to generate accounting profits but not have cash or to generate cash flows but not report accounting profits in the books.

Cash flow, and not profits, drive the value of a business.

We must determine incremental cash flows when making financial decisions. Incremental cash flow is the difference between the

projected cash flows if the project is selected, versus what they will be, if the project is not selected.

Principle 2:Money has a time value

A dollar received today is worth more than a dollar received in the future. Since we can earn interest on money received

today, it is better to receive money earlier rather than later.

Principle 3:Risk requires a Reward

We won’t take on additional risk unless we expect to be compensated with additional reward or return.

Investors expect to be compensated for “delaying consumption” and “taking on risk”. Thus investors expect a return when they put their

savings in a bank (i.e. delay consumption) and they expect to earn a higher rate of return on stocks relative to bank savings account (i.e. taking on risk)

Figure 1-1

Principle 4: Market Prices are generally Right

In an efficient market, the prices of all traded assets (such as stocks and bonds) at any instant in time fully reflect all available information.

Thus stock prices are a useful indicator of the value of the firm. Prices changes reflect changes in expected future cash flows. Good decisions will tend to increase the stock prices and vice versa.

Principle 5: Conflicts of interest cause agency problems

The separation of management and the ownership of the firm creates an agency problem. Managers may make decisions that are not consistent with the goal of maximizing shareholder wealth. Agency conflict is reduced through monitoring

(ex. Annual reports), compensation schemes (ex. stock options), and market mechanisms (ex. Takeovers)

Sole Proprietorship

Partnership

Corporation

5. Basic forms of business organization

Sole Proprietorship

Business owned by an individual

Owner maintains title to assets and profits

Unlimited liability

Termination occurs on owner’s death or by owner’s choice

Sole Proprietorship (cont.)

• Advantages:– Easy to start– No need to consult others while making decisions– Taxed at the personal tax rate.– Retention of all profits.– Few regulations

• Disadvantages:– Personally liable for the business debts– Ceases on the death of the propreitor– Financing limitations

Partnership

• A partnership is an association of two or more persons who come together as co-owners for the purpose of operating a business for profit.

• There is no separation between the partnership and the owners with respect to debts or being sued.

Partnerships (cont.)

Two or more persons come together as co-owners

General Partnership: All partners are fully responsible for liabilities incurred by the partnership.

Limited Partnerships: One or more partners can have limited liability, restricted to the amount of capital invested in the partnership. There must be at least one general partner with unlimited liability. Limited partners cannot participate in the management of the business and their names cannot appear in the name of the firm.

Partnership (cont.)

• Advantages:– Relatively easy to start– Taxed at the personal tax rate– Access to funds from multiple sources or

partners

• Disadvantages:– Partners jointly share unlimited liability.– Difficult to raise large amounts of capital.– Difficult to transfer ownership.

Corporation

Legally functions separate and apart from its owners Corporation can sue, be sued, purchase, sell, and own property

Owners (shareholders) dictate direction and policies of the corporation, oftentimes through elected board of directors.

Shareholder’s liability is restricted to amount of investment in company

Life of corporation does not depend on the owners … corporation continues to exist through easy transfer of ownership

Taxed separately

Corporation (cont.)

• Advantages– Liability of owners limited to invested funds– Life of corporation is not tied to the owner– Easier to transfer ownership– Easier to raise Capital

• Disadvantages – Greater regulation – Double taxation of dividends.– No secrecy of information

6. Financial Institutions & Markets

• Firms that require funds from external sources can obtain them in three ways:

– through a bank or other financial institution

– through financial markets

– through private placements

Financial Institutions & Markets: Financial Institutions

• Financial institutions are intermediaries that channel the savings of individuals, businesses, and governments into loans or investments.

• The key suppliers and demanders of funds are individuals, businesses, and governments.

• In general, individuals are net suppliers of funds, while businesses and governments are net demanders of funds.

Financial Institutions & Markets: Financial Markets (cont.)

• Financial markets provide a forum in which suppliers of funds and demanders of funds can transact business directly.

• The two key financial markets are the money market and the capital market.

• Transactions in short term marketable securities take place in the money market while transactions in long-term securities take place in the capital market.

Financial Institutions & Markets: Financial Markets (cont.)

• Whether subsequently traded in the money or capital market, securities are first issued through the primary market.

• The primary market is the only one in which a corporation or government is directly involved in and receives the proceeds from the transaction.

• Once issued, securities then trade on the secondary markets such as the New York Stock Exchange or NASDAQ or Bursa Malaysia.

Types of offers in primary market (cont.)

• Initial Public Offering (IPO)• The first time the firm’s stock is sold to the

general public.• Seasoned New Issue• A new stock offering by a firm that already

has stock that is traded in the secondary market.

Figure 1.1 Flow of Funds