FIN2603 Exam Study Notes. Latest Document.

FIN2603 Exam Study Notes.
Latest Document.

, Chapter 1


The Financial goal of a firm.

1. Introduction.
• Firms exist because they satisfy a need by providing a product or service.
• Firms do not only meet the need for consumers but also the needs of other firms.
• The emphasis on customers needs and on providing a quality product/service to meet the
needs of customers is normally stated in the firms mission statement.
• Mission statement - describes the fundamental purpose that sets a firm apart from other firms
of its type and identifies the scope of its operations in product and market terms.
• A mission statement is vital in providing focus and direction to the firms management in
deciding how best to utilise the resources of the firm in the competitive environment in which it
functions.
• This environment contains 5 main forces:
- Rivalry within the industry.
- Bargaining power of suppliers.
- Bargaining power of clients.
- Threat of new entrants.
- Threat of new technology.
• Starting up and managing a firm successfully in a competitive environment requires a
sustainable competitive advantage. This can be achieved by one of the 3 generic strategies:
- Cost leadership - involves the sustainable mass production and marketing of standardised
items at a cost below the competitors.
- Differentiation - involves the supply of product/service that are unique, and which provide
good value to customers. The product/service must be capable of offering high perceived
value to buyers on a continuing basis, and competition must be able to imitate such
differentiation.
- Focus - involves concentrating on serving a narrowly defined market, called the niche
market. Focus enables a relatively small firm to respond more rapidly to the customers needs
of the customers than larger, diversified competitors.
• A firms strategies need to be reflected in its marketing plan.

2. Forms of business organisation.
• The size and nature of a firm will determine if it should be organised as a:
- Sole Proprietorships
- Proprietorship
- Partnerships
- Private or public company
• Two types of companies:

Private Companies Public companies
(proprietary) Limited - (Pty) Ltd Limited - Ltd

One and 50 shareholders Minimum 7 shareholders

At least one director Minimum of 2 directors

Right to transfer shares is restricted, and Right to transfer shares is not restricted, and
public are not invited to subscribe to its shares
public may be invited to subscribe to its shares
Financial statements need only be made Obliged to lodge a certified copy of its annual
available to shareholders and directors or financial statements with Registrar of
people selected by them. Companies. Must send members half-yearly
interim reports and audited financial
statements
• Not all public companies are listed on the JSE.

,3. The financial goal of a firm.
• Role of financial management is assessed form viewpoint of an investor in a firm.
• Investors need to diversify their investments.
• Diversification - means not placing all ones money in a single investment, but spending it over
various investments.
• The investor has a choice between various asset classes, the main ones:
- Real estate (rent generating assets)
- Shares (dividend generating assets)
- Fixed-interest securities ( interest generating assets)
- Cash
• Investors want to achieve the highest possible return for the lowest possible risk.
• Investors not only run risk of losing money but also the the opportunity cost when making an
investment.
• Investors and managements long-term financial goal should be to increase the value of firm,
thereby increasing the wealth of owners.
• Short-term financial goals should be:
- Profitability: the firm’s ability to generate revenues that will exceed total costs by using the
firm’s assets for productive purposes; may be achieved by marketing products/services to
maintain a sufficient profit margin with the support of promotions at competitive prices
directed to appropriate target markets through appropriate distribution channels.
- Liquidity: is firms ability to satisfy its short-term obligations as they become due.
- Solvency: the extent to which a firm’s assets exceed its liabilities; differs from liquidity in tha
liquidity pertains to the settlement of short-term liabilities, while solvency pertains to the
excess of total assets over total liabilities.
• The goal of the firm is to maximise shareholders’ wealth and not maximise profit. Profit
maximisation is not consistent with wealth maximisation, because of
- the timing of earnings per share.
- earnings that do not represent cash flows available to shareholders.
- a failure to consider risk.

4. Financial management and accounting.
• Many people regard financial management and accounting in the business environment as the
same thing; however, there is a difference. Handling of funds and decision making are the two
reasons why financial management and accounting are considered different fields.
• Handling of funds
- The primary functions of an accountant are to develop and provide data for measuring the
performance of the firm, to assess its financial position and to see to the payment of taxes.
- The financial manager’s role differs in the way in which he/she views the funds of the firm.
• Decision making
- The accountant devotes the majority of his/her attention to the collection and presentation of
historical financial data, whereas the financial manager evaluates the accountant’s financial
statements, processes and additional data, and makes decisions based on sub- sequent
analyses.

5. The functions of a financial manager.
• Financial managers functions may be evaluated in terms of the firms financial goals.
• He/she has the following primary functions:
- making investment decisions.
- making financing decisions.
- ensuring profitability.
- ensuring positive cash flow.
- ensuring solvency.
• Financing involves 2 major decisions:
- Raising enough equity and loan financing to acquire and maintain non-current and current
assets.

, - Determining which individual short/long term sources of financing should be used in order to
achieve lowest possible cost of capital.

6. Financial management and the non-financial manager.
• The management of the firms assets is not exclusively in the hands of a financial manager.
• The other functional departments, especially procurement and marketing departments play a
significant role in determining inventory levels.
• Inventory represents an investment of a portion of the firms available funds and should be
managed sensibly.
• All functional department in the business devote their energy to the achievement of the firms
gaols.

7. The fundamental principles of financial manager.

• Financial management is based on the following principles:
- the cost-benefit principle
- the risk-return principle
- the time value of money

The cost-benefit principle
- Sound financial decision making requires that an analysis of the total cost and the total benefits
be conducted.
- Decision making based on the cost of resources only will not always lead to most economic
utilisation of resources.
- The benefits should be greater than the cost of any decision.
- Cost-Benefit principle may be used by the following steps:
‣ Obtain clarity about objective to be attained.
‣ Identify alternative ways objective can be attained.
‣ Calculate the cost and benefits of each alternative.
‣ Determine effectiveness of the benefits of each alternative.
‣ Decide on a criterion or standard to be used against which the acceptability of an alternative
may be weighed.
‣ Take a decision about most appropriate course of action.

The risk-return principle
- Risk is an integral component of any decision.
- Risk is the probability that the actual result of a decision may deviate from the planned end
result, with an associated financial loss or waste of funds.
- Risk is different from uncertainty.
- Uncertainty: there is no probability or measure of the chances that an event will take place.
- Risk is measurable by profitabilities.
- The risk-return principle there is a trade off between risk and return.
- The greater the risk, the greater the required rate of return.
- The return should exceed the risk involved in any business decision.
- Risk should me minimised and managed.

The time value of money
- A concept used to evaluate any financial decision involving differences in the timing of cash
inflows and outflows.
- A matter of interest that may be earned if money is available today and invested, or of
opportunity cost if an amount will only be received at some future date – an amount of money
today is worth more than it will be at some point in the future.
- The return that could be earned is strongly influenced by the supply and demand for capital in
the financial markets.