CHAPTER 1

Introduction of Financial Management

o Financial markets and business

organization
o Goals of the firm
o Functions of the financial
manager
o Risks and return relationship
What is Finance?
o To obtained and allocated financial resources
effectively and efficiently
o Maintenance and creation of economic value and
wealth
o Integrate with other department (i.e.. Marketing,
operations)
o Deal with financial decision (e.g. new product, new
asset, borrowing, issue stocks & debts)
Forms of business organization

Advantages Advantages
Advantages
* Ease of formation *Ease of transfer of
* Ease of formation
ownership
*Belongs to only 1 * Belongs by more
that 1 person *Shareholders are co-
person
owner
*Manager & owner is * Share liabilities
*Limited liability
the same person
*Ease of raising
Disadvantages capital
Disadvantages * Limited life
* Limited life *Unlimited liabilities Disadvantages
*Unlimited liabilities * Difficult to raise * Double taxation
*Difficult to raise capital
* High cost – set-up
capital
 Goals of the firm

Profit maximization
Benefits to society
* To obtain profit as much Maximization of (CSR)
as possible shareholders’
Reasons: value/wealth
* To maintain their * Efficient and low
operating stability
*The primary goal is cost operations (i.e.
*To maintain growth low price)
shareholder wealth
*Giving reward to maximization, which
stakeholders *New product
translates to maximizing
stock price. development (i.e.
Drawbacks: consumer choice)
* Can be achieved by
*Time Horizon (i.e. short- considering the present *Provide efficient
term concept) and potential future and courteous service
*Timing of Returns (i.e. earnings per share,
ignore future project) timing or returns,
*Distributions of Returns dividend policy and
(i.e. dividends) other factors that affect
Financial Management Framework
* Outside
the firm
*
* Within
uncontrolla
the firm
ble
*
controllabl
e
Financial Management Framework

Functions of
Financial Manager

Making financial
Planning Controlling
decisions

* Investment
To conform actual * Financing
Ways to achieve
Create strategies performance with (both decision
firm’s goals
stated plan affect the risk and
return)
 What is Financial Market?
q Institutions and procedures that facilitate transactions
in all type of securities (i.e. financial assets)
q To allocate financial resources within the economy
q Provide Sources of Funds to Deficit Units
q Firms receive money from it , while investors (i.e. Firms
or Individual) made investment (i.e. shares, bonds,
marketable securities, government securities)
 Flow of Funds Mechanism
FINANCIAL
INSTITUTIONS

Suppliers Demanders
of Funds (i.e. Of Funds
Surplus units) (i.e. Deficit Units)

FINANCIAL
MARKETS
Supplier & Demanders of Funds
o Also known as surplus & deficit units
o Consists of Households, Govt, Firms
o They are the provider of funds and receiver
of funds
o Provider of funds – purchasing financial
assets (i.e. financial instruments) offered by
deficit units or financial institutions
o Receiver of funds – issued financial assets
Financial Market
Capital Market
n Market in which long-term securities issued by firms and
governments are exchanged
n Equity and Debt (i.e. corporate and government )
instruments traded in capital market
n Carries greater risks but higher in returns (i.e. market risk)
Money Market
n Market short-term debt instruments (i.e. less than 1-year)
n Issued by firms & government
n Low risk and liquid
n Instruments such as commercial paper, NCDs, etc (also known
as Marketable Securities)
 Risk and Return Relationship

Returns
oInvestment returns measure the financial results
of an investment (i.e. ROI).
oReturns may be historical or prospective
(anticipated).
oReturns can be expressed in:
nDollar terms
nPercentage terms
Risk and Return Relationship (cont..)

Risk
oTypically, investment returns are not known with
certainty.
oInvestment risk pertains to the probability of
earning a return less than that expected.
oThe greater the chance of a return far below the
expected return, the greater the risk.
Risk and Return Relationship (cont..)
q Risk and return trade – offs play a major role in influencing
the investment decision made.
q The basic rule states that; higher risk associates with higher
returns and vice versa
q Risk is unavoidable, thus, the key strategy is seek
investment opportunities that offer the highest return with the
least risk
q Bonds and Equities are the instruments that pose Higher
Risks and gives Higher Returns, and there are Less Liquid
(i.e. long-term securities) while Marketable Securities pose
Lower Risk, result to Low in Returns, but High in
Liquidity
 Risk and Return Relationship
(cont..)
Common
Risk Stocks
SML
Preferred Stocks
Bonds

Risk Free Asset

Return
 Risk and Return Relationship
(cont..)
oSystematic Risk (i.e. Market risk)
Risk that is unavoidable and cannot be
eliminated by diversification (e.g. inflation,
interest rate, political etc)
oUnsystematic Risk (i.e. Firm specific risk)
Risk that can be eliminated by diversification
(e.g. management, operations, profit etc)
How To Manage Risk
Diversification
o Diversification in an investment portfolio can reduce
unsystematic risk to some extend, dependent upon the
correlation coefficient that exists between the securities
held in the portfolio (i.e. stocks, corporate bonds,
government bonds)

o Correlation coefficient describes how much linear co –

movement exists between two random variables or
between two securities.
 Market Portfolio (i.e. stocks portfolio)
Risk (%)
Unsystematic Risk
35 (i.e. related to company)

20

Systematic Risk (i.e. Market Risk)

0
10 20 30 40 2,000+

# Stocks in Portfolio
o The possible correlation is:
1. Positive correlation;
o The securities involved has a direct relationship;
an increase risk in one security, tend to increase
risk in another
2. Negative correlation;
o The securities involved has an inverse
relationship; an increase risk in one security, tends
to reduce risk in another
3. Zero correlation;
o The securities involved has no relationships with
one another
The End