MODULE 1 – INTRODUCTION TO FINANCIAL MANAGEMENT

Learning Objectives:

1. Definition and Objectives

2. Traditional Vs Modern Approach to Financial Management -Student reading
3. Role of the Finance Manager
4. Agency Problem
5. Time Value of Money – to be done in Module 3

1. Definition and Objectives

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Financial Management can be defined as the management of the finances of the organisation in order to
achieve the financial objectives of the organisation. Contrary to popular belief, the main objective of the
organisation is to maximise shareholder wealth. This is different to profit maximization.

1.1 Profit Maximization vs. Shareholder Wealth Maximization

In financial management, we assume that the objective of the business is to maximise shareholder
wealth. This is not necessarily the same as maximising profit. Most companies are owned by
shareholders and originally set up to make money for those shareholders. The primary objective of most
companies is thus to maximise shareholder wealth. (This could involve increasing the share price and/or
dividend pay-out.)

Refer note in copybook.

2. Traditional Vs Modern Approach to Financial Management – student reading

2.1 Traditional Approach

The finance function of past decades centered around paper-based manual transactions and processing.
It arranged the procurement of new financing, accounted for various forms of operating capital, and
contributed to the handling of legal matters. Broadly speaking, finance, tax, and treasury were the three
core functions. Depending on the size of the firm and the operating model in place, the finance function
may have held additional responsibilities including insurance, investments, and risk management. Its
main purpose in the organization was to accurately record and report on key financial data, such as:

However, data often lacked dimensionality and wasn’t scalable, accessible, or, in some cases,
meaningful enough to make substantive decisions about the future. Finance was successful at back-
office accounting but its ability to innovate on behalf of the business as a whole was limited.

2.2 Modern Approach

With the advent of technology, there was time-saving, access to more accurate data and this paved the
way for more financial planning and analysis (FP&A), saving on labor, time, and decision-making. With
greater speed, visualization, and formula-based rules built into the back office, data could be viewed
with a new lens and by more stakeholders outside the finance function.
The modern finance function is strategically positioned in the business, with a much larger scope of
work and ecosystem of tools and processes.

As digital transformation efforts made significant inroads in finance, critical time and resources were
redeployed to more strategic, value-add actions. This freed up the back office to think critically about
the allocation of resources throughout the business, the future vision of the firm, and the paths to
securing a larger share of the market.

Current finance functions now touch various other functions due to the overlap and synchronicity of
software. Payroll, human capital management (HCM), ERP, financials, cybersecurity, and various other
key business functions may rely on the same or similar software implemented by finance, solidifying the
finance team’s responsibility to the business as a whole.

As data volume and velocity grew, not all firms had the resources and software to sort through the data
and make sense of what was happening within the business in real time. Advanced business intelligence
(BI) tools assembled, arranged, and systematized the structured and unstructured data now being
generated. BI software works across formats, applications, and systems, extracting past, present, and
future information for analysis.

Finance was able to deliver insights faster thanks to an arsenal of technologies in the cloud, Big Data,
and BI spaces. One of the chief transformations of the finance function – and the world of enterprise
firms overall – is the introduction of robotic process automation (RPA) with machine learning (ML) and
artificial intelligence (AI) capabilities.

Software robotics like RPA automated a majority of traditional financial management tasks, digitalizing
items like audit trails, compliance, invoicing, accounts receivable, accounts payable, and payment
processing. RPA bots work around the clock and can handle more than twice the volume of work that
humans previously handled.

2.3 Nature and Purpose of Financial Management

Financial management is concerned with the efficient acquisition and deployment of both short- and
long-term financial resources, to ensure the objectives of the enterprise are achieved.

Decisions must be taken in three key areas:

2.3.1 Financing Decisions (Capital Structure)

Financial management is concerned with identifying how funds can be raised. These funds would be
required for both long-term and short-term business investments (capital budgeting and working
capital)

Key questions that a finance manager will ask are:

• For how long do I need the funds?

• From where can I source these?
• What is the cost of funds?
• How soon do I need the funds?
 • What are the risks involved?
• What do my owners/shareholders expect?

2.3.2 Investment Decisions (Capital Budgeting)

An investment is when money is given up today with the objective of growing that money and getting
returns over a period of time. Investments help to generate long-term value for shareholders.
Therefore, it is imperative that a company continues to make sound investments, taking into
consideration the company objectives, strategies, and the risk appetite of its shareholders.

Here, the finance manager focuses on long-term investment decisions also known as Capital
Budgeting/Capital Investment Decisions.

2.3.3. Dividend Decisions

• How much of profits should the company pay out as dividends and how much should be
retained to provide for future growth and investment opportunities for the company?
• What Is the dividend policy? Is it progressive?
• Paying out too much may require alternative finance to be found to finance any capital
expenditure or working capital requirements. – Paying out too little may fail to give
shareholders their required income levels.

3. Role of the Finance Manager

Putting all of the above together, therefore, the financial manager’s role involves making decisions
which will increase the wealth of the company's shareholders.

• In summary, financial management decisions relate to investing, financing, and dividend

decisions.
• The main roles and responsibilities of the financial manager can be summarised by the
following:
• investment selection and capital resource allocation
• raising finance and minimising the cost of capital
• distribution and retentions (dividend policy)
• communication with stakeholders
• financial planning and control
• risk management
• efficient and effective use of resources
4. Agency Theory and the Agency Problem

4.1 Agency Theory

An agency, in broad terms, is any relationship between two parties in which one, the agent, represents
the other, the principal, in day-to-day transactions. The principal or principals have hired the agent to
perform a service on their behalf.

Principals delegate decision-making authority to agents. Because many decisions that affect the
principal financially are made by the agent, differences of opinion, and even differences in priorities and
interests, can arise.

Agency theory assumes that the interests of a principal /shareholder and an agent are not always in
alignment. This is sometimes referred to as the principal-agent problem (the agency problem). A conflict
of interest is inherent in any relationship where one party is expected to act in another's best interests.

By definition, an agent is using the resources of a principal. The principal has entrusted money but has
little or no day-to-day input. The agent is the decision-maker but is incurring little or no risk because any
losses will be borne by the principal.
4.2 Agency Problem

In financial management, the agency problem usually refers to a conflict of interest between a
company's management and the company's owners or shareholders. The manager, acting as the agent
for the shareholders, or principals, is supposed to make decisions that will maximise shareholder wealth.
However, it is in the manager's own best interest to maximise his own wealth.

While it is not possible to eliminate the agency problem completely, the manager can be motivated to
act in the shareholders' best interests through incentives such as performance-based compensation,
direct influence by shareholders, the threat of firing and the threat of takeovers.

5. Time Value of Money

The time value of money is a financial concept that holds that the value of a dollar today is worth more
than the value of a dollar in the future. This is true because money you have now can be invested for a
financial return, also the impact of inflation will reduce the future value of the same amount of money.

In simple terms, $1 in your hand today has more value than $1 earned after a year.

ANALYSE - If you won a $1,000 cash prize – would you prefer to receive the money today or after 2
years?

Illustration 1

If you were to invest $12,000 at 6-percent interest for two years, your investment would be? We
illustrate this using the following equation:

FV = PV (1+r)^n

In financial management, finance managers consider the present value (value today) of future expected
cash flows. This is done through a process called ‘discounting’, where future cashflows are brought into
today’s terms. Present values (discounted values) can be calculated as follows by rearranging the
previous equation:

Where, PV = Present Value (value in todays’ terms/discounted value)

FV = Future Value

r = discount rate % (this can be inflation rate, the interest rate or the cost of capital)

n = time period (no. of years)

E.g. 1

If you were to be promised $10,000 due in one year when interest rates are 5-percent, how much do
you have to invest today?
E.g. 2

Suppose an investment that promises to pay $10,000 in one year is offered for sale for $9,500 today.
Your interest rate is 5%. Should you buy?

E.g. 3

How much would an investor have to set aside today in order to have $20,000 five years from now if the
current rate is 15%?