IS-207 (Quiz 1 - Reviewer) Introduction to Financial Management
I. Concept of Finance
Definition: Finance involves the circulation of money, granting credit, making investments, and
providing banking facilities.
o According to Webster’s Dictionary: "Finance is the system that includes the circulation of
money, the granting of credit, the making of investments, and the provision of banking
facilities."
II. Areas of Finance
1. Corporate Finance
o Focus: Ensuring efficient business operations, maintaining liquidity, and maximizing long-term
profitability.
o Involves making investment decisions to allocate resources efficiently for projects and
operations.
o Deals with organizational decisions, personal finance directly addresses individual needs.
o Key Functions:
Capital Structure Decisions: Choosing between debt (loans) and equity (selling shares)
to raise money.
Investment Decisions (Capital Budgeting): Allocating resources to projects, equipment,
or assets for long-term returns.
Risk Management: Addressing risks like market changes or economic conditions to
protect profitability.
Maximizing Shareholder Value: Ensuring the company's long-term success increases
share value.
maximizing shareholder value means increasing the company's long-term
profitability and share value
2. Investment Finance
o Focus: Managing and growing financial assets.
o Focuses on asset selection.
o Investing heavily in one sector exposes a company to market risk, as declines in that sector can
lead to significant losses.
o Key Functions:
Selecting financial assets like stocks, bonds, or mutual funds.
Creating diversified portfolios to spread risk.
Diversification reduces risk by spreading investments across multiple assets,
avoiding overreliance on one asset.
Assessing risks (e.g., market risk, credit risk).
Evaluating returns on investments over time.
3. Financial Markets
o Focus: Platforms for buying and selling financial instruments (e.g., stocks, bonds, commodities).
o Key Concepts:
Primary Market: New securities are issued (e.g., IPOs).
Is where new securities are issued, enabling companies to raise capital.
Secondary Market: Trading of pre-existing securities.
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Is trade pre-owned securities
Stock Exchanges: Formal venues for securities trading.
Regulatory Bodies: Ensure fairness and transparency.
4. Personal Finance
o Focus: Managing individual/family financial activities like budgeting, saving, investing, and
planning for retirement.
o Emphasizes helping individuals meet their financial goals, such as budgeting, saving, and
managing personal investments.
o Key Functions:
Budgeting and saving for daily needs and emergencies.
Investing to grow wealth.
Managing debt and securing insurance for financial risks.
5. International Finance
o Focus: Managing cross-border financial activities and investments.
o When entering foreign markets, analyzing exchange rate fluctuations (A) is essential to
manage currency risks.
o Key Functions:
Understanding foreign exchange markets and trade finance.
Developing cross-border investment strategies.
6. Risk Management
o Focus: Identifying and mitigating financial risks.
o Key Risks:
Market Risk: Losses due to market price changes.
Market risk assessment involves analyzing changes in factors like stock prices,
interest rates, and commodity prices.
Credit Risk: Failure of a borrower to repay.
Operational Risk: Failures in internal processes.
Liquidity Risk: Difficulty converting assets to cash.
7. Financial Services
o Focus: Services provided by banks, insurance companies, and investment firms.
o Key Services:
Offering loans.
Managing retirement plans and wealth.
Brokerage services for buying and selling securities.
8. Behavioral Finance
o Focus: How psychological factors influence financial decisions.
o Studies how emotions influence financial decisions.
o Key Concepts:
Cognitive biases like overconfidence and fear impact decisions.
Behavioral strategies can help investors minimize errors.
III. Key Financial Decisions
Financial management involves making three critical decisions:
1. Investment Decisions
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oAllocate funds to projects or assets to generate maximum returns.
A financial manager’s decision to allocate funds to equipment falls under investment
decision, focusing on capital allocation to generate returns.
o Example: Deciding to invest in new equipment or infrastructure.
2. Financing Decisions
o Choose funding methods (debt vs. equity) to support operations.
A decision to fund a project using debt or equity
o Example: Issuing shares or securing a loan for a project.
3. Dividend Decisions
o Decide whether to distribute profits as dividends or reinvest them.
o Example: Paying shareholders or using profits for new ventures.
4. Cash Management
o Ensure liquidity to cover day-to-day expenses.
o Example: Keeping sufficient cash on hand for payroll and bills.
IV. Objectives of Financial Management
1. Profit Maximization: Focus on short-term profitability.
Focusing solely on short-term profits can lead to unsustainable practices and ignore long-
term value creation.
2. Wealth Maximization: Ensure sustainable growth to increase stakeholder value.
The primary goal of financial management is wealth maximization, which ensures that
shareholders' value and long-term profitability are prioritized. This approach focuses on
sustainable growth rather than just short-term gains, asset accumulation, or resolving
agency relationships. Short-term profit maximization may overlook long-term value,
increasing assets is not an ultimate goal, and reducing agency relationships is a secondary
concern.
V. The Role of Financial Managers
Responsibilities include:
o Budgeting: Develop and monitor budgets.
Creating a detailed budget falls under budgeting (C), which involves planning and
forecasting financial resources.
o Cash Flow Management: Ensure adequate liquidity.
In situations of limited cash flow, cash flow management is critical to meeting short-
term obligations.
o Risk Management: Analyze and mitigate risks.
o Financial Planning: Strategize for long-term success.
VI. Agency Relationships
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1. Definition:
o Occurs when a principal (e.g., shareholders) hires an agent (e.g., managers) to perform tasks on
their behalf.
2. Agency Conflicts:
o Arise when the agent's goals do not align with the principal's goals.
o When management wants to reinvest profits but shareholders demand dividends, this is an
agency problem it reflects conflicting interests
o Example: Shareholders wanting high dividends vs. managers reinvesting profits.
3. Resolving Agency Conflicts:
o Use performance-based incentives to align interests.
Providing performance-based incentives aligns the goals of managers and shareholders.
o Increase transparency in decision-making.
Increasing transparency and performance-based incentives ensures that management
acts in the shareholders' best interests.
VII. Application of Financial Concepts (Case Study - ABC Manufacturing Ltd.)
1. Financial Issues Identified:
o Limited cash flow.
o Inefficient budgeting processes.
o Agency conflicts between shareholders and management.
2. Recommended Strategies:
o Funding Options:
Issue equity shares for long-term capital.
Secure loans for immediate needs.
Reinvest profits for organic growth.
o Prioritized Objectives:
Ensure liquidity to support expansion.
Maximize shareholder value through sustainable growth.
o Agency Conflict Resolution:
Provide transparency in financial reporting.
Align management incentives with shareholder goals.
VIII. Key Takeaways
Financial management ensures effective allocation, raising, and use of funds.
Understanding the different areas of finance is critical for decision-making.
Financial managers play a vital role in achieving organizational goals, resolving conflicts, and ensuring
long-term success.
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