INTRODUCTION TO FINANCE

2ACC0810N

Lecture 1

The Finance Function

Corporate Finance Principles and practice, 6th

ed, Denzil Watson and Anthony Head

LEARNING OBJECTIVES

Identify the key decision areas

concerning a Financial Manager.
Understand why Shareholders Wealth
(SW) Maximisation is the primary
financial objective.
Understand the process of maximising
Shareholders Wealth in practice.
Identify the Constraints to maximising
SW.-Agency problem

INTRODUCTION

Corporate finance is concerned with:

managing the finances of an organisation
efficiently and effectively in order to
achieve the organisations objective;

>Planning and controlling (where finance is

raised from);
>Allocation financial resources.

i.e. Where fund are raised, where to

allocate fund(investment/dividend).

A KEY CORPORATE FINANCE

CONCEPT

Two key concepts in assisting manager to value

alternative choices are the (1)Risk return
relationship and (2)Time value of money
Why invest your hard-earned money in shares of
a company?
Why not place the money in a savings account?
Subscribing shares in a company, you expect to
have a higher return and this comes with risk.
You could lose all your money. Why????

A KEY CORPORATE FINANCE CONCEPT CONTINUED

Risk and Return

An investor or a company takes on
more risk only if a higher return is
offered in compensation

Return refers to the financial rewards

gained as a result of making an
investment.
Risk refers to the possibility that the
actual return may be different from the
expected return.

Time value of money

The time value of money refers to the fact that
the value of money changes over time.
Time: if you have the money now, you can
spend it now, or invest and get income.
inflation undermines the purchasing power of
your money.
Risk: if you take 100 now you definitely have
the money in your possession.

>This lead to the concept of compounding and

discounting in future cash flow

COMPOUNDING

Compounding is the way to determine

the future value of a sum of money
invested now.
FV = C0(1 + i)^n
where: FV = future value
C0 = sum deposited now
i = interest rate
n = number of years until the cash flow
occurs

EXAMPLE OF COMPOUNDING

20 deposited for five years at an

annual interest rate of 6 per cent will
have a future value of:

FV = 20 (1.06)^5 = 26.76

DISCOUNTING

In corporate finance, we can take account

of the time value of money through the
technique of discounting.
While compounding takes us forward from
the current value of an investment to its
future
value, discounting takes us backward
from the future value of a cash flow to its
present value

DISCOUNTING

PV =

FV
(1 + I)^n
PV = present value
FV = future value
i = discount rate
n = number of years until the cash flow
occurs

EXAMPLE

Consider an investor who has the choice

between receiving 1000 now and 1200 in
one years time. The investor can compare the
two options by changing the future value of
1200 into a present value, and comparing
this present value with the offer of 1000 now

PV = 1200/(1.1)^1 = 1091
Alternatively, we can convert our present
value of 1000 into a future value:
FV = 1000 (1.1)^1 = 1110

CORPORATE OBJECTIVES

The primary financial objective of

corporate finance should be to
maximise the value of the company for
its owners Shareholders Wealth
Maximisation (SHWM)
Shareholders also regarded as the
residual owners payment of
employees, suppliers etc

SHAREHOLDER WEALTH
MAXIMISATION

Total shareholders wealth is derived through the

cash they received from dividend payment and
the capital gained derived from owning shares
in a company.
Current and future dividends depend on future
cash flows:
their magnitude or size
their timing
their associated risk.
The indicator usually taken is the companys share
price.

ROLE OF FINANCIAL MANAGER

Investment what projects should be

undertaken by the organisation?
Financing how should the necessary
funds be raised? ( including working
capital management)
Dividends how much cash should be
allocated each year to be paid as a
return to shareholders?
Risk how is risk identified and
managed

KEY FINANCIAL DECISIONS

The key financial decisions cannot be

taken in isolation because they are
interrelated.

No dividend payment (shares are likely to

be sold and share prices will fall).
High dividends (less money to push
through investment programmes).

Decision in one area can have effect on

the other areas.

NPV A

Linking
NPV
to
SHWM

NPV B

NPV C

1
Corporate
Net
Present
Value
2

NPV D

1: NPV is POSITIVE
2: This link relies on
market
efficiency
3: Share price taken
as

Share Price
3
SHWM

IS SHAREHOLDER WEALTH
ALWAYS MAXIMISED?

Will managers (agents) always act in the best

interest of Shareholders (principals)?
Owner delegate Power & Authority to Manager
to run business- AGENCY RELATIONSHIP

NOT Always

What is Agency problem?

Agency problem

THE AGENCY THEORY

(PROBLEM)

The agency problem occurs when

managers make decisions that is not
consistent with the objective of
shareholders wealth maximisation.
Assumptions (Agency theory)

Individual act so as to maximise their own

wealth
Individual act in a rational manner both as
regards furthering their own interests and
expecting others to do likewise.
Individual are risk averse

THE AGENCY PROBLEM

Why does it arise?
1)Separation of ownership and control
2)Managers goals differ from
shareholders
3)Asymmetry of information as
between shareholders and managers.
The agency problem is considered as
an internal constraint.
What are the consequences?

CONSEQUENCES OF AN AGENCY
PROBLEM

Managers will follow their own

objectives
i.e.

Increasing their managerial power

Creating job security
Increasing managerial pay and rewards

Shareholders need to ensure that their

own wealth is maximised (Personal
Aspiration).

DEALING WITH AGENCY

PROBLEM

Best solution to the agency problem is

to design managerial contracts that
minimise the sum of the following
costs:

financial contracting costs

monitoring costs
divergent behaviour costs.

OPTION 1: DO NOTHING
Leaving managers to their own devices
is problematic:
Given human nature, managers will
engage in suboptimal behaviour.
No action is not really an option.

OPTION 2: MONITORING
Problems associated with monitoring:
Auditor/ special report
Costly in terms of both time and money.
Who will pay? Large shareholders? What about
free-riding smaller investors?
Some managerial actions are hard to follow.
May drive bad managers underground.

OPTION 3: REWARD GOOD

BEHAVIOUR

What do we link managerial rewards to?

Most commonly linked to:

profits
share price (e.g. via share options).

Rewarding is more common than

monitoring.
Buttying rewards to profits may
encourage short-termism and creative
accounting.

DEALING WITH AGENCY

PROBLEM

Incentives (encourage goal congruence)

Executive share option schemes

Performance related pay

Corporate governance
Monitor the activities of management
Internal controls (financial reporting and accountability)
Transparency
The role of non-executive directors
Threat of firing manager
Bring in new investor to set up new policy

SUMMARY

1 Two key concepts in corporate

finance are the relationship between
risk and return, and the time value of
money.

2 Compounding calculates future

values from an initial investment.
Discounting calculates present values
from future values. Discounting can
also calculate the present values of
annuities and perpetuities.

SUMMARY

3 While accountancy plays an important role

within corporate finance, the fundamental
problem addressed by corporate finance is
how best to allocate the scarce resource of
money.
4 Financial managers are responsible for
making decisions about raising funds (the
financing decision), allocating funds (the
investment decision) and how much to
distribute to shareholders (the dividend
decision).

SUMMARY

5.While objectives such as profit

maximisation, social responsibility and
survival represent important supporting
objectives, the overriding objective of a
company must be that of shareholder
wealth maximisation.

6. A financial manager can maximise a

companys market value by making
investment,
financing and dividend decisions

SUMMARY

7. Due to its visibility, maximisation of a

companys ordinary share price is used as
a substitute objective to that of
maximisation of shareholder wealth.

8. Managers do not always act in the best

interests of their shareholders, giving rise
to what is called the agency problem.

SUMMARY

9 Agency is most likely to be a problem

when there is a divergence of
ownership and control, when the goals
of managers differ from those of
shareholders, and when asymmetry of
information exists

WORKSHOP

1.What are the functions and areas of responsibility

under the control of the financial
manager?

2.Explain how a financial manager can, in practice,

maximize the wealth of shareholders.

3. Cal the PV of a cash flow of RM10,000 that you

received in 3 years time using a discount of 15% p.a.

4.What is meant by the agency problem in the

context of a public limited company? How is it possible
for the agency problem to be reduced in a company?

1.WHAT ARE THE FUNCTIONS AND AREAS OF RESPONSIBILITY

UNDER THE CONTROL OF THE FINANCIAL
MANAGER?

Investment
Every investor has risk preference, each will invest
according to his/her risk preference. Investment is
allocating resource to a business/investment .
Investor will look for high return of investment.
The concept of risk and return is the higher the risk
the higher the return. Investor will use different
evaluation method to evaluate the return of
investment.

1.WHAT ARE THE FUNCTIONS AND AREAS OF RESPONSIBILITY UNDER THE CONTROL OF THE FINANCIAL
MANAGER?

Financing decision
a)Internal-company retain earning,
working capital
b)External- share issue, bank
borrowing.
Finance manager source for the
cheapest source of financing.

1.WHAT ARE THE FUNCTIONS AND AREAS OF RESPONSIBILITY UNDER THE CONTROL OF THE FINANCIAL
MANAGER?

Dividend policy
Return to shareholders(owner). Management will
decide how much to pay dividend, sometime once a
year or 2 or 3 time a year. Interim dividend , final
dividend.
How much to pay depend on company bank balance
available and also depend on how much the
company need for working capital and investment
activities. And listed company will usually pay the
same dividend everyyear

2.EXPLAIN HOW A FINANCIAL MANAGER CAN, IN PRACTICE,

MAXIMIZE THE WEALTH OF SHAREHOLDERS

Shareholders wealth is measured a capital

gain and dividend received. Capital gain is
increased in value of the investment/company.
Value of company is increased when
management efficiently use its resources
through efficient management of working
capital, good investment and cheap
financing .Hence Value of company or
investment increase when its NPV(net present
value ) of future cash flow is increased. i.e
higher profit will increase cash flow.

3. CAL THE PV OF A CASH FLOW OF RM10,000 THAT YOU RECEIVED IN 3 YEARS TIME USING A
DISCOUNT OF 15% P.A.

Year 0----------------------------------Year 3
PV---------------------------------------Future
cash
flow(RM10,000)
PV=FV
(1 + i)
= 10,000/(1.15)^3
= 6,575.16

4.WHAT IS MEANT BY THE AGENCY PROBLEM IN THE CONTEXT OF A PUBLIC LIMITED

COMPANY? HOW IS IT POSSIBLE FOR THE AGENCY PROBLEM TO BE REDUCED IN A COMPANY?

Agency relationship is Owner employ agent i.e manager to

run the company on his/her behalf. Owner give power and
authority to manager to make decision in the business.
Agency problem arise when :1) separation of owner and control- meaning owner do not
have control over the daily operation of the company.
2) Owner goal is different from manager goal. Owner goal is
to max shareholders wealth but manager goal is self
interest , not the company interest, hence result is company
profit not maximize, i.e shareholders wealth NOT max.
3) asymmetry of information. Meaning manager do not give
accurate information to owner, might be hiding information
from owner.

SOLUTION TO AGENCY PROBLEM

1) Monitoring- engage auditor to check, also insist on special

report form expert on company activities. Require manager to
practice good corporate governance, that mean practice
accountability and transparency and also good internal control

2) reward manager with bonus that is tied to performance, good

performance of company will give higher bonus.
Can also give share as incentive to manager, hence manager
will want to increase company share price. Share price is
increased when the NPV of future cash flow increase, i.e make
more profit.
All the above will reduce divergent cost- Divergent cost is
company not making as much profit as it should due to
divergent action of manager, i.e sub optimal decision result in
less profit.

3) Threat of firing manager

4) Bring in new investor- set up new

rules and regulation for manager to
follow.