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CHAPTER1: FINANCEANDTHEFINANCIAL
MANAGER

1.1 Introduction

Financeisaboutthebottomlineofbusinessactivities.Financedealswithdecisions
concerningcashinflows(financing)andcashoutflows(investing);thus,nearlyevery
decisionmadeinthefirmissomehowrelatedtofinance.

Everything else equal, you should prefer (1) more value to less, (2) to receive cash
soonerratherthanlater,and(3)lessrisktomore.

1.2 GeneralAreasofFinance

o Financial Markets and Institutionsthe financial marketplace and the
relationshipsofbanking,insurance,estateplanning,andsoforth.

o Investmentsevaluating financial assets, such as stocks and bonds, and

determiningwhichinvestmentstoincludeinaportfoliooffinancialassets.

o Financial Servicesservice organizations and mechanisms related to the

managementofmoney.

o Managerial Financeoften called corporate finance, includes decisions regarding

types of real investments (i.e., plant and equipment) that should be made and
how such investments should be financed (i.e., stocks or bonds), whether
dividendsshouldbepaid,andsoforth.
TheImportanceofFinanceinNonfinanceAreas
Regardlessoftheareaofbusinessyoustudy,anunderstandingoffinanceiscrucial;
decisionsaboutmoneyarecommonplaceineveryareaofbusiness,thusfinancial
decisionsarerequired.
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1.3 Corporateandotherformsofbusinessorganization

Commonorganizationalformsforbusinessesinclude:
SoleProprietorship:ownedandmanagedbyasingleindividual,
Partnerships:ownedandmanagedbytwoormoreindividual,and
Corporations: owned by a large number of stockholders but managed by
professional managers, and have distinct legal identity and are governed by the
articlesofincorporation.


Type Advantages Disadvantages
Sole
Proprietorship
Easiesttostart
Leastregulated
Single owner keeps all the
profits
Taxedonceaspersonalincome

Equity capital limited to

ownerspersonalwealth
Limitedtolifeofowner
Unlimitedliability
Difficult to sell ownership
interest
Partnership Twoormoreowners
Morecapitalavailable
Relativelyeasytostart
Income taxed once as personal
income
Unlimitedliability
Partnership dissolves when
one partner dies or wishes to
sell
Difficulttotransferownership
Corporation Limitedliability
Unlimitedlife
Separation of ownership and
management
Transferofownershipiseasy
Easiertoraisecapital
Separation of ownership and
management
Doubletaxation(incometaxed
at the corporate rate and then
dividends taxed at personal
rate)



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1.4 CorporateFinance

1.4.1 Definition

Corporate Financeentailsplanningforthefuture of a businessenterprisetoensure a
positive cash flow. It includes the administration and maintenance of financial assets.
Besides,financialmanagementcoverstheprocessofidentifyingandmanagingrisk.

Someimportantquestionsthatareansweredusingfinance
Whatlongterminvestmentsshouldthefirmtakeon?
Wherewillwegetthelongtermfinancingtopayfortheinvestment?
Howwillwemanagetheeverydayfinancialactivitiesofthefirm?

Financialmanagerstrytoanswersomeorallofthesequestions

1.5 FinancialManager

Corporations use different real assets to run their business. Many of these assets are
tangible such as machineries, factories and offices; others are intangible, such as
technicalexpertiseandtrademarks.

To obtain partly the necessary money the corporation sells pieces of papers called
financial assets or securities that are in the financial markets. These papers have value
becausetheyareclaimsonthefirmsrealassetsandthecashtheyproduce.

The financial manager stands between the firms operation and the financial market,
whereinvestorsholdthefinancialassetsissuedbythefirm.

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1. Cash raised from investors
2. Cash invested in firm
3. Cash generated by operations
4a. Cash reinvested
4b. Cash returned to investors

Financial Managers primary role is deciding which assets to invest in and how to
finance them. Thus there are three types of decisions the financial manager is called
upontomake.Theseare:

Capitalbudgeting
Whatlongterminvestmentsorprojectsshouldthebusinesstakeon?
Capitalstructure
Howshouldwepayforourassets?
Shouldweusedebtorequity?
Workingcapitalmanagement
Howdowemanagethedaytodayfinancesofthefirm?

Theworkofthefinancialmanageristypicallysplitintoseparatepositionswith

the treasurer dealing with cash management, raising capital and dealing with
investorsandfinancialinstitutions;and
the controller entrusted with responsibility for managing the firms internal
accounting,preparationoffinancialstatements,andtaxobligations.

Firms
Operations

Financial
Manager

Financial
Markets
2
3
1
4a
4b
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Asthefirmgetslarger,theorganizationofthefinancialmanagementfunctionbecomes
more complex and a chief financial officer (CFO) supervises the treasurer and the
controllerwithadditionalresponsibilityforfinancialpolicyandcorporateplanning.


1.6 Objectiveofthefirm

In traditional corporate finance, the objective in decision making is to maximize the

value of the firm. A narrower objective is to maximize stockholder wealth and this is
accomplishedbymaximizingthestockprice.

Thevalueofthestockpriceisdeterminedbywhatpeoplearewillingtopayforit.Thus
in general prices are determined by demand and supply. But how do investors decide
whetheritisagoodideatobuyorsellaparticularstockatagivenprice?
First,theyneedtoconsiderthefinancialhealthofthecompanywhosestocktheyare
consideringbuyingorselling.
o Ifitlookslikeacompanyisgoingtolosemoneyperhapsthecompany
justannouncedpoorearningsthenitsstockhaslessvalue.
o Investors will pay more for a company with a history of earning strong
profitsandconsistentlypayinghealthydividends.

ChiefFinancialOfficer(CFO)
FinancialPolicy
CorporatePlanning
Treasurer
CashManagement
RaisingCapital
BankingRelationships
Controller
PreparationofFinancial
Statements
Accounting
Taxes
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While a companys past performance is important, even more important are its
futureprospects.
o A company that has not been making money might turn around, perhaps
under new management, after increasing its efficiency, or by developing
aninnovativenewproduct.
o Likewise, just because a company has made money in the past does not
mean it will continue to do so. Perhaps the companys successful CEO is
retiring,thecompanyisdefendingabiglawsuit,workersarethreatening
tostrikeorcompetitionhasheightened.Announcementsalongtheselines
couldmeanthecompanysfutureisuncertainornegative.
A report that an individual or a company is trying to buy another business usually
increases that business stock prices. Thats because the purchaser has to buy a
majority of the stock to gain control of the company. To do so, the suitor must
persuade stockholders to sell their stock by offering an attractive price for their
shares.

Ingeneral:
a. Thevalueofafirmisdeterminedbywhatpeoplearewillingtopayforit.
b. The financial manager should make decisions that cause people to think more
favorablyaboutthefirm.
c. Valuedependsonfutureprospectsandrisk.
d. Private Investors react to poor investment or dividend decisions by selling
stocksandcausingthetotalmarketvalueofthepublicsharestofall.
e. Investors can react to good decisions by pushing up the price of stocks and
createwealthfortheshareholder.

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1.7 Separationofownershipandmanagement

Large corporations have hundreds of thousands of shareholders and it will be
impossibletohavetheownersmanagethebusinessdirectly.Thus:

Separation of ownership and management becomes a necessity allowing

continuityinmanagement,unaffectedbychangesinownership.
Italsoopensthewayforhiringofprofessionalmanagerstomanagethebusiness.

In the modern publiclytraded corporation, professional managers and directors

manage the corporation; they are agents of the shareholders who are the principal
owners





The disadvantage of this separation of ownership and management is that it causes
potentialprincipalagentproblems.Itispossibleforagentstopursuetheirowngoalsat
the expense of the principal. The fact that owners have limited access to information
Agencyrelationship:theprincipal(stockholder)hiresanother
personagent(manager)torepresenthisinterests.
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about the company they own, and managers and the board hold superior information,
creates further potential for conflict. The principalagent problem arises because
different parties have different information about the value of the business. In other
words,agencyproblemsgeneratedbyinformationasymmetry.


Thisresultstoagencycosts.Agencycostsareincurredwhen:
managersdonotattempttomaximizefirmvalue,and
shareholdersincurcoststomonitorthemanagersandinfluencetheir
actions

Agencycosts
(a)Monitormanagersbehaviour
(b)Createincentiveschemesandcontrolsformanagerstoencouragethe
pursuitofshareholderswealthmaximisation
Agencycostofthelossofwealthcausedbytheextenttowhichprevention
measuresdonotwork
Somesolutions
Linkingrewardstoshareholderwealthimprovements
Firing
Sellingsharesandthetakeoverthreat
Corporategovernanceregulations
Informationflow










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1.8 FinancialMarkets&Institutions:

1.8.1 FinancialMarkets
Financialmarketsaremarketsinwhichfundsaretransferredfrompeoplewhohavean
excessofavailablefundstopeoplewhohaveashortageoffunds
Infinance,financialmarketsfacilitate
Theraisingofcapital(inthecapitalmarkets);
Thetransferofrisk(inthederivativesmarkets);
Internationaltrade(inthecurrencymarkets)
andareusedtomatchthosewhowantcapitaltothosewhohaveit

Marketsaredividedintoprimaryandsecondarymarkets
The Primary market is the market where investors purchase newly issued
securities.
Initial public offering (IPO): An initial public offer occurs when a
companyoffersstockforsaletothepublicforthefirsttime.
The Secondary market is the market where investors trade previously issued
securities.Aninvestorcantrade:
Directlywithotherinvestors.
Indirectlythroughabrokerwhoarrangestransactionsforothers.
Directlywithadealerwhobuysandsellssecuritiesfrominventory.
Secondary markets can be organized as exchanges, in which titles are
tradedinacentrallocation,suchasastockexchange,oralternativelyas
overthecountermarketsinwhichtitlesaresoldinseverallocations.

Financialinstitutionssuchasbanksandinsurancecompaniesarealsoimportantsources
of financing for businesses, and they are essential to wellfunctioning market
economies.

Financialinstitutionsareintermediariesthatgatherthesavingsofmanyindividuals
and reinvest them in the financial market. For example, banks raise money by
takingdeposits,andthentheylendthemoneytoindividuals.
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Financial institutions provide payment mechanism for the economy. Checking

accounts, credit cards, and electronic transfers allow firms and individuals to send
andreceivepaymentsquicklyandsafely.

Financial institutions offer risk pooling to their customers. For example insurance
companiesmakeitpossibletosharetheriskofacaraccidentorahouseholdonfire.