INSTRUCTOR’S MANUAL

CHAPTER
Overview of Financial
1 Management

Learning Objectives
• Describe the importance of financial management in a firm
• Describe the role of a finance manager in a firm
• Describe and explain the goal of a firm
• Define and explain shareholder wealth
• Explain agency problem and suggest solutions to overcome agency problem

Key Teaching Points

INTRODUCTION
• Financial management is concerned with making financial decisions that affect the worth of a
firm. It relates to the creation and sustenance of the economic value of the firm.
• It also covers the use of the best methods to evaluate various alternatives and make the best
decisions thereon.

THE IMPORTANCE OF FINANCIAL MANAGEMENT

• The importance of financial management can be seen through the review of the activities of a firm
and its financial position at any point in time.
• Total assets (fixed + current assets) = total liabilities (current + long term) + shareholders’ equity
• Financial management is important to any firm as it seeks to provide answers to three important
questions:
(a) What sort of fixed assets should a firm invest in?
This deals with capital budgeting issues, and the process of making and deciding on which
fixed assets or business opportunities to invest in.
(b) How shall firms raise the necessary funding to finance the capital expenditure once a decision
has been made as to the type of fixed assets or business opportunities to invest in? Firms
must consider and decide on the appropriate capital structure. The finance manager must
understand the types of long term finances as well as their characteristics, advantages and
disadvan­tages.
(c) How shall a firm manage its short-term operating cash flows? A finance manager must ensure
that adequate operating cash flows into the firm and manage the firm’s net working capital.

THE ROLE AND IMPORTANCE OF A FINANCE MANAGER

• The finance manager plays an important role in firms, which includes strategic planning, financial
and policy making.
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• The role is further broken down into that of Chief Financial Officer (CFO), Treasurer and Controller
(refer to Figure 1.2 on page 6).
• The individual roles/responsibilities of the CFO, Treasurer and Controller are explained on page 7.
• The finance manager serves as an intermediary between the firm’s operations and assets, and the
financial/capital markets (refer to Figure 1.3 on page 8).
• Some of the important activities undertaken by the finance manager cover the following:
(a) Capital budgeting and expenditures
(b) Corporate strategic and financial planning
(c) Sourcing and raising funds
(d) Cash management
(e) Credit Management
(f) Management of foreign currencies

THE GOAL OF THE FIRM

• Question: ‘In whose interests is the firm run?’
• Logically, the interest of all stakeholders should be looked after.
• However, each stakeholder has his/her own objective/goal that may conflict with those of other
stakeholders.
• The assumed goal of the firm for finance is to maximize shareholders’ wealth. Reasons:
(a) Practical,
(b) Legal
• There exist many other possible goals of a firm, which may be conflicting. Page 10 lists the many
other possible goals of a firm.
• Maximizing shareholders’ wealth may be described as ensuring that shareholders are able to
consume and enjoy more products and services.
• This means that shareholders may require more cash in hand, in the form of dividends and/or
capital gains.
• This is further simplified by stating that maximizing the value of the firm maximizes the wealth of
shareholders.

THE AGENCY PROBLEM

• Most firms, especially the larger ones, have a separation of ownership and control.
• Principal–agent relationship exists when shareholders (principal) engage the management team
(agent) to manage and run the business.
• This gives rise to agency problem, when the goals of the firm are not in line with that of management,
i.e. to maximize shareholders’ wealth.
• Agency costs are incurred by firms to monitor and control management arising from the agency
problem. Shareholders may impose organizational checks, revamp the firm, set up audit committee,
establish management audit procedures, introduce reporting requirements and so on.
• Management may also adopt the satisficing principle whereby they do just enough to satisfy
shareholders through the payment of dividends and increases in share prices (capital gains), but
merely enough to satisfy shareholders. In the meantime, management continues with their pursuit
of personal goals.
• Some solutions to overcome agency problem:
(a) Provisions in the Companies Act, 1965
(b) Selling shares and threat of takeover
(c) Information flow
(d) Linking management remuneration to improvements to shareholder wealth
• Conflicts can also arise if finance managers attempt to balance the goal of the firm with those of
other stakeholders in a firm.