Introduction to

Corporate Finance

Chapter 1 1
 Finance
• Definition:
–Application of the principles of
financial economics to an inter-related
set of monetary problems.
• Categories:
–Personnel finance
–Public finance
–Corporate finance

Chapter 1 2
 What is Financial Management?
• Study and practice of money related
decisions within a firm.
• Concerned with planning and
controlling of financial resources
• Involves with balancing risk and
profitability.

Chapter 1 3
 Areas of Decision Functions
1. Investment Decision-
a) Capital Investment decision
b) Working capital investment decision
2. Financing Decision
a) Borrowing
b) Issuing common stock or preferred stock
c) Using retained earnings.
3. Asset Management Decision-

Chapter 1 4
Important Parties in the Financial
Environment
1. Financial managers
• Responsible for deciding how to
invest the firm’s funds for expanding
its business and how to obtain funds
for investment.
2. Investors
• Individual
• Institutional
Chapter 1 5
Important Parties in the Financial
Environment
3. Financial market
• Forum that facilitate the flow of funds among
investors.
• Composed of money and capital market
4. Financial Institutions
• Intermediaries that channel the savings of
individuals, businesses and governments into
loans or investments.
• Include commercial banks, savings institutions,
insurance and finance companies and mutual
funds.

Chapter 1 6
 Money Market
1. Deals with short-term securities.
2. Consists of interbank market and the market
through the intermediary of discount houses.
3. Transactions usually take place over the
telephone.
4. It enables the commercial banks to convert a
portion of their cash reserves into assets
that generate returns.
5. Facilitates firms and institutions in obtaining
short-term loans.

Chapter 1 7
 Capital Market
1. Market where securities have a life of
more than one year
2. Categorized into:
1. Primary market
2. Secondary market
3. Medium and long-term loan market

Chapter 1 8
Financial Manager - Responsibilities
1. Forecasting and planning
• Determine the amount of funds the firm
needs; a large firm seeking rapid growth will
require more funds.
2. Investment and financing decisions
• Determine sales growth rates
• Determine what specific assets to purchase
• Determine the best method of financing
those assets.

Chapter 1 9
Financial Manager - Responsibilities
3. Coordination and control
• interact with other departments within the
organization.
4. Dealing with financial markets
• Has to obtain financing either through
money market or capital market.
• Has to decide on investing idle funds in the
financial market
• Has to foster relationships with creditors.

10
Chapter 1
 The Financial Manager’s Decisions
Affect Stockholders’ Wealth
Maximization by Influencing:
1. Current and future earnings per share
2. Timing, duration and risk of earnings
3. Dividend policy
4. Manner of financing

Chapter 1 11
 Goal of the Firm
1.Profit maximization
2.Shareholders’ wealth
maximization

Chapter 1 12
 Profit Maximization
1. Profit is the amount of revenue remaining after
deducting all costs and expenses. The expenses
include non-cash items such as depreciation and
amortization of fixed assets
2. Can be achieved in short-term (less than 1
year) by either increasing or decreasing the
variables such as sales units or sales price.
3. Emphasized on the amount of profit and not on
when the profits are received.
4. Increased in profit does not mean an increased
in cash.
5. Ignores risk and uncertainty that comes with
the project.

Chapter 1 13
 Drawbacks of Profit Maximization
1. It is a short-term concept .
•Example: A Bhd intends to increase its profits, either by
reducing its investment in R&D or by postponing major
repairs. The reduction in R&D or postponement of major
repairs may result in future decline in sales and profits
2. It does not consider the timing of returns.
• Timing of returns refer to how quickly a firm earns a
return from an investment in fixed assets.
• Example: A Bhd. has 2 projects with the following
earnings:

Year Earnings (RM)

Project A Project B
1 250,000 0
2 0 250,000
14
Chapter 1
 Drawbacks of Profit Maximization
– Project A is equal to Project B since both projects generate the
same earnings.
– According to TVM, the two projects are not equal because the
sooner A receives the earnings, the sooner it can be invested
to generate returns, the higher the value of the money.
3. It does not consider risk
• Risk is defined as chance that the actual results would differ from
the expected results.
• Assume A Co is considering 2 mutually exclusive projects with the
following earnings:

Earnings (RM)

Economic Conditions Project A Project B

Boom 300,000 700,000
Average 300,000 200,000
Recession 300,000 nil
15
Chapter 1
Drawbacks of Profit Maximization
– According to profit maximization, the two
projects are equal since the average earnings
for both projects are RM300,000.
– Rationally, the two projects are not equal
because Project B has a high degree of
uncertainty compared to Project A. B may not
be able to generate earnings if the economy
is in recession.

Chapter 1 16
Shareholders’ Wealth Maximization
1. Shareholders’ wealth refers to the market
value of common stock held in the company.
2. Has to achieve all the short-term goals such
as increase in profits, growth in earnings and
dividends, and maintain financial stability so
that the firm will be more attractive thereby
resulting in an increase in demand for the
firm’s common stock which follows with an
increase in the share price.

Chapter 1 17
 Shareholders’ Wealth
Maximization
3. Apply the principle of time value of
money in which a dollar received today is
worth more than if it is received in ten
years time.
4. Decisions are made after taking into
account the uncertainty or risk factor.
5. Increase in wealth is related to increase
in cash flows.

Chapter 1 18
 Advantages /Disadvantages of Profit
Maximization
1. Easy to calculate profit 1. Emphasized short
2. Easy to determine the term gains
link between financial 2. Ignore risk and real
decisions and profit world complexities
3. Stress on efficient use when making financial
of capital resources decisions
3. Concentrates on EPS
4. Ignore costs of funds
provided by
shareholders in
computing profit.

Chapter 1 19
 Advantages/Disadvantages of
Shareholders’ Wealth Maximization
1. Emphasize long-term 1. Goal does not offer any
returns clear relationship
2. Consider risk when making between stock price
financial decisions and financial decisions.
3. Consider timing of returns 2. It may take a long time
4. Takes into account the to achieve.
economic expectations
since it affects movement in
stock price.
5. Emphasize market price per
share

Chapter 1 20