A complete summary of Chapter 1: Introduction to Financial Management from the Corporate Finance textbook assigned to the module. This includes outlines from the slides as well.
The financial function is primarily concerned with the flow of capital to and from
businesses. All businesses are guided by the same financial principles. Typical
decisions to be made include financing decisions, investment decisions, and
relationships between acquisition and application of capital.
Defining Financial Management
Financial management can be described as the process of creating value in an
organisation. This process consists of planning, organizing, directing and controlling
financial activities. Value is created when there is an increase in the wealth of
shareholders.
Financial management is NOT accounting. Accounting has a historical perspective,
whereas financial management uses information from accountants to make
decisions.
Financial management is; however, linked to economics. Financial managers have
to make decisions within an ever-changing economic environment, dealing with
different types of economic indicators. South Africa is an emerging market and is
more susceptible to adverse developments in global financial markets.
Financial Management Decisions
The financial manager is responsible for an organisation’s financial-management
activities. There is a broad range of activities that financial managers deal with.
The decisions which financial managers make can be categorized into three main
groups:
1. Capital-Budgeting Decisions
What should the business invest in?
This category involves the acquisition and management of non-current assets
(capital projects or investments). Financial managers should only invest in value-
adding non-current assets.
To determine whether or not a non-current asset is value-adding, the net present
value (NPV) needs to be determined. To calculate the NPV of an asset, three
aspects of future cash flows generated need to be evaluated:
Size: How much initial investment is required (cash outflow) and how much
income will be received (cash inflow).
Timing: When and for how long income will be received.
Risk: The likelihood of receiving the income.
If the present value of an asset’s cash flows exceeds its cost, the asset has a
positive NPV. All positive NPV investments are deemed to be value-adding
investments.
, Financial Management 244
2. Capital-Structure Decisions
Where will the business get long-term financing to pay for the new investment?
These decisions concern the mix of debt and equity that the business uses to fund
its activities. There are three options available:
Borrow long-term funds (debt) – Risk Increases
Use savings of the company (retained earnings)
Issue more shares (equity) – Ownership declines
The option chosen for obtaining finance will have an effect on the business from both
a risk and value perspective. Another factor that should be considered is which form
of financing is the cheapest.
3. Working-Capital Management Decisions
How will the business manage its day-to-day financial activities?
Working capital refers to the short-term assets and liabilities of a firm (current assets
and current liabilities). Decisions center on how the firm will approach the day-to-day
financial management.
Day-to-day decisions are important, to ensure that firms function efficiently and that
there are sufficient resources to remain profitable and liquid.
The Goals of Financial Management
Financial managers need goals to guide and motivate them when making decisions
on behalf of the organisation. Three of these goals require close attention, given how
prevalent they are in financial-management practice:
Profit Maximization
To increase the net after-tax profit attributable to ordinary shareholders, financial
managers should increase the firm’s turnover and decrease its operating and other
expenses.
The main flaws of profit maximization; however, is that accounting profit can be
manipulated through malpractice; and profit maximization ignores the issues of
timing and risk associated with generating the profit.
Maximizing the Rate of Return
Financial managers may aim to maximize the ratio of net profit to total assets,
instead of merely maximizing net profit after tax. The rate of return is a percentage
which offers the advantage that several investments can be compared with each
other.
Despite this, this goal is still subject to the same risks associated with profit
maximization.
Maximizing Shareholders’ Wealth
Shareholders’ wealth is influenced by the number of shares owned and the current
share price.
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