finance management fin420chp 1

Introduction to Corporate Finance Chapter 1

1 | P a g e

Today, corporate finance managers must make

decision in a much more coordinated manner and

generally has direct responsibilities for a control

process. Because there are financial implications in

virtually all segments of business, she/he must have

knowledge of finance to work these sufficient

implications into the area

Learning objectives

After learning this chapter, you should be able to:

1. Understand the nature of corporate finance.

2. Understand financial management framework.

3. Identify the basic corporate finance goals.

4. Objectives and functions of corporate finance.

Introduction to

Corporate Finance

GOAL

Chapter 1 Introduction to Corporate Finance

2 | P a g e

1.0 INTRODUCTION Finance is the science of management of money and other assets. Therefore, if you think

that finance is about money and how to make profit especially when you running your own

business. Then, you are partly right as finance is much more than that. The understanding of

financial theories and practices are the essential elements in developing an effective and

efficient decision to meet the organizational goals and objectives. Even if you are not

managing any formal organization, the knowledge of finance is applicable in most of our day-

to-day decision making because modern economy cannot strive without the element of

money.

1.1 THE SCOPE AND NATURE OF CORPORATE FINANCE

Corporate finance involves in the management of the firm's resources to its full potential to

provide maximum benefits to the owners or the stockholders. It deals with:

“An attempt to obtain and allocate financial resources effectively and efficiently to achieve the firm's objective; that is to maximize the shareholders' wealth by maximizing share price.”

Thus, it represents a continuous process that focuses on accumulation and allocation of

scarce resources to generate revenues to fulfill the motive of establishing the business in the

first place; that is to get profits. The definitions also introduce the concept of wealth

maximization as the focus of decision-making that differs to some extends with maximization

of profits.

As a profit seeking entity, business organizations exist to produce goods and services

efficiently; and satisfy customers’ demands at a profit. The organization is therefore must:

1. Acquire or invest in real assets for the purpose of productions,

2. Search for ways and means to pay or finance them, and

3. Manage its day-to-day activities in production and distributions of goods and

services.

They will continue to do so to ensure the firm is properly managed and remains as a viable

entity in the market place. This is what corporate finance is all about, that is the acquisition

and allocation of firm’s resources to maintain and create wealth through present and


3 | P a g e

potential activities. Thus, the study of corporate finance deals with trying to provide answers

concerning:

1. What long-term investment (assets) should the firm make? Investment decisions or

asset allocation.

2. Where will the firm get the funds or capital (debt and equity) to finance the

investment? Financing decisions or acquisition of resources.

3. How will then firms manage the short-term assets and liabilities? Working capital

management.

Figure 1-1 outlined essential functions of corporate finance that directly provides answers to

capital budgeting question, the capital structure question, and the net working capital

question.

Figure 1-1 Financial Management Framework

External environment

Investment decision

Asset structure

Business risk

Financial consideration and decisions

Total risk

Share price

Returns

Financing decision

Financial structure

Financial risk

Internal Environment

Market or investors’ feedback

1.2 CORPORATE FINANCE GOALS The development of the firm's primary financial goal is in line with the above financial

management concept as presented in Figure 1-1; that is:

“To make and execute decisions that provides maximum benefits to the owners or shareholders by maximizing owners' wealth through share price maximization.”

The above statement seems to deviate main motive of business enterprise to gain maximum

profits. This leads to the basic differentiation between wealth maximization and profit

maximization approach. There are several arguments of why getting as much profit as


4 | P a g e

possible will not ensure the firm's viability in the long-term. In contrast to wealth

maximization, the profit maximization holds on to the following views in term of:

1. Time Horizons. It focuses on short-term benefits and tries to gain as much profit as

possible regardless of the long-term effects.

2. Timing of Returns. It does not consider the timing of returns and thus time value of

money.

3. Distributions of Income. It tends to ignore the owners wish to receive a portion of

earnings in the form of dividends.

4. Risk. It gives less consideration to risk in an attempt to maximize profits, as higher

risks will associate with higher return.

Other goals of the firm are essential to be stated to avoid any misunderstanding. In order to

achieve wealth maximization, the following goals are essentials:

1. Maximization of profits. To make profits is essential to provide stability and growth

in operations and rewards to individuals and institutions that contribute to the firm. It

is essential, however to consider the above constraints and the risk of making a

decision that is higher risk relates to higher return.

2. Maximization of sales. The efforts to maximize sales are in line with the effort to

maximize profits. Higher sales volume represents higher market control and would

ultimately increase profit.

3. Minimization of risk. The risk will act, as a control factor in maximization of profits

that is the firm should only venture in activities that provide profits more than

associated risks.

4. Maximization of share price. By keeping other factors constant, an increase in the

profits coupled with appropriate risk will lead to an increase in the market value of the

firm's common stock. Therefore, it is essential for the firm to maximize profits and

minimize risks simultaneously.


5 | P a g e

The maximization of share price in reality not only depends on the profits and risks

associated with the firm as shown in Figure 1-1. A firm's stock price is generally dependent

upon:

1. External environments. These represent factors that are beyond the control of the

financial manager such as level of economic activity and taxes, general stock market

conditions, political and legal framework, and social values.

2. Strategic policy decisions. It represents the policy arms of the firm that will guide

the operations of the company and how it is managed. It will directly affect the

availability of internal resources to support the firm's activities, especially in financing

and investment decisions in an effort to achieve its stated goals.

3. Expected profitability and degree of risk. Any actions taken by the firm will lead to

certain level of expected return and risks. This will directly influence the market share

price as investors will continuously analyze and judge whether to purchase or not to

purchase the firm's share in the market. The supply and demand for the shares in the

market tends to influence the share price directly.

The approach to maximize wealth seems to show that management acts to maximize its

own welfare. Is this true? In most cases however, those actions that maximize the share

price are the same actions that benefit the society in general. For example, to achieve its

goals, the firm will (1) require efficient and low cost operations; (2) develop new

technologies, products and jobs; and (3) require efficient and courteous customer service. All

these actions will benefit the society as a whole in the long-term.

1.3 THE FUNCTIONS OF THE FINANCIAL MANAGER

In the efforts to achieve the firm's goal, financial managers in reality have no free reign in

decision-making and in carrying out their duties and responsibilities. Several internal and

external constraints are at times beyond their control that they must observe. The financial

manager must continuously develop plans, monitor, and control the activities in consistent

with the achievement of the firm's short- and long-term objectives to ensure the attainment of

wealth maximization goal. The responsibilities include forecasting and planning, investment

decisions, financing decisions and dealing with the capital markets.


6 | P a g e

1.3.1 Forecasting and Planning

The financial manager must work closely with other departments and

executives to guide and ensure the firm's growth and future viability is in line

with the stated goals. It is necessary to develop plans and strategies to

influence the future outcomes and at the same time forecast the expected

outcome of the present day decisions. In other words, it involves the

questions of:

1. What the firm is aiming to do?

2. How it proposes to do it?

3. When to do it?

4. What is the impact on the firm’s performance in future?

1.3.2 Investment Decisions

The investment decisions concerned with decisions regarding the firm's asset

or asset structure. It concerns with the determination of the appropriate mix in

the asset structure held by the firm, that is:

1. Determining the appropriate Ringgit to be invested in current assets

versus fixed assets,

2. Determining the optimal levels of investment in each type of current

assets, and

3. Recommending the acquisition new assets and disposal of existing

fixed assets.

The decisions on asset structure will directly influence the firm's size, growth,

and profitability. Consequently, it will determine the level of business risk, the

risk involved in dealing in any business activities that arises from the nature of

the business itself, and the returns that the firm could generate from

investments.


7 | P a g e

1.3.3 Financing Decisions

The financing decisions will support the needs of the firm by accumulating

funds through a desirable combination of debt and equity financing; which

determines the firm's financial structure. It involves the determination of:

1. Appropriate mix of short-term and long-term source of funds for

financing,

2. Appropriate source of funds for specific investment in asset structure,

and

3. Appropriate dividend policy to ensure the availability of internally

generated funds for reinvestment.

These decisions will consequently influence the level of financial risk that is

the risk inherent in using a particular source of funds to finance the asset

base of the firm. It will also determine the level of financing cost that will

consequently determine the returns that the firm could generate.

1.3.4 Dealing with the Financial Markets

In order to execute their duties, the financial managers must deal with the

money and capital markets for financing and investment purposes. The two

essential responsibilities of the financial manager are investment and

financing decisions. Both investments and financing decisions affect the

firm's risk and return as manipulated by the management and as perceived

by the investors in the market place.

Thus, it directly influences the share price and hence the owner's wealth. In

turn, the share price movement will indicate investors' responses on the

decisions made. These responses will give management necessary

information and indication of approvals from stockholders as a reference for

controlling and developing plans to reinforce or rectify current or expected

performance.


8 | P a g e

1.3.5 Dividend Policy

Another issue concerning the firm's financing and investment decisions worth

mentioning is the dividend policy. It has considerable importance to common

stockholders as it directly influences the amount of earnings available to

common stockholders that will be distributed as cash dividends and retained

earnings. In the event that the firm decided to give higher dividends or higher

dividend payout ratio, there will be less internally generated funds provided

through retained earnings to finance the company's operations.

Therefore, the company has to rely more on external financing that are more

expensive than internally generated funds. This represents a financial

decision tradeoff; that is to satisfy the needs of common stockholders for

dividends or the needs of the firm to reinvest the funds back in the company

to finance its operations. The dividend policy in essence is influenced by

several factors such as the needs of the stockholders, funds requirements,

growth rate of the company and liquidity of the firm that need to be

considered explicitly.

Role of the financial manager has gone through dramatic changes over the

years.

Financial managers must make decisions concerning the investment,

financing and management of the company’s assets.

The objective of financial decision making is the maximization of the wealth of

the owners.

Dividend policy determines the ultimate distribution of a company’s earnings

between retention and cash dividend payments to its shareholders.


9 | P a g e

1. Discuss the decisions that the financial manager needs to make.

2. Compare and contrast the goals of profit maximization and maximization of

shareholders wealth.


10 | P a g e

finance management fin420chp 1

Documents