Advanced Financial Management
Lecture 1
Introduction to Financial Management
Course leader : Million Gizaw (Assistant
professor)
Learning Goals
LG1 Define finance and the managerial finance
function.
LG2 Describe the legal forms of business organization.
LG3 Describe the goal of the firm, and explain why
maximizing the value of the firm is an appropriate
goal for a business.
Learning Goals (cont.)
LG4 Describe how the managerial finance function is
related to economics and accounting.
LG5 Identify the primary activities of the financial
manager.
LG6 Describe the nature of the principle-agent
relationship between the owners and managers
of a corporation, and explain how various
corporate governance mechanisms attempt to
manage agency problems.
What is Finance?
• Finance can be defined as the science and art of
managing money.
• At the personal level, finance is concerned with
individuals’ decisions about:
• how much of their earnings they spend
• how much they save
• how they invest their savings
• In a business context, finance involves:
• how firms raise money from investors
• how firms invest money in an attempt to earn a profit
• how firms decide whether to reinvest profits in the
business or distribute them back to investors.
Career Opportunities in Finance:
Financial Services
• Financial Services is the area of finance
concerned with the design and delivery of advice
and financial products to individuals, businesses,
and governments.
• Career opportunities include:
• banking
• personal financial planning
• Investments
• real estate
• insurance
Career Opportunities in Finance:
Managerial Finance
• Managerial finance is concerned with the duties
of the financial manager working in a business.
• Financial managers administer the financial
affairs of all types of businesses—private and
public, large and small, profit-seeking and not-for-
profit. Tasks include:
• developing a financial plan or budget
• extending credit to customers
• evaluating proposed large expenditures
• raising money to fund the firm’s operations.
Career Opportunities in Finance:
Managerial Finance (cont.)
• The recent global financial crisis and subsequent
responses by governmental regulators, increased
global competition, and rapid technological change
also increase the importance and complexity of the
financial manager’s duties.
• Increasing globalization has increased demand for
financial experts who can manage cash flows in
different currencies and protect against the risks
that naturally arise from international transactions.
Legal Forms of Business Organization
• A sole proprietorship is a business owned by one
person and operated for his or her own profit.
• A partnership is a business owned by two or more
people and operated for profit.
• A corporation is an entity created by law.
Corporations have the legal powers of an individual
in that it can sue and be sued, make and be party
to contracts, and acquire property in its own name.
Table 1.1 Strengths and Weaknesses of the
Common Legal Forms of Business Organization
Figure 1.1 Corporate Organization
Table 1.2 Career Opportunities in
Managerial Finance
Goal of the Firm:
Maximize Shareholder Wealth
• Decision rule for managers: only take actions that
are expected to increase the share price.
Figure 1.2 Share Price Maximization Financial decisions and
share price
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
Goal of the Firm:
What About Stakeholders?
• Stakeholders are groups such as employees,
customers, suppliers, creditors, owners, and others
who have a direct economic link to the firm.
• A firm with a stakeholder focus consciously avoids
actions that would prove detrimental to
stakeholders. The goal is not to maximize
stakeholder well-being but to preserve it.
• Such a view is considered to be "socially
responsible."
The Role of Business Ethics
• Business ethics are the standards of conduct or
moral judgment that apply to persons engaged in
commerce.
• Violations of these standards in finance involve a
variety of actions: “creative accounting,” earnings
management, misleading financial forecasts, insider
trading, fraud, excessive executive compensation,
options backdating, bribery, and kickbacks.
• Negative publicity often leads to negative impacts
on a firm
The Role of Business Ethics: Considering
Ethics
• Robert A. Cooke, a noted ethicist, suggests that the
following questions be used to assess the ethical
viability of a proposed action:
– Is the action arbitrary or capricious? Does the action
unfairly single out an individual or group?
– Does the action affect the morals, or legal rights of any
individual or group?
– Does the action conform to accepted moral standards?
– Are there alternative courses of action that are less likely to
cause actual or potential harm?
The Role of Business Ethics:
Ethics and Share Price
• Ethics programs seek to:
– reduce litigation and judgment costs
– maintain a positive corporate image
– build shareholder confidence
– gain the loyalty and respect of all stakeholders
• The expected result of such programs is to
positively affect the firm’s share price.
Managerial Finance Function
• The size and importance of the managerial finance
function depends on the size of the firm.
• In small firms, the finance function is generally
performed by the accounting department.
• As a firm grows, the finance function typically
evolves into a separate department linked directly
to the company president or CEO through the chief
financial officer (CFO) (see Figure 1.1).
Figure 1.1 Corporate Organization
Managerial Finance Function:
Relationship to Economics
• The field of finance is closely related to economics.
• Financial managers must understand the economic
framework and be alert to the consequences of
varying levels of economic activity and changes in
economic policy.
• They must also be able to use economic theories as
guidelines for efficient business operation.
• marginal cost–benefit analysis
Managerial Finance Function:
Relationship to Economics (cont.)
• Marginal cost–benefit analysis is the economic
principle that states that financial decisions should
be made and actions taken only when the added
benefits exceed the added costs
Managerial Finance Function:
Relationship to Accounting
• The firm’s finance and accounting activities are
closely-related and generally overlap.
• In small firms accountants often carry out the
finance function, and in large firms financial
analysts often help compile accounting information.
• 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.
Managerial Finance Function:
Relationship to Accounting (cont.)
• Whether a firm earns a profit or experiences a loss,
it must have a sufficient flow of cash to meet its
obligations as they come due.
• The significance of this difference can be illustrated
using the following simple example.
Managerial Finance Function:
Relationship to Accounting (cont.)
The Nassau Corporation experienced the following
activity last year:
Sales: $100,000 (100% still uncollected)
Costs: $80,000 (all paid in full under supplier terms)
Managerial Finance Function:
Relationship to Accounting (cont.)
Now contrast the differences in performance under
the accounting method (accrual basis) versus the
financial view (cash basis):
Managerial Finance Function:
Relationship to Accounting (cont.)
Finance and accounting also differ with respect to
decision-making:
– Accountants devote most of their attention to the collection
and presentation of financial data.
– Financial managers evaluate the accounting statements,
develop additional data, and make decisions on the basis
of their assessment of the associated returns and risks.
Financing Activities
• Financing decisions determine how the firm raises
money to pay for the assets in which it invests. One
way to visualize the difference between a firm’s
investment and financing decisions is to refer to the
balance sheet shown in Figure 1.3.
– Investment decisions – left side
– Financial decision – right side
• Keep in mind, though, that financial managers make
these decisions based on their impact on the value
of the firm
Figure 1.3
Financial Activities
Governance and Agency:
Corporate Governance
• Corporate governance refers to the rules,
processes, and laws by which companies are
operated, controlled, and regulated.
• It defines the rights and responsibilities of the
corporate participants such as the shareholders,
board of directors, officers and managers, and other
stakeholders, as well as the rules and procedures
for making corporate decisions.
• The structure of corporate governance was
previously described in Figure 1.1.
Governance and Agency:
Individual versus Institutional Investors
• Individual investors are investors who own
relatively small quantities of shares so as to meet
personal investment goals.
• Institutional investors are investment
professionals, such as banks, insurance companies,
mutual funds, and pension funds, that are paid to
manage and hold large quantities of securities on
behalf of others.
• Unlike individual investors, institutional investors
often monitor and directly influence a firm’s
corporate governance by exerting pressure on
management to perform or communicating their
concerns to the firm’s board.
Governance and Agency:
Government Regulation
• Government regulation generally shapes the
corporate governance of all firms.
• During the recent decade, corporate governance
has received increased attention due to several
high-profile corporate scandals involving abuse of
corporate power and, in some cases, alleged
criminal activity by corporate officers.
Governance and Agency:
The Agency Issue
• A principal-agent relationship is an arrangement
in which an agent acts on the behalf of a principal.
For example, shareholders of a company
(principals) elect management (agents) to act on
their behalf.
• Agency problems arise when managers place
personal goals ahead of the goals of shareholders.
• Agency costs arise from agency problems that are
borne by shareholders and represent a loss of
shareholder wealth.
The Agency Issue: Management
Compensation Plans
• In addition to the roles played by corporate boards,
institutional investors, and government regulations,
corporate governance can be strengthened by
ensuring that managers’ interests are aligned with
those of shareholders.
• A common approach is to structure management
compensation to correspond with firm performance.
The Agency Issue: Management
Compensation Plans
• Incentive plans are management compensation
plans that tie management compensation to share
price; one example involves the granting of stock
options.
• Performance plans tie management
compensation to measures such as EPS or growth in
EPS. Performance shares and/or cash bonuses are
used as compensation under these plans.
The Agency Issue: The Threat of Takeover
• When a firm’s internal corporate governance
structure is unable to keep agency problems in
check, it is likely that rival managers will try to gain
control of the firm.
• The threat of takeover by another firm, which
believes it can enhance the troubled firm’s value by
restructuring its management, operations, and
financing, can provide a strong source of external
corporate governance.
Self-Assessment question s
• What is finance? Explain how this field affects all the activities in
which businesses engage.
• Which legal form of business organization is most common? Which
form is dominant in terms of business revenues?
• What is the goal of the firm and, therefore, of all managers and
employees? Discuss how one measures achievement of this goal.
• For what three main reasons is profit maximization inconsistent with
wealth maximization?
• In what financial activities does a corporate treasurer engage?
• What are the major differences between accounting and finance with
respect to emphasis on cash flows and decision making?
• What are the two primary activities of the financial manager that are
related to the firm’s balance sheet?
• Define agency problems, and describe how they give rise to agency
costs. Explain how a firm’s corporate governance structure can help
avoid agency problems.
End of lecture one
