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CHAPTER 1
Objectives
At the end of the chapter, you should be able to answer the following
questions;
▪ What is Financial Management?
▪ Why is the objective of financial management to maximize the value of
the firm?
▪ What is the role of a financial manager?
▪ What is the relationship of corporate finance to accounting and
economics?
▪ What are the various forms of business organization?
▪ What are some of the underlying concepts of financial management?
▪ How do agency issues that arise between managers and owners' impact on
wealth maximization?
▪ What is the role of corporate governance and King III (King IV)?
▪ How does a firm decide on its corporate strategy?
▪ What is the role of ethics in business?
2
©Correia, Flynn, Uliana, Wormald & Dillon
INTRODUCTION
Management Accounting vs. Financial Accounting

Figure 1.1 Management Accounting compared with Financial Accounting
INTRODUCTION
Management Accounting vs. Financial Accounting
Table 1.1 Users of management accounting versus financial accounting information

THE MASTER BUDGET (STATIC/FIXED BUDGET)
The master budget
Figure 11.1 Master budget
Context of
Financial Economics
Management
How do individuals/organisations/countries make the
best use of scarce resources?
Financial Management
How does the financial manager use best practice to add value to
capital received in the form of debt and equity and thereby create
wealth?
Financial Manager
Measured by the value created by finding projects with

returns that are greater than the firm’s cost of capital 6
Context of Financial Management
https://images.app.goo.gl/VNWFqHRf14gvP7te9

Fundamental Objective of
8
9
• At the annual general meeting of Steinhoff in April 2018, it was

disclosed that Steinhoff had overstated its income and assets in its
annual financial statements prior to the collapse of
its share price set out in Figure 1.4. Steinhoff’s reported operating
profit for 2016 was €1 793m which we roughly estimate would result
in a negative EVA if we use a cost of capital above 7.5% but this is
based on overstated income and asset numbers.
• Steinhoff’s shareholders have paid a heavy price for the accounting
irregularities and profit manipulation.
9
Definitions
• Definition 1: Financial management is the use of best
practice to add value to capital received in the form of
debt and equity thereby creating wealth.
• Definition 2: Financial management is strategically

planning how a business should earn and spend money.
This includes decisions about raising capital,
borrowing money and budgeting.
• Definition 3: Financial Management means planning,

organizing, directing and controlling the financial
activities such as procurement and utilization of funds
of the enterprise.
10
• Definition 1: Financial management is the use of best practice

to add value to capital received in the form of debt and equity
thereby creating wealth.
• Definition 2: Financial management is strategically planning
how a business should earn and spend money. This includes
decisions about raising capital, borrowing money and
budgeting. (https://www.xero.com/us/resources/accounting-
glossary/s/what-is-financial-management/)
• Definition 3: Financial Management means planning,
organizing, directing and controlling the financial activities such
as procurement and utilization of funds of the enterprise.
(http://www.managementstudyguide.com/financial-
management.htm)
10
Links with Accounting
• The financial manager will be required to

analyse and interpret financial statements and
general accounting data.
• This will be used in a forward-looking
perspective as the information required for
financial management decisions.
• Accounting information on its own has many
limitations, particularly regarding its historic
perspective.
11
Environment of Financial Management
• Deregulation/Regulation (e.g. electricity prices,

shopping hours)
• Taxation
• Interest rates
• Inflation
• Privatisation / nationalisation (e.g. Telkom)
• High input costs.
• Globalisation and internationalisation
12
• Deregulation/Regulations. Governments are increasingly removing regulations that

restrict economic activity. This has occurred in the banking sector, the
telecommunications sector, the electricity and gas sectors as well as other sectors such
as the airline industry.
• Taxation. South Africa has undertaken major changes to the tax system which are
impacting on investment and financing decisions. The significant reduction in the
corporate tax rate
from 48% to 28% in the last 25 years has affected corporate investment and financing
decisions.
• Interest rates. Interest rates have fallen significantly over the last two decades. This
means that interest rates are at low levels and this will reduce the effective cost of
borrowing and impact on the company’s investing and financing decisions.
• Inflation. Inflation has fallen significantly, and companies are currently operating in a
low inflation environment. South Africa’s inflation rate is expected to stay within the
range
of 3 to 6%.
• Privatisation/Nationalisation. The privatisation of firms such as Telkom means that
the government has followed a policy of transferring businesses to the private sector.
However, recently there have been calls for nationalisation of sectors such as mining
and the government has begun issuing mining rights to a state mining company
(AEMFC).
• High input costs. The South African government is committed to a process of
commercialising certain public entities such as Transnet and Eskom. The
focus is on making the public sector more efficient. However, higher electricity tariffs
are increasing the costs of doing business in South Africa.
• Globalisation and internationalisation. Globalisation has forced South African
companies to be internationally competitive and South African companies have
expanded into foreign markets and have obtained listings in London and New York.
Companies are also raising loans and issuing bonds offshore. Tariffs may impact global
trade.
12
Environment of Financial Management
• Mergers and acquisitions (e.g. SABMiller by AB

InBev)
• Currency exchange rates
• Broad-based BEE.
• Developments in China, the USA and Europe.
• Business disruption. (e.g. Netflix, Uber)
• Climate Change.
13
• Mergers and acquisitions. Increasingly we are seeing firms merging and there is increasing
consolidation in many sectors. For example, the acquisition of SABMiller by AB InBev
resulted in the world’s largest brewer.
• Currency exchange rates. Foreign exchange rates are highly volatile and companies are
required to factor in future exchange rate movements in their investment and financing
decisions. The significant fall in the rand exchange rate from the beginning of 2011
($1=R6.70) to the beginning of 2016 ($1 = R15.50) and its subsequent appreciation to
about R11.80 in February 2018 and then fall (25 June 2018: $1=13.47) had significant effects
on importers, exporters, as well as local and foreign investors.
• Broad-based BEE. The implementation of Broad-based Black Economic Empowerment is
leading to changes in corporate ownership structures, management profiles, employment,
procurement policies and financing structures. The effect of BEE is generally seen as positive
for the South African economy.
• Developments in China, the USA and Europe. China’s burgeoning economy has resulted in
strong demand for resources and other exports from South Africa. At the same time,
local manufacturers are feeling the heat of competition from China. The USA has been
incurring fiscal deficits and undertaking “quantitative easing” by buying bonds in the market,
which increases the money supply and further reduces interest rates. This is not sustainable in
the long term. However, discontinuing this policy may have effects for emerging markets. A
debt crisis in the Euro zone a few years ago resulted in austerity and yet countries such as
Ireland, Spain and Portugal have rebounded and the Euro zone is experiencing real
economic growth and falling unemployment. The UK, due to Brexit, is experiencing
economic headwinds with higher inflation and a weak economic outlook.
• Business disruption. Companies are increasingly subject to disruption and business models
may quickly come under pressure or even become obsolete. We can see what Amazon is
doing to retailers, how Airbnb is impacting the hotel sector, how Uber is affecting taxi
operators and what Netflix has done to videos and demand for DStv.
• Climate Change. The effects of climate change are becoming increasingly relevant and will
impact on financial decisions, operating costs and demand for a firm’s products. Where a firm
locates a factory will be affected by access to resources such as water.
13
Forms of South African business entities
15
• From the viewpoint of financial management, it is relevant

to classify activities in terms of their form of ownership.
The form of ownership has numerous legal and tax
implications that affect financial management decisions. We
will focus only on the common forms of ownership
encountered in business entities which have the objective of
making a profit. These are the sole proprietorship, the
partnership, and the limited liability company.
• Limited liability - the condition by which shareholders are
legally responsible for the debts of a company only to the
extent of the nominal value of their shares.
• Nominal value is the price of a share, bond, or stock when it
was issued, rather than its current market value.
• Sole proprietorship – the income of the business is
considered to be the personal income of the owner.
15
Types of Business Organisations
Sole Proprietorship
 Most common form of business entity
 Usually small businesses and family
enterprises
 Three major disadvantages
 Continuity of business depends on sole
owner
 Growth is hampered by limited funds
 Liability is not limited
16
• This is probably the most common form of business entity.

Anyone conducting any legal form of business activity may
be established as a sole proprietor. For tax purposes, the
income of the business is considered to be personal income
of the owner and is added to whatever other assessable
income may have been earned during any given tax year.
• Three major disadvantages of this form of ownership are
immediately apparent. Firstly, the continued existence of the
business depends on one person, the owner. Secondly,
because most individuals have limited funds available,
growth is often hampered by the inability to raise further
finance. Thirdly, should the business fail, the owner’s
liability is not limited, so there is a risk that his or her
personal estate may be declared insolvent.
16
Partnership
 May be formed when two of more persons come
together to start business
 Advantage of pooling resources from each partner
 Agreement to set out the terms of the partnership
 Partners are jointly and severally liable for debts
of the partnership
17
• A partnership may be formed when two or more persons

come together to start a business. From an individual
partner’s viewpoint it is identical in every respect to a sole
proprietorship, except that profits and losses are divided in
an agreed proportion. A partnership has the advantage of a
pooling of the resources that each individual partner may be
able to contribute. These include contributions such as
financial resources, technical skills, and management
expertise. There is usually a partnership agreement which
will set out the responsibilities of each partner and how each
partner will share in the profits of the business.
• From a legal perspective, partners are jointly and severally
liable for the debts of the partnership. This is a significant
disadvantage as it means that each partner is responsible for
the actions and consequent debts of all other partners.
17
Close Corporation
 Separate legal entity in terms of the Close
Corporations Act
 No new registrations allowed
 Members, not shareholders
 Maximum = 10 members
 Limited liability may be restricted
 Low cost and low level of regulation
 No audit
18
• A close corporation may be formed by between one and ten

persons who are referred to as members. Members each
have a proportional interest in the business. Unlike a
partnership, the interest of a member may be sold without
terminating the existence of the business. A close
corporation is taxed as an entity apart from the members.
Members of a close corporation enjoy limited liability
unless they conduct themselves in a way which can be
proved to be reckless or fraudulent.
• In terms of the Companies Act of 2008, no further
registrations of close corporations will be permitted,
although current close corporations will be allowed to
remain in place.
18
Company
 A separate legal entity from the owners and
governed by the Companies Act
 The owners of the company are known as
shareholders as they own shares in the
company
 Shareholders have limited liability – their
maximum loss is the investment in the
company
19
• The company is a separate legal entity from the owners and is governed by the
Companies Act. This means that a company is legally like any other person and
can buy, sell and transact in its own name. It can enter into contracts and raise
finance, is required to pay tax and has the same rights and responsibilities as a
natural person.
• The owners of the company are called shareholders, as ownership is
represented by shares of a company. As the company is a separate legal entity
apart from the shareholders, it means that shareholders have limited liability.
This means that shareholders are only at risk up to what they have invested in
the company. If a company fails, then the creditors cannot look to the personal
assets of the shareholders. This will encourage investment and enable
companies to raise large amounts of capital and enables shareholders to
effectively diversify their investments. In a sense it creates an option-like
scenario, gains are unlimited and losses are limited to the amount invested in a
particular company. However, creditors are required to undertake additional risk
and may require that shareholders of smaller companies sign personal sureties.
• The word Limited (Ltd) must appear in the name of the company to warn
creditors that they have the right only to the assets of the company and not to
any of the shareholders’ personal assets.
19
 There are two types of companies
 Private company
Proprietary (Pty) Limited Ltd
ABC (Pty) Ltd
 Public company
Limited Ltd
ABC Ltd
 Public companies may have their shares listed on
the JSE Securities Exchange
20
• There are two main types of companies, a private company which has to include the words
Proprietary Limited or (Pty) Ltd after its name, and a public company which will
have only the word Limited or Ltd after its name. Public companies may have their shares
listed on a stock exchange such as the JSE Securities Exchange and these companies have
to
comply with the listing requirements of the JSE. The shares of public companies are freely
transferable and if listed, shareholders can freely buy and sell shares on the JSE. There are
about 400 listed companies in South Africa
• Private companies often have restrictions on the transfer of shares. A private company’s
Memorandum of Incorporation (MOI) is required to state that it is not permitted to issue
shares to the public. Not all corporate entities have limited liability. A personal liability
company (Inc.) is a company whereby the directors and past directors are jointly and
severally liable, together with the company, for any debts and liabilities of the company.
However, we will not focus on this type of entity.
• A private company is in essence a company whose shares are privately held by, for
example, the company’s founders, a group of private investors or a subsidiary of a larger
company. The main advantage is that the sale of shares is restricted and the shares cannot
be offered to the public thereby protecting the shareholders’ interests.
• A public company’s shares are held by the public and there are no restrictions on the
transfer of shares to third parties. The main benefit is that a public company has relatively
easy access to capital.
20
 Characteristics of a Company
 Shareholders will elect the board of directors
who then appoint management
 There will be a chairman to the board
 Day to day management is handled by the
Chief Executive Officer (CEO)
21
• The use of the company entity form enables the separation of management
from ownership. The shareholders will elect a board of directors who will
then appoint a
management team. A number of directors will usually be involved, as
executive directors, in the daily management of the affairs of the company.
• There will be a chairperson of the board, but day-to-day management will
often be the responsibility of the Chief Executive Officer (CEO). Although
the separation of management and ownership enables the company to raise
large amounts of finance, it does have certain drawbacks. For example, how
do we know that management is motivated to follow the interests of the
shareholders?
• A company’s lifespan is not limited by the life-span of its owners. It has
continuity of existence unless, of course the company fails. Although limited
liability has enabled the expansion of companies, it has also been misused by
investors who hide behind the “corporate veil”.
• Increasingly, the law is shifting responsibility to the directors of the company.
For example, directors become personally liable if they permit the company
to trade whilst insolvent, that is where the company’s liabilities exceed its
assets
21
Differences between the various
forms of organisation
Sole Proprietorship Partnership Private Company 1 Public Company
Separate legal entity? No No Yes Yes

Liability of the owners? Unlimited Unlimited Limited Limited
Low (but higher than

Cost of formation, regulation and operation? Low Low sole proprietorship High (if listed)
and partnership)
Separately taxed from the owners No No Yes Yes

High (particularly if
Ability to raise financing in the capital markets? Low Low Low, in most cases
listed)
Income tax rate 2 Up to 40% Up to 40% 28% 28%
Continuity of existence? No No Yes Yes
Separation of management and ownership? No No No, in most cases Yes
Secrecy of operating returns Yes Yes Yes No
Disclosure requirements Low Low Low High (if listed)
No/Yes (if in public
Audit requirement (Companies Act 2008) No No Yes
interest)
Ownership freely transferable? No No No, in most cases Yes
1. A Close Corporation is similar to a private company but results in lower costs and requires no audit.
2. Companies will be required to apply a withholding dividend tax of 15% of dividends paid resulting in an effective tax rate of 38.8% (28% + 72% x 15%) i f the
company pays 100% of its after-tax earnings as a dividend. Small companies may qualify to pay a tax rate of 10% for income up to R300 000 in 2013/14.
22
What is the Fundamental Objective
of Financial Management?
Is it Profit Maximisation?
What are the problems with this concept?
 Manipulation of accounting profits
 Timing of Returns
 Does not reflect cash flows
 Accounting profits do not account for the cost
of equity capital
 Risk – if higher profits come with much higher
risk, then the share price may fall 23
Manipulation of accounting profits

• Management may be able to increase this year’s profits by reducing such costs as advertising, research and
development, and replacement of plant and equipment. However, how would investors react if a
pharmaceutical company such as Merck or an IT company such as Intel indicated it was reducing research
and development costs? The reduction in costs would increase this year’s profits but detrimentally affect
future profits. A company can reduce the current depreciation expense by not investing in new plant
equipment but eventually this will translate to the company becoming increasingly uncompetitive in terms
of quality and price.
Timing
• Profit maximisation does not directly factor in the time value of money. A project that results in a total
profit of R20m per year for 5 years would be preferred to a project that generates R10m per year for 10
years. Why? Profits that are received sooner can be reinvested to earn higher future returns.
Cash flows
• Accounting profits do not always reflect cash flows. Profits are determined by the company’s accounting
policies, whilst corporate finance is focused on cash flows.
Accounting profits and the cost of capital
• Accounting profits do not include an adjustment for the cost of equity financing. In practice, accounting
profits are often reported in terms of the company’s earnings per share (EPS). This is determined by
dividing the company’s net profit by the number of shares issued by the company.
Risk
• Profit maximisation ignores the impact of risk on value. Shareholders will prefer less risk and will value a
company not only in terms of its future cash flows, but also in terms of the risk of those cash flows. For
example, the risk of future cash flows of Pioneer Foods will be lower than the future cash flows of
Harmony Gold. Investors will adjust for risk in determining future cash flows. This means that an
investment that promises an increase in accounting profits but also an increase in risk may actually result
in a fall in the value of the company.
23
25
• If we accept that the objective of corporate finance is to

maximise the value of the firm, then we need to determine
how this is achievable. Firstly management needs to make
investments that offer a return that exceeds the cost of
capital, i.e. the cost of financing. Secondly, the cost of
capital will take into account the underlying risk of the
company’s investments. Thirdly, the value of the firm will
be increased by the company being able to reduce its cost of
capital.
25
 Economic Value Added (EVA)
 Growth in the use of EVA to measure company
performance, as accounting does not take into
account the opportunity cost of equity capital
 Example: Company has operating profits of 70m
after tax. Equity investment amounts to 600m and
after tax cost of financing is 9%.
 EVA = 70m – (600m x 9%)
 EVA = 16m
26
• We can calculate a company’s EVA to determine whether the company has

added value over a period by comparing a company’s return on invested
capital to its cost of financing (cost of capital). This means that we deduct
the cost of financing from the company’s after-tax operating profit.
• In relation to the future, the calculation of EVA corresponds to the
determination of a project’s net present value, which we will describe later.
We can also determine the EVA of a company over a period such as a
financial year. For example, assume that a company has reported operating
profits of R70m after tax. If the company’s investment amounts to R600m
and its after-tax cost of financing is 9%, then the company’s EVA will be
determined as follows:
EVA = 70m – (600m x 9%)

EVA = 16m
• We can see that if the company had reported an accounting profit of R50m
for the year, then the company’s EVA would have been a negative R4m and
the company would have destroyed shareholder value for that year.
26
27
• EVA is a performance metric that calculates the creation of

shareholder value, but it distinguishes itself from traditional
financial performance metrics such as net profit and earnings
per share (EPS).
• EVA is the calculation of what profits remain after the costs of a
company's capital - both debt and equity - are deducted from
operating profit.
27
Major Financial Management
Decisions
1. Investing Decision
Which assets should the company invest in?
2. Financing Decision
How should the company finance these investments?
29
• Having placed the environment and objectives of financial management into perspective, we
turn to the role of the financial manager. In many companies, the Chief Financial Officer
(CFO) represents the position of financial manager. However, the Chief Executive Officer
(CEO) and the Executive team will often be involved in financial decision-making and so we
will stay with the general term of “financial manager”. A pertinent question to pose is, “what
does the financial manager do?”
• Once we have determined what the role of the financial manager is, the text will explore the
principles and theories which are commonly used for effective financial management.
• Two primary roles are performed by the financial manager. The first of these is to pursue
wealth- creating investment opportunities, and the second is to find funds to finance the
investments. This is illustrated in Figure 1.5 and further explained in this section.
• The first role of the financial manager is to explore investment opportunities within the
context of the type of business operation in which the company is engaged. Such
opportunities are then evaluated in order to establish whether they are profitable by
determining whether they are likely to increase the value of the business. Needless to say,
there are often numerous possible opportunities available from which to select. The financial
manager is required to evaluate the possibilities and rank them in order of potential
profitability.
• This may seem to be a relatively straightforward procedure. However, when it is considered
that such evaluation is based on predicted outcomes and that different opportunities have
different levels of risk attached to them, it becomes apparent that selection from among
competing investment opportunities requires consideration of many interacting factors.
Investment opportunities can be broadly classified into two categories, namely investment in
operating assets and investment in financial assets.
29
Role of the Financial Manager
• Pursue wealth-creating investment
opportunities
• Source funds to finance the investments
30
• What are financial assets ? The investment in equity shares, preference

shares and bonds as well as other financial instruments.
• Financial Markets: Capital vs. Money Markets. ... Money markets are
used for a short-term basis, usually for assets up to one year. Conversely,
capital markets are used for long-term assets, which are those with
maturities of greater than one year. Capital markets include the equity
(stock) market and debt (bond) market.
• Assets can be divided into two categories: current and noncurrent.
Current assets are items listed on a company's balance sheet that are
expected to be converted into cash within one fiscal year. Converse to
current assets, noncurrent assets are long-term assets that a company
expects to hold over one fiscal year that cannot readily be converted to
cash within a year.
30
Financing Decision: Selecting
the Optimal Finance Mix
 Sourcing the funds to finance the
investment decisions.
 Emphasis on cost of financing.
 Cost of financing is the risk associated with
the investment
 Risk depends on:
• Type of projects undertaken
• Length of time for which funds are provided
31
• The finance manager is constantly looking for investment

opportunities and constantly making decisions regarding the
source of funds to be used in order to finance the investment
projects.
31
Financing Decision: Sources of
Finance
 Finance from Capital Markets:
• Long-term financing
• Equity versus debt financing depends on risk
preference of the investor
 Issue of shares
• Equity shares : High risk but high expected
return
 Issue of debt
• Debt : Low risk
32
• Capital markets are markets in which long-term financing instruments are bought and sold. The
financial manager of a growing company is likely to be trying to acquire finance or, stated
differently, to be selling financial assets. We have been referring to investors generically up to this
point. Investors, however, all have different attitudes toward risk. Those who are prepared to
assume higher risk – with an expected high return – will prefer to acquire shares. Those who are
more risk-averse will prefer to purchase bonds which are more secure and invest in loans secured
against fixed property. Investment opportunities, from the perspective of individual investors, can
therefore be broadly categorised into shares or debt, in return for which they offer their cash.
• Issue of shares. If a company raises long-term capital by issuing shares, ordinary shareholders face
the ultimate risk in that they will be the last to be repaid in the event of
liquidation. For this reason share capital is relatively expensive. Shareholders expect a high return
for the risk which they take. Shares may be packaged in different forms in order to
reduce the risk for some categories of shareholders. So, for example, shares of a certain type may
give the holder a preference payment of dividends and in some instances preference in the event of
liquidation. Ordinary shares, bear the highest risk, but also gain the most benefit if a company is
profitable and shows growth.
• Issue of debt. A company may go to the capital market in order to raise long-term debt. Once
again there are numerous forms of debt which could be issued. These range from
debentures or bonds, which may be secured by mortgage over immovable property or be
convertible into shares, to term loans at fixed interest rates or rates fluctuating with a base
rate such as the prime rate or JIBAR. Increasingly capital markets such as the JSE have electronic
trading systems in place. For example, it is possible to trade corporate bonds and
shares on the JSE. Markets for other long-term debt are usually created by investment banks and
other financial institutions which place long-term debt with companies for their clients. These
markets may have no specific location, but operate as a result of negotiation between parties, often
initiated by telephone.
32
Financing Decision: Sources of
Finance
 Finance from Money Markets:
• Short term financing
• Based on cyclical nature of businesses
 Finance from Creditors
• Working capital financing
 Finance from Retained Income
• Use of accumulated profits of prior years
• Retain or distribute profits through dividends?
33
• Money markets play an essential role in satisfying short-term financing needs. This
need arises most frequently as a result of the cyclical or seasonal nature of many
businesses. It would be an unnecessary waste of resources to borrow funds for a
long term and then keep them idle for a large part of each year.
• The money market creates the opportunity for short-term borrowings and short-term
investments of surplus cash. A bank overdraft facility is an example of a short-term
borrowing,
which is normally renegotiated with the bank every year.
• Finance from creditors A large component of current assets often comprises goods
purchased from suppliers. The extent to which suppliers offer credit terms will
determine their contribution to the financing of working capital.
• Finance from retained income A fourth method of obtaining finance is by
retaining part of the company’s profits each year. How much of the net earnings
should a firm retain and how much should the firm pay as a dividend? If the firm
has highly profitable projects, then it should retain all its current profits to invest in
these projects. Yet, it is also true that if a company decides to cut its dividend, this
may cause its share price to fall. In Chapter 16, we will study a number of dividend
theories, in regard to the effect that the dividend decision can have on the value of
the firm.
33
Fundamental concepts in
Corporate Finance
 Present Value
 The value today of expected future cash
flows
 Time value of money
 The value of any investment is determined
by both the size of future cash flows, timing
of cash flows and the use of a risk adjusted
discount rate
34
• The emphasis in this text will be placed on the fundamentals essential to an

understanding of the issues and decisions that confront financial managers. All
practices in financial
management, evidenced by the decisions and actions of the financial manager, are
based on underlying concepts. Of particular significance in finance is the assumption
that people
will choose an investment with a higher expected return rather than a lower expected
return, all other factors being constant. Similarly, if two investments both have the
same expected return, investors acting rationally will prefer the investment with the
lower risk. We will now explain some of the key concepts in financial management.
• Present Value The present value concept enables us to determine the value today
of expected future cash flows. This means that we can compare investments with
differing cash flows which will occur at different times in the future. This concept is
based on the premise that there are active capital markets in order to determine
appropriate required returns or discount rates.
• Time value of money The value of any investment is determined by both the size
of the future cash flows and the timing of the cash flows. Investors prefer to receive
cash flows sooner rather than later, as these cash flows can be reinvested to earn a
return. The use of a discount rate to determine the present value will include an
adjustment to take into account the time value of money.
34
Fundamental concepts in
Corporate Finance
 Risk and Return
 The expected return of an asset is determined by
its level of risk. Risk is measured in terms of the
risk of loss and variability of cash flows.
 Efficient Market Hypothesis
 This hypothesis asserts that securities markets
react immediately and without bias to all
publicly available information
 Portfolio Theory
 The theme of diversification (not to hold all
your eggs in one basket) 35
• Risk and return Corporate finance is based on the concept that investors will
prefer low risk investments and therefore will require higher returns from projects
with higher risk. How do we measure risk? How do we adjust for risk? These are
questions we will address later in the text. For now, it is important to understand that
a company should only invest in a project that offers a return that is in line with its
level of risk.
• Efficient markets The efficient markets hypothesis (EMH) postulates that
securities markets react immediately and without bias to all new information. The
EMH assumes that prices fully reflect all available information. If the EMH actually
applies in practice, then it is impossible for any investor to earn a consistent return in
excess of the return warranted by the risk class of the investment. Stated more
simply, any “hot tips” or news about “winners” which will earn above normal returns
is out of date when heard, because the share market will already have absorbed the
information into the price.
• Portfolio theory Almost intuitively we all know the dictum that we should never
place all our eggs in one basket. This is another way of saying that if we are to
behave in a rational manner, we should diversify our investments so as to reduce our
risk. Portfolio theory has explored this theme with some implications for financial
management.
35
Do managers act in interest of
shareholders? Is there an agency
problem?
 The agency problem arises from the separation
of management and ownership in a firm which
may result in conflicts of interests.
 A conflict of interest arises from the fact that
managers may make decisions that are not in
line with the goal of shareholders’ wealth
maximisation.
36
• The agency problem is a conflict of interest inherent in any relationship where

one party is expected to act in another's best interests.
• In corporate finance, the agency problem usually refers to a conflict of interest
between a company's management and the company's stockholders.
• The manager, acting as the agent for the shareholders, or principals, is
supposed to make decisions that will maximize shareholder wealth even though
it is in the manager’s best interest to maximize his own wealth.
• While it is not possible to eliminate the agency problem completely, the
manager can be motivated to act in the shareholders' best interests through
incentives such as performance-based compensation, direct influence by
shareholders, the threat of firing and the threat of takeovers.
36
Agency Problems
Examples:
 Expensive corporate jets and head office
structures
 Management will structure for themselves
excessive remuneration plans
 Empire building by diversifying into other
business sectors
 Avoidance of risky but worthwhile projects
[unless management remuneration is weighted
towards share options]
37
• What actions may management take that may not be in the interests
of the shareholders?
• Management may unnecessarily acquire an expensive corporate jet;
operate from gleaming head offices with views; and incur expensive
travel such as spending about R90 000 for three days in Rome on a
“business” visit. Management will be motivated to structure for
themselves overly generous remuneration plans.
• More serious for the wealth of shareholders is a propensity to engage
in the acquisition of companies in unrelated business areas – so
called corporate diversification and empire building. Also,
management might avoid risky but worthwhile projects as the risk to
their own financial position is high as compared to the risk of the
project to well diversified shareholders.
37
Solutions to agency problem
 Shareholders will incur costs in order to ensure
a closer alignment of the objectives of
shareholders and management.
 Shareholders appoint the board of directors,
who appoint management.
 Increasing focus on corporate governance
• King III (King IV)
 Threat of take-over/unemployment
 Share options to align objectives
38
• How do shareholders ensure a closer alignment of the objectives of shareholders and management? In
order to avoid conflicts of interest, and ensure that management do not follow their own objectives,
shareholders will incur monitoring costs which will include controls and incentives to encourage
management to take decisions that maximise shareholders’ wealth. These controls and incentives
reflect agency costs.
• Shareholders appoint the board of directors at the annual general meeting and the board has the
responsibility to ensure that management acts in the best interests of the shareholders. Although the
executive directors and management may have effective control of the board of directors, the current
focus on proper corporate governance and the appointment of independent and non-executive
directors mean that it is expected that this will ensure a greater propensity by the board to change the
management team if it is not acting to maximise the value of the firm.
• It is also true that the Companies Act 2008 places greater responsibilities on the board of directors
and there are greater risks of personal liability. King IV also places greater corporate governance
requirements on all directors.
• The threat of take-over is real for underperforming companies as a depressed share price often
reduces the effective cost of a take-over which invariably leads to the incumbent management team
being shown the door. Ensuring a high share price means that a company will be unattractive as a
take-over target, although sometimes a strong management team may be an incentive for the merger.
• Compensation plans provide incentives that ensure an alignment of the interest of shareholders and
management. For example, the granting of share options to management, so that management will
share in any share price appreciation, means that management will be focused on maximising the
share price.
38
Corporate Governance
• Corporate governance deals with the relationships
between management, shareholders,
directors and other stakeholders.
• It includes the checks and balances required to reduce
the potential for conflict between management and
the board of directors, shareholders and other
stakeholders.
• Management accountability, transparency and
responsible behaviour is required.
• Corporate code of ethics is needed.
• Appropriate risk management is required.
39
• Companies play a pivotal role in the global economy, in society and often have a significant impact on
the environment. The governance of companies is arguably almost as important as the governance of
countries. We explained in a prior section the potential conflicts between shareholders, management
and bondholders.
• Corporate governance may play an important role in resolving some of these conflicts. Corporate
governance deals with the relationships between management, shareholders, directors and other
stakeholders. It includes the policies, procedures, processes and controls employed in the management
of a company. It includes the checks and balances required to reduce the potential for conflict between
management and the board of directors, shareholders and other stakeholders.
• The separation of ownership and control has led to an increased focus on such issues as management
accountability, transparency and the role of the board of directors who are elected by the shareholders
of the company.
• Corporate governance should ensure that management and the board of directors act in the interest of
the shareholders, although increasingly, this includes other stakeholders.
• The board should be independent of management and there should be adequate systems of internal
controls in place, good IT governance and good risk management policies in place. Management
should ensure that the company adheres to high ethical standards, acts within the law and complies
with all applicable regulations. Management should ensure that the company’s financial performance
and position, information on operations and risks are properly reported to its shareholders.
39
Corporate Governance : King IV
 Focus of King IV
• Leadership - “The governing body should lead ethically
and effectively”
• Organisational ethics - “Govern the ethics of the
organisation in a way that supports the establishment of an
ethical culture”
• Reporting - “The governing body should ensure that
reports issued by the organisation enable stakeholders to
make informed assessments of the organisation’s
performance, and its short, medium and long term
prospects”
40
• The King Report on Corporate Governance is a ground-breaking booklet of guidelines

for the governance structures and operation of companies in South Africa. It is issued by
the King Committee on Corporate Governance.
• Three reports were issued in 1994 (King I), 2002 (King II), and 2009 (King III) and a
fourth revision (King IV) in 2016. The Institute of Directors in Southern Africa (IoDSA)
owns the copyright of the King Report on Corporate Governance and the King Code of
Corporate Governance.
• Compliance with the King Reports is a requirement for companies listed on the
Johannesburg Stock Exchange. The King Report on Corporate Governance has been
cited as "the most effective summary of the best international practices in corporate
governance“.
• The key principles of King IV relate to effective leadership, sustainability and corporate
citizenship. The board of directors should set the ethical values of the firm and define
corporate strategy.
• Sustainability is defined as the primary moral and economic imperative of the current
century. Corporate citizenship requires that the company should operate in a
sustainable manner and sustainability is embedded in the South African Constitution.
Companies are required to consider the social, environmental and economic impacts of
their operations. King IV implies that strategy, risk, performance and sustainability are
inseparable.
40
Corporate Governance : King IV
Focus of King IV
• Risk Governance - “The governing body should govern
risk in a way that supports the organisation in setting and
achieving its strategic objectives”
• Technology and information governance - “The
governing body should govern technology and
information in a way that supports the organisation setting
and achieving its strategic objectives”
• Remuneration governance - “The governing body
should ensure that the organization remunerates fairly,
responsibly and transparently so as to promote the
achievement of strategic objectives and positive outcomes
in short, medium and long term”
41
Corporate Strategy
 Corporate strategy is about direction and
action.
 Financial management decisions should be
aligned with a company’s corporate strategy.
 Companies always want to create a sustainable
competitive advantage in the sectors they
operate in.
 Management incentives need to be aligned
with a company’s strategy.
42
• Corporate strategy is about direction and action. It is important

that a company sets out its mission and objectives and
understands the business environment that it is operating in.
Financial management decisions should be aligned with a
company’s corporate strategy. A key question relates to how a
company should create a sustainable competitive advantage in
each sector it operates in. Should the firm focus on low cost or
differentiation strategies? Often a company needs to decide
what businesses the company should be in and then focus on
making decisions that increase the value of the firm. This also
means that sometimes a firm should divest of poor-performing
divisions.
• In order to increase the value of the firm, we need to understand
the competitive landscape, and future likely developments in a
sector. Further, management incentives need to be aligned with
a company’s strategy. Firms will often use models such as
Porter’s Five Forces, SWOT analysis and PESTEL analysis in
order to frame their strategic analysis.
42
Corporate Strategy
 SWOT Analysis
• Analysis of company’s internal Strengths
and Weaknesses
• Analysis of company’s external
Opportunities and Threats
• Select strategies that enhance strengths and
avoid weaknesses
• Issue of subjectivity
43
43
Corporate Strategy
Source: https://mktoolboxsuite.com/swot-analysis-examples/
44
44
Porter’s Five Forces
Source: https://www.business-to-you.com/porters-five-forces/
45
45
Corporate Strategy
https://www.business-to-you.com/scanning-the-environment-pestel-analysis/ 46
PESTEL analysis refers to a framework for considering the Political, Economic, Social, Technological,
Environmental and Legal factors that will have a material impact on a
company’s operations and level of profitability. What do these factors include?
• Political: taxation, tariffs, labour legislation, environmental regulations, trade barriers, impact of
government policies such as income grants, provision of housing, health care regulations, education and
infrastructure. Companies may win or lose if there are changes in these factors. A company providing low
cost housing will gain from a focus by government to provide low cost housing to South Africa’s
population.
• Economic: interest rates, economic growth rate, inflation rate, exchange rates. Lower interest rates may
mean a greater level of disposable income and greater spending by consumers
thereby increasing the demand for a company’s products.
• Social: population growth rates, changing demographics and age distribution, focus on safety, rising Black
middle class, changing values, use of credit, focus on food quality and health, increase in demand for
travel. A growing population and a growing Black middle class have increased the demand for the
products of many South African companies. Companies such as Truworths have benefited greatly by a
rising Black middle class with access to credit.
• Technological: advances in software and IT capabilities, research and development, automation, robots,
rate of change in processes. The improvement in IT has enabled companies to monitor sales very carefully
so that inventory management and orders reflect product sales particularly for companies such as Edcon,
Truworths and Shoprite. Inventory control due to scanning has enabled a lower investment in inventory
and lower losses from shrinkage and obsolescence.
• Environment: Climate change and the impact of South Africa’s mining legacy will impact on the
agricultural sector and other sectors that make material use of water resources.
Legal: Increasingly, legal risks relating to competition law, environmental law, consumer protection laws,
access to credit laws, employment and labour laws, health and safety
regulations are all having a material impact on corporate strategies.
46

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CHAPTER 1

Management Accounting vs. Financial Accounting

Table 1.1 Users of management accounting versus financial accounting information

Measured by the value created by finding projects with

©Correia, Flynn, Uliana, Wormald & Dillon

• At the annual general meeting of Steinhoff in April 2018, it was

• Definition 2: Financial management is strategically

• Definition 3: Financial Management means planning,

• Definition 1: Financial management is the use of best practice

• The financial manager will be required to

• Deregulation/Regulation (e.g. electricity prices,

• Deregulation/Regulations. Governments are increasingly removing regulations that

• Mergers and acquisitions (e.g. SABMiller by AB

• Currency exchange rates

• Developments in China, the USA and Europe.

• Business disruption. (e.g. Netflix, Uber)

• From the viewpoint of financial management, it is relevant

• This is probably the most common form of business entity.

• A partnership may be formed when two or more persons

• A close corporation may be formed by between one and ten

Separate legal entity? No No Yes Yes

Low (but higher than

Separately taxed from the owners No No Yes Yes

Manipulation of accounting profits

• If we accept that the objective of corporate finance is to

• We can calculate a company’s EVA to determine whether the company has

EVA = 70m – (600m x 9%)

• EVA is a performance metric that calculates the creation of

Which assets should the company invest in?

How should the company finance these investments?

• What are financial assets ? The investment in equity shares, preference

• The finance manager is constantly looking for investment

• The emphasis in this text will be placed on the fundamentals essential to an

• The agency problem is a conflict of interest inherent in any relationship where

• The King Report on Corporate Governance is a ground-breaking booklet of guidelines

• Corporate strategy is about direction and action. It is important

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