Chapter 1
Define what Financial Management is
Based on 2 decisions
1. Which asset should the company invest in?
- Assets should increase the value of the firm
2. How should the company finance these investments?
- Requiring capital by equity or debt
These decisions are required to ensure the growth of the business enterprise; to achieve END GOAL
Issues = sources and funds
Investment decisions = ASSETS & Financing decisions = EQUITY AND LIABILITIES
Environment of financial management
FM can’t be seen in isolation; it is linked to economies and takes its size and nature into account.
- Deregulations and regulations made by government
- Taxation; cost to a business
- Interest rates
- Inflation
- Privatisation/ Nationalisation
- Commercialisation/ High input costs
- Broad based Black Economic Empowerment (BEE)
- Globalisation and internationalisation
- Mergers and acquisitions
- Currency exchange rates
- Growth in the use of financial derivatives
- Developments
- Other; aging population, climate change
Objectives of financial management
To maximise the value of the firm, thus maximising shareholder value.
Why is PROFIT not the best objective for FM?
- Manipulation of accounting profits
o To company’s detriment
o Reducing costs, depreciation
- Timing
o Profit vs Time Value of money
- Cash Flows
o Vs Accounting profit
- Accounting profits and the cost of capital
- Risk considerations
o Increased risk= Increased profits can result in a fall of value of company
o Return > cost of capital
- Shareholders want management to maximise value
o Managers must increase interest, but act in a responsible way
- Focus of FM on decision making
o Allocate scarce resources optimally
- Economic Value Added (EVA)
o Operating profit after tax – Cost of finance (after tac=x COF x investment) = EVA
,Role of the financial manager
Find the funds to finance investments
- Opportunities to create wealth
o Invest in operating assets
Any form of tangible or intangible assets bought with a view to its returning a profit
Non-current or current Assets
o Investment in financial assets
Capital markets; Issue of shares or issue of debt
Money markets; short term
Creditors; suppliers, large component of current assets financed
Retained earnings; retain part of income - reinvest
Forms of business organisations
Sole Proprietor Partnership Private Public Company
Company
Separate legal No No Yes Yes
entity
Liability of Unlimited Unlimited Limited Limited
owners (Pty)Ltd. Ltd.
Cost of Low Low Low, but higher High, if listed
formation, than SP and P
regulation and
operation
Separately No No Yes Yes
taxed from
owners
Ability to raise Low Low Low in most High, very if listed
financing in the cases
capital markets
Income tax rate Sliding scale, up 0%, Partners pay 28% 28%
to 40% in personal name
Continuity of No No Yes Yes
existence
Separation of No No No Yes
management
and ownership
Secrecy of Yes Yes Yes No
operating
returns
Disclosure Low Low Low High if listed
requirements
Audit No No No/Yes if in Yes
Requirement public interest
Ownership No No No, in most Yes
freely cases
transferable
Forms of business activities:
- Extractive activities; mining and agriculture
- Manufacturing activities; production of goods using raw materials
- Merchandising activities; retailers and wholesalers
, - Service activities; government and professional services
Financing of a business:
1. Capital markets (JSE)
Issue of shares/ debentures
Long term finance
2. Money market
Short term finance
3. Creditors (suppliers)
Large component of current assets financed
For a period of +- 60 days of interest free “loan”
4. Retained earnings
Retained part of income – reinvest in business
Agency issues impact on wealth maximisation
Separation between owners and managers of businesses
Managers don’t own large volume of shares
Agency relationship: managers act as agents on behalf of shareholders but may put their own
interests first when making decisions
Prevent by:
- Monitoring costs
- Implementing controls
- Salary incentives
- Share options = agency costs
Underlying Concepts of financial management
a. Present Value
- Determine the value today of expected future cash flows.
- Used to compare investments with differing cash flows which will occur at different times in the
future
b. Time Value of Money
- Value is determined by size and the future - and timing of cash flows
c. Risk and return
- Corporate finance is based in concept that investors will prefer low risk investments thus will
require higher returns from projects with higher risks.
- Required return = Risk-free rate + Risk premium
Ethics
Most financial decisions have ethical consequences
Ethics – Measuring business decisions against standards called values (Integrity, respect, honesty,
responsibility, accountability)
King Report
King governs SA based companies’ corporate governance matters:
- It makes board of directors (focal point) responsible for ensuring a company’s ethics are
managed effectively
- E.g.:
Implement good ethical policies in company
Establish a code of conduct
, Comply with laws and regulations
- Ensure split between management and ownership; ensure act in best interest of shareholders
performed by management and board of directors
Corporate governance and King
Deals with the relationship between management, shareholders, directors and other stakeholders.
Includes
- Policies
- Procedures
- Processes
- Controls employed in the management of a company
- Reduce the potential for conflict
Should ensure that management and the board of directors act in the interest of the shareholders and
stakeholders.
Requirements:
a. Board = independent of management
b. Adequate systems of internal controls
c. Good IT governance
d. Good risk management policies
Corporate strategy:
Porter’s Five Forces Model
- Level of rivalry amongst existing companies in the sector
- Existence and threat of substitute products
- Threat of new entrants and existence of barriers to entry
- Bargaining power of a firm’s customers
- Bargaining power of a firm’s suppliers
SWOT Analysis
- Strengths; Strong brands, product quality, distribution channels, management team
- Weaknesses; Lack of skills, customer retention problems, poor financial position
- Opportunities: New technologies, falling interest rates, change in customer tastes
- Threats; Changes in technology making products obsolete, climate change, loss of key staff
PESTEL
- Social factors
- Environmental factors
- Legal factors
Define what Financial Management is
Based on 2 decisions
1. Which asset should the company invest in?
- Assets should increase the value of the firm
2. How should the company finance these investments?
- Requiring capital by equity or debt
These decisions are required to ensure the growth of the business enterprise; to achieve END GOAL
Issues = sources and funds
Investment decisions = ASSETS & Financing decisions = EQUITY AND LIABILITIES
Environment of financial management
FM can’t be seen in isolation; it is linked to economies and takes its size and nature into account.
- Deregulations and regulations made by government
- Taxation; cost to a business
- Interest rates
- Inflation
- Privatisation/ Nationalisation
- Commercialisation/ High input costs
- Broad based Black Economic Empowerment (BEE)
- Globalisation and internationalisation
- Mergers and acquisitions
- Currency exchange rates
- Growth in the use of financial derivatives
- Developments
- Other; aging population, climate change
Objectives of financial management
To maximise the value of the firm, thus maximising shareholder value.
Why is PROFIT not the best objective for FM?
- Manipulation of accounting profits
o To company’s detriment
o Reducing costs, depreciation
- Timing
o Profit vs Time Value of money
- Cash Flows
o Vs Accounting profit
- Accounting profits and the cost of capital
- Risk considerations
o Increased risk= Increased profits can result in a fall of value of company
o Return > cost of capital
- Shareholders want management to maximise value
o Managers must increase interest, but act in a responsible way
- Focus of FM on decision making
o Allocate scarce resources optimally
- Economic Value Added (EVA)
o Operating profit after tax – Cost of finance (after tac=x COF x investment) = EVA
,Role of the financial manager
Find the funds to finance investments
- Opportunities to create wealth
o Invest in operating assets
Any form of tangible or intangible assets bought with a view to its returning a profit
Non-current or current Assets
o Investment in financial assets
Capital markets; Issue of shares or issue of debt
Money markets; short term
Creditors; suppliers, large component of current assets financed
Retained earnings; retain part of income - reinvest
Forms of business organisations
Sole Proprietor Partnership Private Public Company
Company
Separate legal No No Yes Yes
entity
Liability of Unlimited Unlimited Limited Limited
owners (Pty)Ltd. Ltd.
Cost of Low Low Low, but higher High, if listed
formation, than SP and P
regulation and
operation
Separately No No Yes Yes
taxed from
owners
Ability to raise Low Low Low in most High, very if listed
financing in the cases
capital markets
Income tax rate Sliding scale, up 0%, Partners pay 28% 28%
to 40% in personal name
Continuity of No No Yes Yes
existence
Separation of No No No Yes
management
and ownership
Secrecy of Yes Yes Yes No
operating
returns
Disclosure Low Low Low High if listed
requirements
Audit No No No/Yes if in Yes
Requirement public interest
Ownership No No No, in most Yes
freely cases
transferable
Forms of business activities:
- Extractive activities; mining and agriculture
- Manufacturing activities; production of goods using raw materials
- Merchandising activities; retailers and wholesalers
, - Service activities; government and professional services
Financing of a business:
1. Capital markets (JSE)
Issue of shares/ debentures
Long term finance
2. Money market
Short term finance
3. Creditors (suppliers)
Large component of current assets financed
For a period of +- 60 days of interest free “loan”
4. Retained earnings
Retained part of income – reinvest in business
Agency issues impact on wealth maximisation
Separation between owners and managers of businesses
Managers don’t own large volume of shares
Agency relationship: managers act as agents on behalf of shareholders but may put their own
interests first when making decisions
Prevent by:
- Monitoring costs
- Implementing controls
- Salary incentives
- Share options = agency costs
Underlying Concepts of financial management
a. Present Value
- Determine the value today of expected future cash flows.
- Used to compare investments with differing cash flows which will occur at different times in the
future
b. Time Value of Money
- Value is determined by size and the future - and timing of cash flows
c. Risk and return
- Corporate finance is based in concept that investors will prefer low risk investments thus will
require higher returns from projects with higher risks.
- Required return = Risk-free rate + Risk premium
Ethics
Most financial decisions have ethical consequences
Ethics – Measuring business decisions against standards called values (Integrity, respect, honesty,
responsibility, accountability)
King Report
King governs SA based companies’ corporate governance matters:
- It makes board of directors (focal point) responsible for ensuring a company’s ethics are
managed effectively
- E.g.:
Implement good ethical policies in company
Establish a code of conduct
, Comply with laws and regulations
- Ensure split between management and ownership; ensure act in best interest of shareholders
performed by management and board of directors
Corporate governance and King
Deals with the relationship between management, shareholders, directors and other stakeholders.
Includes
- Policies
- Procedures
- Processes
- Controls employed in the management of a company
- Reduce the potential for conflict
Should ensure that management and the board of directors act in the interest of the shareholders and
stakeholders.
Requirements:
a. Board = independent of management
b. Adequate systems of internal controls
c. Good IT governance
d. Good risk management policies
Corporate strategy:
Porter’s Five Forces Model
- Level of rivalry amongst existing companies in the sector
- Existence and threat of substitute products
- Threat of new entrants and existence of barriers to entry
- Bargaining power of a firm’s customers
- Bargaining power of a firm’s suppliers
SWOT Analysis
- Strengths; Strong brands, product quality, distribution channels, management team
- Weaknesses; Lack of skills, customer retention problems, poor financial position
- Opportunities: New technologies, falling interest rates, change in customer tastes
- Threats; Changes in technology making products obsolete, climate change, loss of key staff
PESTEL
- Social factors
- Environmental factors
- Legal factors
