Chapter 1: Introduction to financial

management

Aims of the chapter

This chapter is clearly one of the most important in the subject
guide because it deals with the fundamentals of financial
management. Without a clear understanding of the fundamentals
the remainder of this subject will not be easy to grasp. As with any
subject area, a knowledge of the background, the environment to
which the subject relates, is important as it helps to put everything
learnt later into appropriate perspective.
The chapter starts by looking at the key tasks of financial
management. Since knowledge of the financial environment is vital
to managers this comes next before the review of the differing
organisational forms of business that are in use.
An outline of corporate objectives follows because these form the
basis of much of the theory that is covered in this subject. The roles
of financial managers come next, to be followed by a discussion of
some of their conflicts of interest and how they might be resolved.
One area of major interest is the corporate governance debate on
how the relationship between owners and controllers should be
systemised to maximise the corporate gain.
Brief descriptions of how risk is treated in financial management
theory, and how accounting is linked in with financial
management, are included and the chapter is concluded with a
note of the direction and importance of taxation in today’s financial
decisions.
The unit 25 Principles of accounting, if studied carefully and
fully, should have meant you already have all this background
knowledge. If that is true, then perhaps only a quick review of this
subject matter is necessary, but if the practise questions and
problem(s) here and in the essential text cause you any problems,
then a more detailed and careful review of your pre-requisite unit
may be needed.

Learning objectives
By the end of this chapter, and having completed the essential
reading and activities, you should be able to:
describe the general financial environment in which
corporations operate
explain the importance and roles of financial markets

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list/outline the roles financial managers can have within an

organisation
outline such things as taxation, accounting information and
form of business and their implications for financial
management
give examples of the various objectives a company may have
and why the main objective is deemed to be shareholder
wealth maximisation
explain and give examples of how the influence of risk will
permeate all aspects of financial management, the theories
presented, the appraisal and selection, the changes suggested,
and the control methods used.

Essential reading
Brealey, R.A., S.C. Myers and A.J. Marcus Fundamentals of Corporate
Finance. (McGraw-Hill Inc, 2007) Chapters 1, 2 and 3.

Further reading
Brealey, R.A., S.C. Myers and F. Allen Principles of Corporate
Finance. (McGraw-Hill, 2008) Chapter 1.
Atrill, P. Financial Management for Decision makers. (FT Prentice
Hall Europe, 2005) Chapters 1 and 2.

Key tasks of financial management

There are five key tasks undertaken in financial management
financial planning
investment project appraisal
financial decisions
capital market operations
financial control.
Financial planning provides the means, through plans and
projections, to evaluate the proposed courses of action. Similarly
financial control deals with the ways and means by which the plans
are achieved. The next two tasks, investment project appraisal and
financing decisions are seen by some, including Brealey and Myers,
as the two most important tasks.
Investment project appraisal is the assessment and evaluation of
the relative strengths of a company’s investment propositions. The
financing decisions involve the identification and choice of the
sources of funds which will provide the cash to be invested into the
selected projects. Part of the finance function is dealing with the
capital market since a large part of the finance is obtained through
the capital market, not least those funds provided by the equity
owners, the ordinary shareholders. This function does not just
deal with the raising of funds but also with the ongoing relationship
between the company and the market place; information

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 Chapter 1: Introduction to financial management

disseminated to the capital markets affects the market’s perception

of the company and the price of the company’s shares, and thus
wealth of the shareholder.

Financial environment
The economic and social background of a country is a major
influence on a firm, on its structure and on its objectives and
operations. Firms in socialist or communist countries have
different structures and objectives from those that operate in
capitalist economies. Countries that are still developing may not
have a public market place (i.e. a stock market) in which the shares
in a company can be traded. Different phases of the trade cycle
have different implications for financial operations. In depressed
times, interest rates payable on loans will be higher, trading
conditions much more risky and so returns to shareholders may be
lower or non-existent.
In the capitalist economies of developed countries where there are
stockmarkets, the owners of the shares in trading companies will
expect returns on those shares. The quality and amount of that
return, the dividend, will be one of the elements influencing the
price at which the share is quoted in the market. Potential owners
of shares as well as existing owners of shares are interested in the
quoted price of a company’s share and in the return obtainable
from that investment. How and why those returns and share prices
can be influenced will be covered later. The extent of a country’s
capital markets, of which the stockmarket is but a part, vary
enormously from the very large, very sophisticated, very structured
markets such as London and New York to some of the very small
nascent markets in some developing countries in Africa and the
Middle East.
Each country has its own sets of laws and regulations which
provide the parameters for the structure of the entity and how it
can operate on a daily basis.

Organisational forms of business

Businesses established for profit-making purposes generally are
organised into one of two forms: incorporated and un-incorporated.
The incorporated firm are the companies or corporations, while the
un-incorporated are either proprietorships or partnerships.
The corporation or company is a legal entity of unlimited life,
independent of its owners. The owners of a company, its
shareholders, have limited liability for the debts and obligation of
the company. The liability being limited to the par or nominal value
of the shares or equity held. With ownership usually comes some
form of control through voting rights, but this does not extend to
managerial control of day to day operations. For that, management,
by way of directors, have to be appointed to act as the shareholders’
agents. Therefore, in theory, ownership and management are likely
to be separate, unless of course managers are also major
shareholders.
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The unincorporated form of business make up the majority of the

numbers of businesses, though not the majority in terms of value or
employment. These businesses are generally sole proprietorships or
partnerships. The liability of the owners of these entities is
unlimited. They are managed by the owners and do not have a
separate legal entity even though they may have a separate trading
name. Ownership and management risks are intertwined which
makes raising very large sums of capital almost impossible. If the
owner/partners want the entity to continue to grow then usually a
change in form for the entity will be necessary. In this subject guide
we will be viewing financial management from the perspective of a
corporate entity, but much of what is covered is also relevant to the
unincorporated business.

Corporate objectives
Generally we assume that a company’s objective is to increase the
value of the shareholders’ investment in the firm. We also assume
that all managers act to further that objective. Shareholder wealth
maximisation is the normative objective of a company that
underlies financial management theory.
In practice, a company has many stakeholders, employees,
customers, government, creditors, lenders as well as shareholders.
As groups they have their objectives for the company and as
individuals they have their own objectives for their stake in the
company. Some of these individual objectives may be at slight
variance with the others, for example, customers want the company
to provide the product with the highest quality and lowest price,
but this may not result in high profits and share price
maximisation. Corporate objectives are determined by a relatively
small group of senior management, probably the directors. These
can be influenced by a number of things with an outcome which
may not be shareholder wealth maximisation, and which can be
allowed to vary with circumstances and over time. It is often
argued in the UK financial press that though companies may be
trying to increase shareholder wealth it is not with a long-term
perspective but is only short-term oriented.

Activity 1.1
Consider the stakeholders of a business as described earlier.
Try to list what you believe are the major objectives of each group. There
may be two, three or more for each group.
Then try to rank each group’s objectives in order of importance.
Now draft your reasons for your rankings.
Next assume you are the Board of Directors and you are required to publish
the company’s objective(s).
Which one(s) would you list and why? Do they all directly or indirectly lead
to shareholder wealth maximisation?

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Your lists could be based upon the company(s) you know or work for. Do not be
surprised by the differences and variations, and do not forget the power of the
financial market place in steering you towards your final selection.
 See VLE for solution

Role of managers
A company is a complex organisation made up of many employees
each with their own objectives. In theory, the manager is expected
to act in furtherance of the goals of the owners. The financial
manager is expected to act as the intermediary who will undertake
the tasks of financial management. That is, the manager, using the
evaluation, planning and control techniques and systems, will
attempt to maximise the return from the optimal selection of
investments so as to satisfy the providers of finance from whom
(s)he has obtained the cheapest and best combination of funds via
the capital markets. However, managers may not be owners.

Conflicts of interest and their resolution

One of the major disadvantages of the corporate form is the
separation of management and ownership. This separation can
create costs which have been called the costs of agency since
management is deemed to be the agent of the owners (the
principals). Agency theory attempts to explain this situation and
how conflicts between principal and agent can arise, as well as
possible ways in which the costs of any such conflict can be
minimised. It is argued that agents will tend to pursue their own
goals and the greater the deviation of those goals from the
corporate goals, the greater the agency costs. Therefore incentives
should be provided to try to ensure convergence of goals between
principal and agent (e.g. share option schemes). Systems should be
used to monitor and ensure control of agents, for example use of
annual reports, the setting up of an appropriate governance
structure which restricts, minimises and hopefully enables the
removal of management, and in particular directors, who abuse
their powers and who are therefore not attempting to ensure the
company achieves its goals.

Corporate governance
The essence of the corporate governance debate is the effects of the
particular relationship between directors and shareholders. The
greater the separation between the two, the greater the potential
for abuse and also the greater the possibility of suboptimal
behaviour by managers as viewed by shareholders. At present in
the UK there is a voluntary system of governance in place. The
framework has evolved through, or been impacted upon, by six key
reports starting with the Cadbury report in 1992. The various
recommendations of these reports have been incorporated into the
combined code which is included in the Listing Rules of the London
Stock Exchange as an appendix. The rules require a company to
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make a disclosure statement in its annual report about its

compliance with the combined code. Though not legally
enforceable, the regulations require compliance and provide for
penalties. Different corporate structures, business, legal and social
environments require different governance requirements and
systems. All this is important because it highlights the differences
between the normative theory and the practical application.

Financial management and risk

Since financial management is concerned with making decisions,
and decision making is concerned with the future and the future is
uncertain, risk must be a major factor in all aspects of financial
management. Risk may be defined as the extent to which what we
estimate will happen in the future may or may not happen. If there
is only one single possible outcome, there is no risk. If there are
many possible outcomes and many of them are very different from
our estimate of the outcome, then there is a lot of risk.
Broadly speaking, both theory and practice show us that risk and
return are correlated. We seek higher expected returns for investing
in riskier projects. Where we perceive little risk (e.g. an investment
in government securities), we are prepared to accept relatively
small returns.

Activity 1.2
Choose a few practical situations where a business faces the effect of risk,
(e.g. projecting next year’s sales budget or evaluating a new investment
proposal).
Try to identify the causes of that riskiness.
Then think of ways to try to measure it and ways to control it.
 See VLE for solution

Financial management and accounting

Financial management is not the same as, or even a
branch of, accounting.
Accounting has been defined as:
the process of identifying, measuring and communicating economic
information to permit informed judgements and decisions by users
of the information. (American Accounting Association).

Given this definition, it is clear that financial managers will be

major users of accounting information.
Those who work as financial managers may very well have a
background in accounting. In many small businesses one person
combines the roles of accountant and financial manager. Despite
these facts, the role of the accountant and that of financial manager
are distinctly different. The accountant is concerned with the
provision of information: financial managers use information

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supplied by the business’s accounting system and other sources to

help them to make financing and investment decisions.

Financial management and taxation

Virtually all decisions taken by financial managers have tax effects.
In the UK, for example, the tax treatment of loan interest is
different from that of dividends paid to shareholders. Therefore the
decision between raising funds from shareholders and from lenders
has tax implications. Returns from investments made by the
business (i.e. profits) are taxed. It is not one of the objectives of this
unit to turn you into an expert on the UK tax system. It is
important, however, that you have a broad appreciation of the
major aspects of the UK tax system, which has much in common
with the tax systems which prevail in other of the world’s countries.

Activity 1.3
Think of similarities and differences between the UK tax systems and another
country you are familiar with. Are there any major differences in the corporate
taxation system?

; A reminder of your learning outcomes

By the end of this chapter, and having completed the essential
reading and activities, you should be able to:
describe the general financial environment in which
corporations operate
explain the importance and roles of financial markets
list/outline the roles financial managers can have within an
organisation
outline such things as taxation, accounting information and
form of business and their implications for financial
management
give examples of the various objectives a company may have
and why the main objective is deemed to be shareholder
wealth maximisation
explain and give examples of how the influence of risk will
permeate all aspects of financial management, the theories
presented, the appraisal and selection, the changes suggested,
and the control methods used.

Practise questions
1. Consider what objectives might be important to a company
other than shareholder wealth maximisation. Describe these
objectives and show how there may or may not be consistency
between the different objectives. Discuss the implications of
your findings.

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2. How might a manager’s objectives differ from those of the

company? What are the implications for corporate policies in
order to ensure congruence between the sets of objectives?

Problems
In BMM, attempt the following problems:
Chapter 1, p. 23, numbers 2, 5, 7, 8 and 9
Chapter 2, pp. 44 and 45, numbers 4, 10 and 17
Chapter 3, p. 65, numbers 2, 3 and 4.

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