Chapter 1 - Intro to Financial Management

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Faizal Basri

UiTM Shah Alam, 2011

CHAPTER 1:INTRODUCTION TO

FINANCIAL MANAGEMENT1.1 Financial markets and business organisation

1.2 Goals of a firm

1.3 Functions of a financial manager 1.4 Risks and return relationship

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1.1 Financial markets and business

organisation What is finance?

Finance can be defined as the ³art and science of

managing money´ (Gitman, 2009).

To obtain and allocate financial resources effectivelyand efficiently

Maintenance and creation of economic value and

wealth.

Integrate with other department (i.e.. Marketing,operations).

Deal with financial decision (e.g. new product, new

asset, borrowing, issue stocks & debts).

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organisation Finance is concerned with the process, institutions,

markets and instruments involved in the transfer of

money among individuals, businesses and

governments. Those who work in non-financial jobs will benefits by

being able to interact effectively with the firm¶s financial

personnel, processes, and procedures.

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organisationFinancial institutions

An intermediary that channels the savings of individuals,

businesses and governments (depositors) into loans or

investments.

Financial markets

Forums in which suppliers of funds and demanders of funds can

transact business directly.

Two key financial markets; money market and capital market

1. Money market Where short term debt and marketable securities are traded.

2. Capital market

Involving transactions in long term securities (bonds and stocks).

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organisationTypes of financial market

1. Primary market: for new issues of shares

2. Secondary market (second-hand market): Increases liquidity of shares

Generates pricing information

Barometer of corporate performance

3. Stock exchange market

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organisationLegal forms of business organisation

1. Sole proprietorships

A business owned by one person and operated for his or her own profit.

Easy to set up.

2. Partnerships

A business owned by two or more people and operated for profit.

May operate under different degrees of formality, ranging from informal,

oral understandings to formal agreements.

3. Corporations

A legal entity created by state, separate and distinct from its owners and

managers, having unlimited life, easy transferability of ownership, and

limited liability.

A business entity with a legal rights as a person.

Two types; private limited and public limited.

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organisation

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PART 1: INTRODUCTIONTO FINANCIAL

MANAGEMENT

1.2 Goals of a firm

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1.2 Goals of a firm

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1.2 Goals of a firm

1. Shareholder wealth maximisation

The primary goal for management decisions; considers the risk

and timing associated with expected earning per share in order

to maximise the price of the firm¶s common stock.2. Corporate governance

The system used to direct and control a corporation.

Defines the right and responsibilities of key corporate

participants, decision-making procedures, and the way in which

the firm will set, achieve, and monitor its objectives.

3. Social Responsibility

The concept that businesses should be actively concerned with

the welfare of society at large.

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MANAGEMENT

1.3 Functions of a financial manager

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The financial managers¶ responsibilities

1. Forecasting and planning

Coordinate the planning process which involve interacting with

other departments as they look ahead and lay the plans that willshape the future of the firm.

2. Major investment and financing decisions

Must help to determine the optimal sales growth rate, help decide

what specific assets to acquire, and then choose the best way to

finance those assets.3. Coordination and control

Must interact with other personnel in order to ensure that the firm is

operated as efficiently as possible.

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4. Dealing with the financial markets Each firms affects and is affected by the general financial markets

where funds are raised, where the firm¶s securities are traded, andwhere investors either make or lose money.

5. Dividend policy To decide whether to distribute the profit to the shareholders or

to retain the profit in the business itself.

6. Risk management Responsible for the firm¶s overall risk management programme,

including identifying the risks that should be managed and thenmanaging them in the most efficient manner.

E.g. managing risks of fire and natural disasters by purchasinginsurance, or managing the uncertainties in commodity and securitymarkets, volatile interest rates and fluctuating in foreign exchangerate by hedging in the derivatives market.

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MANAGEMENT

1.4 Risks and return relationship

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1.4 Risk and return relationship

Risk defined as the chance of financial loss or more formally,

the variability of return associated with a given asset. E.g. if

you forecast that your company will get RM1,000,000 of

profits next year and due to the presence of risk, you mayfind that the actual income will be less than expected.

Risk refers to the possibility that actual outcome may differ

from expected outcome.; measured by standard deviation.

Two types of risk:1. Systematic risk

2. Unsystematic risk

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Systematic risk

Is non-diversifiable risks that cannot be eliminated no

matter how many securities are held in investment

portfolio.. These risk occur outside the company (external) and

beyond the financial manager¶s control.

Types of systematic risks:

1. Market risk2. Interest rate risk

3. Purchasing power risk

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1. Market risk

It is the result of investors¶ expectation towards the price

of the company's securities in the market, or the

consumers

expectation towards the price of thecompany's products in the market.

E.g. if the investor expects that the price of the

company's shares to go up in the near future, he or she

will buy the shares now in expectation of higher return.

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2. Interest rate risk

Interest rate is the price mechanism for supply and

demands for funds in the market, and therefore any

fluctuations or movements in the current interest raterepresent risk to both investors and firms alike.

Higher interest rate will increase the interest expense

and hence, lowering the company's profit and reduce

the value of return received by investors.

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3. Purchasing power risk

This risk relates to the increasing inflation rate; that is

the purchasing power of the consumers will decline due

to rapid increase in prices. It will lead to lower sales for the company as well as the

profits, especially those that are dealing with non-

durable goods.

The effect will be lesser on companies that produce

basic needs products, e.g. food and drinks compared to

luxury goods.

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Unsystematic risk Is a diversifiable risk that is unique only to a particular

company.

These are the risks that occur inside or within thecompany and thus within the financial manager¶scontrol.

This type of risk cannot be eliminated but can bereduced to some extent with proper mixture of securities

in the investment portfolios. Types of unsystematic risk:

1. Business risk

2. Financial risk

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1. Business risk

Risks are caused by mismanagement of the

company's asset.

A normal company may comprise of several

departments, such as the personnel, marketing,

production, and etc.

All these departments must be able tocooperate with each other in order for the

company to achieve its stated objectives.

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1. Business risk (cont.)

A failure to manage any of the assets and/ or one of

the departments in the company will lead to lower

performances and hence lower profits.E.g. if the management of the production department

is poor, the output produced by the company will

decrease.

This leads to lower sales and consequently lower profits.

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2. Financial risk

This is cause by improper financing mix used bythe company to finance its investment activities.

E.g. if the firm depends too much on debts, it willhave to incur higher amount of interest expensesand increase the firm's risks of insolvency.

The company is perceived to be highly risky byinvestors if the company has too much fixed

obligations of principals and interest payments ondebt.

This leads to future difficulty in the event that thecompany is trying to raise more funds externally.

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Return defined as the total gain or loss experience on an

investment over a period of time.

The payoff from an investment or effort for foregoing current

consumption.

Investors require increasing compensation (return) for taking on

increasing risk.

Return on an investment can be measured over a standard period,

i.e. one year which represents the annual rate of return.

Shareholder return is annual dividend (D1) plus share price

increase (P1 ± P0).

Relative return in percentage terms is

100 x [(P1 ± P0) + D1]/P0; total shareholder return.

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It is logical to take account of the riskiness of projects/funds/companies. A risk

premium is added to the risk-free rate to derive the appropriate rate of return. A

higher return will normally be expected from projects where the risks are higher.

Thus, the riskier the project, the higher the risk premium.

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Chapter 1 - Intro to Financial Management

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