Rania El Ghalbzouri 1
IBT 2B1
,1.1 Finance and the firm
What is finance?
Finance is a multifaceted field encompassing both the science and art of effectively
managing money. At the individual level, finance revolves around the crucial
decisions people make regarding their finances, which include:
➢ Expenditure Choices: Deciding how much of one's earnings to spend, considering
factors such as daily expenses, bills, and lifestyle preferences.
➢ Savings Strategies: Determining the amount to save for future goals and financial
security. This entails understanding the importance of building a financial safety
net.
➢ Investment Selection: Deliberating on how to allocate savings into various
investment opportunities. This involves assessing risk tolerance, financial goals, and
market dynamics.
In the realm of business, finance encompasses a range of critical activities that
collectively drive the financial health and success of a company. These activities
include:
➢ Capital Acquisition: The process through which companies secure funding from
various sources, including investors, lenders, and shareholders. This financial influx
is essential for the company's operations and growth.
➢ Investment Strategies: The prudent allocation of funds by businesses into ventures
and assets with the aim of generating returns and profits. This involves assessing risk,
evaluating potential projects, and optimizing resource utilization.
➢ Profit Management: The decision-making process regarding the allocation of
profits earned by the company. Businesses must choose between reinvesting these
profits back into the company for expansion and development or distributing them
to shareholders as dividends.
What is the goal of the firm?
In the realm of corporate finance, the overarching objective of a firm is to maximize
the wealth of its shareholders, who are the ultimate owners of the company. This
central goal entails several key considerations:
➢ Wealth Maximization: The primary responsibility of company managers is to work
towards enhancing the overall wealth of the firm's shareholders. This involves
making decisions that are in the best interests of the owners.
➢ Stock Price Maximization: In practice, the pursuit of shareholder wealth
maximization often translates into efforts to maximize the firm's stock price. A higher
stock price reflects increased shareholder value and wealth.
Rania El Ghalbzouri 2
IBT 2B1
,While maximizing profit might seem like a straightforward goal, it does not necessarily
align with maximizing shareholder wealth. This discrepancy is due to several factors:
➢ Timing: Profit maximization might not coincide with the optimal timing of cash flows
and returns, which can affect shareholders' wealth differently.
➢ Cash Flows: The focus on profit alone may not account for the timing and
sustainability of cash flows, which are crucial in determining the true value of a
firm.
➢ Risk: Profit maximization does not inherently consider the level of risk associated
with various decisions, whereas shareholder wealth maximization often involves risk
assessment and management to protect and enhance wealth over the long term.
Example:
Nick Dukakis serves as the financial manager at Neptune Manufacturing, a company
that specializes in producing marine engine components. He is currently faced with a
decision between two investment options: Rotor and Valve. The table below illustrates
the expected earnings per share (EPS) for each investment over a 3-year period. If
Dukakis prioritizes maximizing profits, he would advise Neptune to opt for the Valve
investment over Rotor. This choice is based on the fact that Valve is projected to yield
higher total earnings per share during the 3-year timeframe, with $3.00 EPS as opposed
to Rotor's $2.80 EPS.
Rania El Ghalbzouri 3
IBT 2B1
,What is the goal of the firm?: Maximizing Stakeholders' Welfare?
In discussions surrounding the objective of a firm, an alternative perspective suggests
a more balanced approach that takes into account the well-being of not only
shareholders but also other key stakeholders associated with the firm. These
stakeholders encompass a broad spectrum, including employees, suppliers,
customers, and members of the local community where the firm operates.
This viewpoint emphasizes the following:
➢ Balanced Welfare: Advocates of this approach argue for a balanced
consideration of the interests and welfare of both shareholders and these diverse
stakeholders. It suggests that a firm should aim to create positive outcomes for all
parties involved.
➢ Stakeholder Inclusion: Recognizing that businesses have a broader impact beyond
just their shareholders, it acknowledges the significance of fostering positive
relationships with employees, suppliers, customers, and the local community.
In contemplating the goal of maximizing stakeholders' welfare, it is imperative for
managers to recognize and prioritize the interests of all parties associated with a firm.
Several key principles underpin this perspective:
➢ Holistic Consideration: Managers should refrain from disregarding the concerns
and interests of all individuals and entities connected to the firm, including
shareholders, employees, suppliers, customers, and the broader community.
➢ Long-Term Perspective: In their pursuit of maximizing shareholder value, managers
must adopt a forward-looking approach that carefully evaluates the enduring
consequences of their decisions. This entails considering the long-term implications
of actions, rather than focusing solely on short-term gains.
➢ Ethical and Legal Boundaries: An essential component of maximizing stakeholders'
welfare is the adherence to established legal and ethical standards. Managers
are obligated to operate within these boundaries to ensure that the interests of all
stakeholders are protected and promoted.
Rania El Ghalbzouri 4
IBT 2B1
,The role of business ethics
Business ethics encompass the established principles and codes of moral conduct
applicable to individuals engaged in commercial activities. These ethical standards
play a pivotal role in guiding the behaviour and decision-making processes of
businesses and market participants. The primary aim of business ethics is to inspire
adherence to both the explicit provisions and the broader intentions of laws and
regulations governing business conduct. A notable example highlighting the
relevance of business ethics is the Volkswagen scandal, where engineers devised
intricate schemes to circumvent pollution controls, illustrating the repercussions of
unethical behaviour within the business realm.
Effective ethical decision-making in business often involves a systematic evaluation of
actions against established ethical guidelines. Several key considerations come into
play:
➢ Moral and Legal Rights: One fundamental aspect is assessing whether a given
action violates the moral or legal rights of any individual or group involved. This
ensures that ethical decisions respect the rights and interests of stakeholders.
➢ Alignment with Accepted Standards: Ethical decisions should align with commonly
accepted moral standards within society. This entails considering prevailing norms
and values when evaluating actions.
➢ Harm Mitigation: Evaluators should explore whether alternative courses of action
exist that are less likely to cause actual or potential harm to individuals, groups, or
society at large. This emphasizes the importance of minimizing negative
consequences.
A pertinent example can be found in the case of Google, which frequently faces
ethical dilemmas related to privacy, data handling, and search engine optimization
practices.
Rania El Ghalbzouri 5
IBT 2B1
,1.2 The Managerial Finance Function
Within the domain of managerial finance, financial managers play a pivotal role in
making critical decisions that shape the financial well-being and performance of an
organization. These key decisions fall into three primary categories:
1. Investment Decisions: Financial managers are tasked with evaluating and
selecting investment opportunities that align with the firm's strategic goals. This
process involves capital budgeting decisions, which entail assessing and
allocating resources to long-term projects or investments.
2. Capital Budgeting Decisions
Capital budgeting decisions are an integral part of investment choices. These
decisions involve allocating resources to specific long-term projects or investments. It
entails evaluating the costs, benefits, and risks associated with each investment
opportunity.
3. Financing Decisions: The financing decisions undertaken by financial managers
encompass various aspects:
➢ Capital Structure Decisions: This involves determining the proportion of debt and
equity in the firm's financial structure. It is a fundamental choice that impacts the
cost of capital and risk profile.
➢ Raising Funds: Financial managers are responsible for acquiring the necessary
funds to support the firm's operations and growth. This involves decisions regarding
how the firm raises capital.
➢ Working Capital Decisions: These decisions pertain to the management of a firm's
short-term resources, including inventory, payables, and receivables. Effective
working capital management is vital for day-to-day operations.
Rania El Ghalbzouri 6
IBT 2B1
,Principal-Agent Problem
The principal-agent problem is a common challenge in corporate governance. It
arises due to the separation of ownership and management in a firm, where the
owners (principals) appoint managers (agents) to run the business. The issue emerges
when agents do not always act in the best interests of the principals, often prioritizing
their own goals or divergent interests. This problem becomes particularly pronounced
in large corporations where there is a significant divide between the firm's owners and
its managers.
Organization of the Finance Function
The finance function within an organization typically comprises several key roles and
positions:
➢ CEO (Chief Executive Officer): The highest-ranking executive responsible for overall
strategic direction and decision-making.
➢ CFO (Chief Financial Officer): The CFO is responsible for overseeing the financial
activities of the organization, including financial planning, reporting, and risk
management.
➢ Treasurer (Cash Management): This role focuses on managing the organization's
cash resources, optimizing liquidity, and making decisions related to investments
and financing.
➢ Controller (Accounting): The controller oversees the accounting function, ensuring
accurate financial reporting, compliance with accounting standards, and internal
controls.
➢ Director of Risk Management: Responsible for identifying, assessing, and mitigating
risks that could affect the organization's financial stability.
➢ Director of Investor Relations: Manages communication and relationships with the
organization's investors and stakeholders.
➢ Director of Internal Audit: This role focuses on conducting internal audits to
evaluate and improve the organization's processes and controls.
➢ Foreign Exchange Manager: Manages foreign exchange exposure and
transactions in organizations with international operations.
Rania El Ghalbzouri 7
IBT 2B1
,Relationship to Accounting
In the context of finance and accounting, two distinct bases are used for recognizing
financial transactions:
➢ Accounting uses an Accrual Basis: This approach recognizes revenue when it is
earned, often at the time of sale, even if cash is received later. Similarly, expenses
are recognized when they are incurred, even if cash is paid at a later date.
➢ Finance uses Cash Flows: Finance, on the other hand, primarily focuses on actual
cash inflows and outflows. It recognizes revenues and expenses only when cash is
received or paid, providing a more immediate and cash-centric view of financial
performance.
Example:
Nassau Corporation recently sold a yacht for $1,000,000 in the past calendar year.
They had originally bought the yacht for $800,000. Despite having paid for the yacht
in full during the year, they have not yet received the $1,000,000 from the customer
(the customer hasn't paid yet).
The company's performance can be viewed in two ways: from an accounting
perspective and from a financial perspective, as shown in the income and cash flow
statements below.
From an accounting standpoint, Nassau Corporation appears to be profitable.
However, when considering actual cash flow, a problem arises. The issue stems from
the fact that they haven't received the $1,000,000 accounts receivable. This lack of
cash inflow means they may struggle to meet their financial obligations, and even
though they are profitable on paper, without sufficient cash flow, the company's
survival is at risk.
Rania El Ghalbzouri 8
IBT 2B1
,Example:
Individuals typically don't utilize accrual accounting methods. Instead, they primarily
rely on cash flow to assess their financial situation. Let's take Ann Bach as an example.
She estimates her cash flow for the month of October as follows:
Ann calculates her total expenses to be $4,835, while her total income is $4,620. The
difference between these figures reveals that her net cash flow for October will be -
$215. In order to cover this deficit, Ann has a few options. She can either borrow $215,
which might involve putting it on a credit card, or she can withdraw $215 from her
savings. Alternatively, Ann could decide to cut down on her discretionary spending,
such as clothing purchases, dining out, or miscellaneous expenses totalling $425, as a
means to balance her budget.
Rania El Ghalbzouri 9
IBT 2B1
, The Managerial Finance Function
Within the field of managerial finance, it is essential to understand the relationship
between financial management and accounting, as well as the nature of decision-
making in this context.
Relationship to Accounting
Accounting plays a crucial role in providing financial data and historical records.
However, the financial manager's perspective differs in terms of how this information
is utilized:
➢ Accounting Focus: Accountants primarily concentrate on collecting and
presenting past financial data. Their main responsibility is to document and report
on financial transactions that have already occurred.
➢ Financial Manager's Role: Financial managers, while utilizing accounting
statements, extend their scope beyond the past. They engage in forecasting and
utilize these forecasts to make decisions concerning future returns and associated
risks. This forward-looking approach is integral to their role.
Assessing Risk
Assessing and managing risk is a fundamental aspect of financial management. This
process involves developing scenarios to gauge potential outcomes and associated
risks. Three primary scenarios are typically considered:
➢ Best Case Scenario: This represents the most favourable circumstances and
outcomes. Financial managers assess the potential for exceptional returns and
minimal risks under these conditions.
➢ Base Case Scenario: The base case scenario is a realistic projection that forms the
foundation for decision-making. It reflects the most likely outcomes, providing a
benchmark for evaluating other scenarios.
➢ Worst Case Scenario: Financial managers also consider the worst-case scenario,
which outlines the most adverse conditions and potential risks. This helps them
prepare for and mitigate extreme challenges.
Rania El Ghalbzouri 10
IBT 2B1
IBT 2B1
,1.1 Finance and the firm
What is finance?
Finance is a multifaceted field encompassing both the science and art of effectively
managing money. At the individual level, finance revolves around the crucial
decisions people make regarding their finances, which include:
➢ Expenditure Choices: Deciding how much of one's earnings to spend, considering
factors such as daily expenses, bills, and lifestyle preferences.
➢ Savings Strategies: Determining the amount to save for future goals and financial
security. This entails understanding the importance of building a financial safety
net.
➢ Investment Selection: Deliberating on how to allocate savings into various
investment opportunities. This involves assessing risk tolerance, financial goals, and
market dynamics.
In the realm of business, finance encompasses a range of critical activities that
collectively drive the financial health and success of a company. These activities
include:
➢ Capital Acquisition: The process through which companies secure funding from
various sources, including investors, lenders, and shareholders. This financial influx
is essential for the company's operations and growth.
➢ Investment Strategies: The prudent allocation of funds by businesses into ventures
and assets with the aim of generating returns and profits. This involves assessing risk,
evaluating potential projects, and optimizing resource utilization.
➢ Profit Management: The decision-making process regarding the allocation of
profits earned by the company. Businesses must choose between reinvesting these
profits back into the company for expansion and development or distributing them
to shareholders as dividends.
What is the goal of the firm?
In the realm of corporate finance, the overarching objective of a firm is to maximize
the wealth of its shareholders, who are the ultimate owners of the company. This
central goal entails several key considerations:
➢ Wealth Maximization: The primary responsibility of company managers is to work
towards enhancing the overall wealth of the firm's shareholders. This involves
making decisions that are in the best interests of the owners.
➢ Stock Price Maximization: In practice, the pursuit of shareholder wealth
maximization often translates into efforts to maximize the firm's stock price. A higher
stock price reflects increased shareholder value and wealth.
Rania El Ghalbzouri 2
IBT 2B1
,While maximizing profit might seem like a straightforward goal, it does not necessarily
align with maximizing shareholder wealth. This discrepancy is due to several factors:
➢ Timing: Profit maximization might not coincide with the optimal timing of cash flows
and returns, which can affect shareholders' wealth differently.
➢ Cash Flows: The focus on profit alone may not account for the timing and
sustainability of cash flows, which are crucial in determining the true value of a
firm.
➢ Risk: Profit maximization does not inherently consider the level of risk associated
with various decisions, whereas shareholder wealth maximization often involves risk
assessment and management to protect and enhance wealth over the long term.
Example:
Nick Dukakis serves as the financial manager at Neptune Manufacturing, a company
that specializes in producing marine engine components. He is currently faced with a
decision between two investment options: Rotor and Valve. The table below illustrates
the expected earnings per share (EPS) for each investment over a 3-year period. If
Dukakis prioritizes maximizing profits, he would advise Neptune to opt for the Valve
investment over Rotor. This choice is based on the fact that Valve is projected to yield
higher total earnings per share during the 3-year timeframe, with $3.00 EPS as opposed
to Rotor's $2.80 EPS.
Rania El Ghalbzouri 3
IBT 2B1
,What is the goal of the firm?: Maximizing Stakeholders' Welfare?
In discussions surrounding the objective of a firm, an alternative perspective suggests
a more balanced approach that takes into account the well-being of not only
shareholders but also other key stakeholders associated with the firm. These
stakeholders encompass a broad spectrum, including employees, suppliers,
customers, and members of the local community where the firm operates.
This viewpoint emphasizes the following:
➢ Balanced Welfare: Advocates of this approach argue for a balanced
consideration of the interests and welfare of both shareholders and these diverse
stakeholders. It suggests that a firm should aim to create positive outcomes for all
parties involved.
➢ Stakeholder Inclusion: Recognizing that businesses have a broader impact beyond
just their shareholders, it acknowledges the significance of fostering positive
relationships with employees, suppliers, customers, and the local community.
In contemplating the goal of maximizing stakeholders' welfare, it is imperative for
managers to recognize and prioritize the interests of all parties associated with a firm.
Several key principles underpin this perspective:
➢ Holistic Consideration: Managers should refrain from disregarding the concerns
and interests of all individuals and entities connected to the firm, including
shareholders, employees, suppliers, customers, and the broader community.
➢ Long-Term Perspective: In their pursuit of maximizing shareholder value, managers
must adopt a forward-looking approach that carefully evaluates the enduring
consequences of their decisions. This entails considering the long-term implications
of actions, rather than focusing solely on short-term gains.
➢ Ethical and Legal Boundaries: An essential component of maximizing stakeholders'
welfare is the adherence to established legal and ethical standards. Managers
are obligated to operate within these boundaries to ensure that the interests of all
stakeholders are protected and promoted.
Rania El Ghalbzouri 4
IBT 2B1
,The role of business ethics
Business ethics encompass the established principles and codes of moral conduct
applicable to individuals engaged in commercial activities. These ethical standards
play a pivotal role in guiding the behaviour and decision-making processes of
businesses and market participants. The primary aim of business ethics is to inspire
adherence to both the explicit provisions and the broader intentions of laws and
regulations governing business conduct. A notable example highlighting the
relevance of business ethics is the Volkswagen scandal, where engineers devised
intricate schemes to circumvent pollution controls, illustrating the repercussions of
unethical behaviour within the business realm.
Effective ethical decision-making in business often involves a systematic evaluation of
actions against established ethical guidelines. Several key considerations come into
play:
➢ Moral and Legal Rights: One fundamental aspect is assessing whether a given
action violates the moral or legal rights of any individual or group involved. This
ensures that ethical decisions respect the rights and interests of stakeholders.
➢ Alignment with Accepted Standards: Ethical decisions should align with commonly
accepted moral standards within society. This entails considering prevailing norms
and values when evaluating actions.
➢ Harm Mitigation: Evaluators should explore whether alternative courses of action
exist that are less likely to cause actual or potential harm to individuals, groups, or
society at large. This emphasizes the importance of minimizing negative
consequences.
A pertinent example can be found in the case of Google, which frequently faces
ethical dilemmas related to privacy, data handling, and search engine optimization
practices.
Rania El Ghalbzouri 5
IBT 2B1
,1.2 The Managerial Finance Function
Within the domain of managerial finance, financial managers play a pivotal role in
making critical decisions that shape the financial well-being and performance of an
organization. These key decisions fall into three primary categories:
1. Investment Decisions: Financial managers are tasked with evaluating and
selecting investment opportunities that align with the firm's strategic goals. This
process involves capital budgeting decisions, which entail assessing and
allocating resources to long-term projects or investments.
2. Capital Budgeting Decisions
Capital budgeting decisions are an integral part of investment choices. These
decisions involve allocating resources to specific long-term projects or investments. It
entails evaluating the costs, benefits, and risks associated with each investment
opportunity.
3. Financing Decisions: The financing decisions undertaken by financial managers
encompass various aspects:
➢ Capital Structure Decisions: This involves determining the proportion of debt and
equity in the firm's financial structure. It is a fundamental choice that impacts the
cost of capital and risk profile.
➢ Raising Funds: Financial managers are responsible for acquiring the necessary
funds to support the firm's operations and growth. This involves decisions regarding
how the firm raises capital.
➢ Working Capital Decisions: These decisions pertain to the management of a firm's
short-term resources, including inventory, payables, and receivables. Effective
working capital management is vital for day-to-day operations.
Rania El Ghalbzouri 6
IBT 2B1
,Principal-Agent Problem
The principal-agent problem is a common challenge in corporate governance. It
arises due to the separation of ownership and management in a firm, where the
owners (principals) appoint managers (agents) to run the business. The issue emerges
when agents do not always act in the best interests of the principals, often prioritizing
their own goals or divergent interests. This problem becomes particularly pronounced
in large corporations where there is a significant divide between the firm's owners and
its managers.
Organization of the Finance Function
The finance function within an organization typically comprises several key roles and
positions:
➢ CEO (Chief Executive Officer): The highest-ranking executive responsible for overall
strategic direction and decision-making.
➢ CFO (Chief Financial Officer): The CFO is responsible for overseeing the financial
activities of the organization, including financial planning, reporting, and risk
management.
➢ Treasurer (Cash Management): This role focuses on managing the organization's
cash resources, optimizing liquidity, and making decisions related to investments
and financing.
➢ Controller (Accounting): The controller oversees the accounting function, ensuring
accurate financial reporting, compliance with accounting standards, and internal
controls.
➢ Director of Risk Management: Responsible for identifying, assessing, and mitigating
risks that could affect the organization's financial stability.
➢ Director of Investor Relations: Manages communication and relationships with the
organization's investors and stakeholders.
➢ Director of Internal Audit: This role focuses on conducting internal audits to
evaluate and improve the organization's processes and controls.
➢ Foreign Exchange Manager: Manages foreign exchange exposure and
transactions in organizations with international operations.
Rania El Ghalbzouri 7
IBT 2B1
,Relationship to Accounting
In the context of finance and accounting, two distinct bases are used for recognizing
financial transactions:
➢ Accounting uses an Accrual Basis: This approach recognizes revenue when it is
earned, often at the time of sale, even if cash is received later. Similarly, expenses
are recognized when they are incurred, even if cash is paid at a later date.
➢ Finance uses Cash Flows: Finance, on the other hand, primarily focuses on actual
cash inflows and outflows. It recognizes revenues and expenses only when cash is
received or paid, providing a more immediate and cash-centric view of financial
performance.
Example:
Nassau Corporation recently sold a yacht for $1,000,000 in the past calendar year.
They had originally bought the yacht for $800,000. Despite having paid for the yacht
in full during the year, they have not yet received the $1,000,000 from the customer
(the customer hasn't paid yet).
The company's performance can be viewed in two ways: from an accounting
perspective and from a financial perspective, as shown in the income and cash flow
statements below.
From an accounting standpoint, Nassau Corporation appears to be profitable.
However, when considering actual cash flow, a problem arises. The issue stems from
the fact that they haven't received the $1,000,000 accounts receivable. This lack of
cash inflow means they may struggle to meet their financial obligations, and even
though they are profitable on paper, without sufficient cash flow, the company's
survival is at risk.
Rania El Ghalbzouri 8
IBT 2B1
,Example:
Individuals typically don't utilize accrual accounting methods. Instead, they primarily
rely on cash flow to assess their financial situation. Let's take Ann Bach as an example.
She estimates her cash flow for the month of October as follows:
Ann calculates her total expenses to be $4,835, while her total income is $4,620. The
difference between these figures reveals that her net cash flow for October will be -
$215. In order to cover this deficit, Ann has a few options. She can either borrow $215,
which might involve putting it on a credit card, or she can withdraw $215 from her
savings. Alternatively, Ann could decide to cut down on her discretionary spending,
such as clothing purchases, dining out, or miscellaneous expenses totalling $425, as a
means to balance her budget.
Rania El Ghalbzouri 9
IBT 2B1
, The Managerial Finance Function
Within the field of managerial finance, it is essential to understand the relationship
between financial management and accounting, as well as the nature of decision-
making in this context.
Relationship to Accounting
Accounting plays a crucial role in providing financial data and historical records.
However, the financial manager's perspective differs in terms of how this information
is utilized:
➢ Accounting Focus: Accountants primarily concentrate on collecting and
presenting past financial data. Their main responsibility is to document and report
on financial transactions that have already occurred.
➢ Financial Manager's Role: Financial managers, while utilizing accounting
statements, extend their scope beyond the past. They engage in forecasting and
utilize these forecasts to make decisions concerning future returns and associated
risks. This forward-looking approach is integral to their role.
Assessing Risk
Assessing and managing risk is a fundamental aspect of financial management. This
process involves developing scenarios to gauge potential outcomes and associated
risks. Three primary scenarios are typically considered:
➢ Best Case Scenario: This represents the most favourable circumstances and
outcomes. Financial managers assess the potential for exceptional returns and
minimal risks under these conditions.
➢ Base Case Scenario: The base case scenario is a realistic projection that forms the
foundation for decision-making. It reflects the most likely outcomes, providing a
benchmark for evaluating other scenarios.
➢ Worst Case Scenario: Financial managers also consider the worst-case scenario,
which outlines the most adverse conditions and potential risks. This helps them
prepare for and mitigate extreme challenges.
Rania El Ghalbzouri 10
IBT 2B1
