Overview of Financial Management CHAPTER 1 Overview of Financial Management

Learning Objectives At the end of this chapter, you should be able to: Describe the importance of financial management in a firm Describe the role of a finance manager in a firm Describe and explain the goal of a firm Define and explain shareholder wealth Explain agency problem and suggest solutions to overcome agency problem

Introduction Financial management is principally concerned with making financial decisions that influence and affect the worth of a firm. It relates to creation and sustenance of the economic value of the firm. The goal is to create wealth and economic value of the firm, including its sustenance It also covers the use of the best methods to evaluate various alternatives and make the best decisions thereon.

Importance of Financial Management Equation: Total assets (fixed + current assets) = Total liabilities (current + long term) + Shareholders’ equity Figure 1.1

Importance of Financial Management (cont.) Financial management knowledge is important to a firm to answer the following questions: What sort of fixed assets should a firm invest in? How shall firms raise the necessary funding to finance the capital expenditure once a decision has been made as to the type of fixed asset or business opportunity to invest in? How shall a firm manage its short-term operating cash flows?

Finance Area in a Firm Figure 1.2

Role of Treasurer Undertake capital budgeting and make capital expenditure decisions—employ appraisal techniques such as payback, internal rate of return and net present value to examine the viability and attractiveness of proposed investments, projects and products Perform financial planning—contribute in corporate planning and development of financial policy for the firm Source and raise funds—plan and raise financing from various financial institutions (e.g. term loans) or raising equity finance

Role of Treasurer (cont.) Perform cash and credit management—look after the firm’s cash needs, banking and maintenance of security systems of cash Manage flow of foreign currencies into and out of the firm Perform risk management exercises—undertake appropriate risk management in firm; for e.g. price risks faced by firms may be managed by using financial derivatives such as forwards, futures, options and swaps

Role of Accounts Management Produce regular financial statements (statement of financial position, income statement and statement of cash flows) Perform cost and management accounting roles (to provide regular management accounting information so that the planning and monitoring of daily and monthly activities can be performed) Comply with taxation requirements (completing the various tax returns, collection of indirect taxes, and remittances of tax revenues to the Inland Revenue Board (Lembaga Hasil Dalam Negeri))

Importance of Finance Manager Finance manager acts as an intermediary between the firm’s operations and the financial markets. Some roles include capital budgeting & expenditures; corporate strategic & financial planning; sourcing and raising funds; cash management; credit management; management of foreign currencies Figure 1.3

Goal of the Firm Question: ‘In whose interests does the firm run?’ Logically, the interest of all stakeholders should be looked after. However, each stakeholder has his/her own objective/goal that conflicts with those of other stakeholders.

Goal of the Firm (cont.) Traditional objective: To maximize the wealth of shareholders Practical reason When making investment and financing decisions for the firm, decisions can be made much more simply and quickly. If the interests of other stakeholders were also to be considered, decisions may not be made quickly and efficiently.

Goal of the Firm (cont.) Traditional objective: To maximize the wealth of shareholders Legal reason Shareholders are the owners of the firm. Firms come into being due to the contributions and risks taken on by the shareholders. Shareholders are protected by the provisions of the Companies Act, 1965. Finance managers owe some kind of allegiance to the ‘owners’ of the firm.

Other Possible Goals Maximize sales and/or market share Minimize costs Maximize profits Achieve adequate profits Ensure continued earnings growth (with minimum % growth targets) Catch up and overtake competitors Avoid financial distress and bankruptcy Survive

Other Possible Goals (cont.) Limit working hours and days in a week Achieve high reputation for product quality and service Achieve good employer–employee relations Be environmentally friendly—do not pollute Be ethical Question: What are the problems with the ‘other possible goals’?

Shareholder Wealth Figure 1.4

Agency Problem For larger firms, there usually exists a large spread of ownership over huge number of shareholders with varying backgrounds. Difficult to expect every shareholder to participate in the management and running of the business. Management team is engaged to manage the firm on behalf of the shareholders.

Agency Problem (cont.) Principal–Agent Relationship or the Agency Relationship Exists when one party, known as the principal, engages another party, know as the agent, to act in the former’s interest. Separation of ownership and control Figure 1.5

Agency Problem (cont.) Ownership of the firm lies in the hands of the shareholders. Control (management of the firm—strategic and operational decisions) lies in the management team of the firm

Agency Costs Agency costs are incurred by the firm, when: i) Managers do not attempt to maximize firm value ii) Shareholders incur costs to monitor the managers and influence their actions

Agency Costs (cont.) Shareholders impose organizational checks and revamp the firm to keep everyone on their toes. Shareholders monitor management’s behaviour through use of audit committee or establishing management audit procedures, reporting requirements or obtain assurances from management about shareholders’ interest. Stock market quotation—control device whereby a firm’s relative share price performance to other companies acts as a signal about managerial effort and ability

Satisficing Principle Management would do just sufficient to keep shareholders satisfied (dividends/capital gains) while concentrating on the pursuit of their objectives. Management’s performance is based on short-term results and on accounting rather than on economic results.

Suggested Solutions to the Agency Problem Provisions in the Companies Act, 1965 Selling shares and threat of takeover Information flow Linking management remuneration to improvements to shareholder wealth

Goals of Other Stakeholders Employees Loan creditors (Providers of Finance) Trade creditors Customers Government