1-1

CHAPTER 1Introduction to Financial Management

What is Finance? Goals of the Corporation Conflicts Between Managers and

Shareholders Stock Prices and Intrinsic Value Describe the managerial finance

function Forms of Businesses

1-2

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.

1-3

Corporate Organization

1-4

Major Areas & Opportunities in Finance: Financial Management Financial Management is concerned

with the duties of the financial manager in the business firm.

The financial manager actively manages the financial affairs of any type of business, whether private or public, large or small, profit-seeking or not-for-profit.

They are also more involved in developing corporate strategy and improving the firm’s competitive position.

1-5

Responsibility of the Financial Staff

Forecasting and planning Investment and financing decisions Coordination and control of Working

capital Transactions in the financial markets Dividend Policy Managing risk

Financial Management for the Hospitality industry by Andrew, Damitio & Schmidgall ( 2005)

1-6

Financial Goals of the Corporation

The primary financial goal is shareholder wealth maximization, which translated from stock price maximization.

1-7

Financial Goals of the Corporation

Renong Corporation- RM 2.25/ shares

- An individual owns 1,000 Unit of shares

- Total Wealth :RM2.25 x 1000 Unit

= RM2,250

1-8

Financial Goals of the Corporation

Investor’s Wealth Maximization

t0 = RM2.25/shares – Investor’s wealth RM2,250

t1 = RM3.75/shares – Investor’s wealth RM3,750

1-9

Factors that affect stock price

Projected cash flows to shareholders

Timing of the cash flow stream

Riskiness of the cash flows

A. Projected of cash flows to shareholders

1-10

Capital gain

Dividend

Purchase shares @ RM2.25/shares

Sell shares @ RM3.75/ shares

Capital gain: RM3.75-2.25 =RM 1.50/

shares

i.e: RM0.02 for every share owned1,000 units x RM0.02 = RM20

-Net income to be distributed to shareholders

-Profit Dividend Projected cash

flows to s/holdersshare price wealth maximization

materialize

B. Timing of the cash flow stream

Investors expect consistency in the cash flows to be received

ie. dividend payment

1-11

C. Riskiness of the cash flows Must reduce the possibilities of interruption

on the cash flows Possibility of interruption may arise due to

mismanagement in the company

Mismanagement Profit Dividend Stock price Wealth maximization

1-12

Organization structure

1-13

1-14

Conflicts Between Managers and Stockholders

Managers are naturally inclined to act in their own best interests (which are not always the same as the interest of stockholders).

This give rise to Agency Problem

Example of Agency problem

1-15

CEO “Denise” spent more than $2m of company money on his wife’s

birthday

Reduce profit

Reduce dividend

Reduce expected cash flow

Reduce wealth maximization

Source of Conflicts Between Managers and Stockholders

1-16

CEO

SalaryRM1.2m/ year

Company’s No. of shareholdersprofit (t=1) = 100 individualRM 10m/ yr = RM100,000/

individual

Company’s profit (t=2)After new strategy

RM30m/ yr = RM300,000/ individual

1-17

How minimize agency problem

Managerial compensation plans Bonus Options Stock Options

Direct intervention by shareholders The threat of Firing

1-18

Stock Prices and Intrinsic Value

In equilibrium, a stock’s price should equal its “true” or intrinsic value.

Stock Prices and Intrinsic Value

1-19

Stock Prices

Projected cash flows

Supply & demand for the shares

Intrinsic valueMarket price(Quoted)

“Market = Intrinsic” price value

Stock Prices and Intrinsic Value

1-20

1-21

Financial Goals of the Corporation

Is stock price maximization good or bad for society?

Should firms behave ethically?

Should firms behave ethically

Desperate attempt to maximize stock price may lead to:

1. Window dressing2. Earning management

1-22

Example An asset should be depreciated for 5 years,

but instead it was depreciated over a 10 years life (i.e: Asset value= RM10m)

-If 5 years total depreciation expense RM2m/yr

-If 10 years total depreciation expense RM1m/yr

1-23

1-24

Depreciationexpense

5 years(RM2m/yr)

10 years(RM1m/ yr)

Net Income Net Income<

Example 2 & 3 Goods ordered but not shipped

A company considers goods that have been ordered but not yet shipped to be part of revenue earned.

Extended reporting period Companies try to meet revenue expectations by

keeping their books open for few days- even a few weeks into the next reporting period in order to generate last minute sales revenues

1-25

1-26

Alternative Forms of Business Organization Proprietorship Partnership Corporation

1-27

Proprietorships & Partnerships Advantages

Ease of formation Subject to few regulations Confidentiality

Can limit the amount of information that they must file. ie. can leave their competitors guessing.

Flexibility Family member can easily decide how much

they want to pay for one another without having to worry about shareholders scrutinity

1-28

Proprietorships & Partnerships Disadvantages

Difficult to raise large sums of capital Because a private company do not sell

shares or issue bonds to the public, it spends a lot more of time finding investors who are willing to risks their funds

Sometimes difficult to find potential investors to invest in the company that have the same vision.

Unlimited liability

1-29

Corporation Advantages

Unlimited life Easy transfer of ownership Limited liability Ease of raising capital

Disadvantages Double taxation Cost of set-up and report filing