Lecturer’s Guide Corporate Financial Management 6th edition by Glen Arnold Deborah Lewis

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Lecturer’s

Corporate Financial
Management


Sixth edition

Glen Arnold
Deborah Lewis

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CHAPTER 1

The financial world

Learning outcomes
At the end of this chapter, the reader will have a balanced perspective on the purpose and
value of the finance function, at both the corporate and the national level. More specifically,
the reader should be able to:

 describe alternative views on the purpose of the business and show the importance to any
organisation of clarity on this point;

 describe the impact of the divorce of corporate ownership from day-to-day managerial
control;

 explain the role of the financial manager;

 detail the value of financial intermediaries;

 show an appreciation of the function of the major financial institutions and markets.

Key points and concepts
 Firms should clearly define the objective of the enterprise to provide a focus for decision
making.

 Sound financial management is necessary for the achievement of all stakeholder goals.

 Some stakeholders will have their returns satisficed – given just enough to make their
contribution. One (or more) group(s) will have their returns maximised – given any
surplus after all others have been satisfied.

 The assumed objective of the firm for finance is to maximise shareholder wealth.
Reasons:
 practical, a single objective leads to clearer decisions;
 the contractual theory;
 survival in a competitive world;
 it is better for society;
 counters the tendency of managers to pursue goals for their own benefit;
 they own the firm.

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 Maximising shareholder wealth is maximising purchasing power or maximising the
flow of discounted cash flow to shareholders over a long time horizon.

 Profit maximisation is not the same as shareholder wealth maximisation. Some factors
a profit comparison does not allow for:
 future prospects;
 risk;
 accounting problems;
 communication;
 additional capital.

 Corporate governance. Large corporations usually have a separation of ownership
and control. This may lead to managerialism where the agent (the managers) takes
decisions primarily with their interests in mind rather than those of the principals (the
shareholders). This is a principal–agent problem. Some solutions:
 corporate governance regulation;
 link managerial rewards to shareholder wealth improvement;
 sackings;
 selling shares and the takeover threat;
 improve information flow.

 Financial institutions and markets encourage growth and progress by mobilising
savings and encouraging investment.

 Financial managers contribute to firms’ success primarily through investment and
finance decisions. Their knowledge of financial markets, investment appraisal methods,
treasury, risk management and value analysis techniques is vital for company growth and
stability.

 Financial institutions encourage the flow of saving into investment by acting as brokers
and asset transformers, thus alleviating the conflict of preferences between the
primary investors (households) and the ultimate borrowers (firms).

 Asset transformation is the creation of an intermediate security with characteristics
appealing to the primary investor to attract funds, which are then made available to the
ultimate borrower in a form appropriate to them. Types of asset transformation:
 risk transformation;
 maturity transformation;
 volume transformation.




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 Intermediaries are able to transform assets and encourage the flow of funds because of
their economies of scale vis-à-vis the individual investor:
 efficiencies in gathering information;
 risk spreading;
 transaction costs.

 The secondary markets in financial securities encourage investment by enabling
investor liquidity (being able to sell quickly and cheaply to another investor) while
providing the firm with long-term funds.

 The financial services sector has grown to be of great economic significance in the
United Kingdom. Reasons:
 high income elasticity;
 international comparative advantage.

 The financial sector has shown remarkable dynamism, innovation and adaptability
over the last three decades. Deregulation, new technology, globalisation and the rapid
development of new financial products have characterised this sector.

 Banking sector:
 Retail banks – high-volume and low-value business.
 Wholesale investment banks – low-volume and high-value business. Mostly fee
based.
 International banks – mostly Eurocurrency transactions.
 Building societies – still primarily small deposits aggregated for mortgage lending.
 Finance houses – hire purchase, leasing and factoring.

 Long-term savings institutions:
 Pension funds – major investors in financial assets.
 Insurance funds – life assurance and endowment policies provide large investment
funds.

 The risk spreaders:
 Unit trusts – genuine trusts which are open-ended investment vehicles.
 Investment trusts – companies which invest in other companies’ financial
securities, particularly shares.
 Open-ended investment companies (OEICs) – a hybrid between unit and
investment trusts.
 Exchange traded funds (ETFs) – set up as companies to invest in a range of
securities.

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2019