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The Key principles of Finance
Title : The Key principles of finance
Instructor : Khin Ma Ma Myo
Grade Level : Level 2
Document type : Lesson Plans
Description : This teaching plan traces the basic ideas relating to the
theory of corporate finance. It outlines the key decisions relating to the
financing of a company's operations, the role and effects capital markets,
agency theory and the theory of the maximization of shareholder wealth.
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Introduction
Corporate finance addresses the relationship between the financial markets
and firms. The corporate financial manager has the important task of ensuring
that they are sufficient funds available to meet all the likely needs of the
business. To do this properly, he or she requires a clear grasp both of the key
decisions related to the financing of a company's operations and the theory of
the maximization of shareholder wealth.
'The key principles of finance' teaching plan is designed for finance and
economics teachers. It is presented in three parts. Part 1 is the core of the
plan and is presented in a double-column format. The left column provides a
summary of background information, concepts and definitions that are more
fully explained in the right column.
Part 2 contains questions and exercises and is designed to assure that the
learning objectives outlined below have been met. Suggested answers are
provided.
Part 3 contains two figures of the key principles of finance. Figure 1 shows the
role of the financial manager as the link between the firm's operations and the
financial markets. Figure 2 depicts the full model of capital markets with all
sectors being connected.
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Learning Objectives
'The key principles of finance' is designed to allow students to participate with
their teacher in a program about the basic principles of corporate finance. By
combining the underlying concepts and theories, the program will enable
students to do the following:
• Outline the relationship between finance and the objectives of the
organizations
• Outline the relationship between the stakeholders in an organization
• Outline agency theory
• Outline the role and effects of the capital markets
• Outline the theory of the maximization of shareholder wealth
Contents
The program consists of the following:
• presentation material (powerpoint slides)
• Hands-out (figures in part 3)
• this teaching plan
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Part I: Core Plan
Introduction to Finance
To acquire real assets,
the company must
raise finance by
issuing financial
assets such as shares
or bonds.
In order to carry on business, companies to
employ real assets, both tangible and intangible.
Tangible assets are assets that physically exist
(eg. Machinery and buildings), whereas intangible
assets are assets that do not physically exist (eg.
Goodwill, trademarks and brand names).
To acquire such assets, the company must raise
finance by issuing financial assets such as shares
or bonds.
Thus, the financial manager (who is responsible
for the major investment and financing decisions)
stands between the firm's operations (for
example, the purchase of real assets, which are
then used by the firm to undertake projects in
order to generate profits) and the financial
markets (where investors hold the financial assets
issued by the firm to obtain money).
Therefore, the role of the financial manager canbe considered as a link between the firm's
operations and the financial markets and two
main questions are raised.
• What real assets should the firm
investment?
• How should the cash for the investment be
raised?
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Capital budgeting
decisions consider the
choice of projects in
which the firms
should invest.
Financing decisions
consider how best to
raise the required
finance.
The first question considers the choice of projects
in which the firms should invest. As firms use real
assets to undertake projects, a firm can be
thought of as a collection of projects. The
underlying objective of the business firm is to
undertake those projects to generate revenues
and incur costs, on behalf of the owners of the
firm. Thus the firm has to estimate the future
profitability of various projects, and choose
between alternative capital assets, dates of
commencement and methods of financing. All
these decisions are also known as capital
budgeting decisions.
Alternatively, the second question considers how
best to raise the required finance. The typical
project requires a significant expenditure prior to
the receipt of the first revenues and a net
investment will be required to get the project off
the ground. How should the cash for the
investment be raised? Should the finance be
raised by issuing shares (equity finance) or by
borrowing (debt finance)? All these decisions are
also known as financing decisions.
The responsibilities for capital budgeting decisions
are normally the remit of a controller, or, in many
cases, the Chief Financial Officer (CFO). The
responsibilities for financing decisions rest with
the treasurer who looks after the company's cash,
raises new capital and maintains relationships
with banks, shareholders and other investors.
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business objectives and agency theory
The divorce of
ownership from
control occurs when
the directors delegate
operational decision
making to the
executives, while
retaining control of
strategic issues.
In fact, ultimate responsibility for financial
decisions usually lie with the directors who are
acting on behalf of the shareholders who elect
them. Sometimes, the directors run the company
themselves, but quite often they hire general
managers, who are not shareholders but who are
experts in their fields, to run the company.
Most often, the directors delegate operational
decision making to the executives, while retaining
control of strategic issues. This is also known as
'the divorce of ownership from control'.
Such separation of ownership and management
has advantages such as freedom for ownership to
change without affecting operational activities and
freedom to hire professional managers. But it
may have disadvantages if the interests of the
owners and managers diverge.
When managers are motivated by objectives
which are at variance with the desires and
interests of the shareholders, the scope for
conflicts between owners and managers becomeprominent.
One theory that tries to explain the complex
relationships and conflicting objectives within an
organization is agency theory.
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Agency theory, which
considers the
relationship between
a principal and an
agent of that
principal, include
issues such as the
nature of the agency
costs, conflicts of
interests and how
agents may be
motivated.
Agency theory, which considers the relationship
between a principal and an agent of that
principal, include issues such as the nature of the
agency costs, conflicts of interests and how
agents may be motivated.
Consider the relationship between the
shareholders and the management. The
shareholders are the principals who employ the
management as the agents to run the company
on their behalf. Divergence of their interests can
lead to the possibility of conflicts of interest. Such
conflicts are also referred to as principal-agent
problems.
These conflicts of interest may equally arise
between other stakeholders- junior management,
other employees, customers, suppliers,
pensioners and the state. For example, the
company's management (principals) may wish to
motivate the employees (agents) to work hard so
that the company's profits are hight and the
management receive large profit-related bonuses.
Conversely, the employees may wish to have an
easy time at work.
Such problems may be easier to resolve if all
parties share the same insights into the fortunes
of the company. So, how might the interests of a
company's management be aligned with those of
the shareholders?
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The maximization of shareholder wealth
Provided that a free,
competitive, capital
market exists,
shareholders can
choose their
investments to meet
their needs for cash
flows, risks and so on.
Most modern organizations have many thousands
of individual shareholders and the objectives of
these shareholders will vary according to the
factors such as attitudes towards risk, time
preferences and consumption needs, balance
between the need for income and for capital
growth and tax positions.
How can managers and directors, acting as
agents for the ultimate owners, satisfy the
different desires of these owners? How can they
even know what these desires are?
There is a mechanism that enables this
conundrum to be solved. This is called the
market. Provided that a free, competitive, capital
market exists, shareholders can choose their
investments to meet their needs for cashflow, risk
and so on. If we assume that all shareholders
seek to be as rich as possible, then the goal of
the financial manager can be simply stated: to
increase the market value of each shareholder's
stake in firm.
This goal can be further refined to provide an
operational tool for financial management. Any
operational decision will be reflected in a pattern
of future cashflows and the market enables us to
identify the appropriate cost of capital to use in
decision-making.
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The capital markets
The capital markets
are the markets in
long-term finance for
companies, such as
the stock market and
the bond market.
The presence of the
capital markets'
continuous
assessment
stimulates efficient
and provides
incentives to business
managers to improve
their performance.
The capital markets are the markets in long-term
finance for companies, such as the stock market
and the bond market. For large, publicly quoted
companies, the stock market serves as a
performance monitor. While share prices may
react to the general economy or industry-wide
factors, the basic component of the share price is
the market's perception of the particular form's
current and expected future performance.
If managers are not performing effectively,
relative to the potential of the assets under their
control, it will not be long before this is reflected
in a lower share price. This may make the firm a
bargain for a take-over bid will be made.
Business organizations are, therefore, directly
and measurably subject to the disciplines of the
financial markets. In fact, the presence of the
capital markets' continuous assessment
stimulates efficiency and provides incentives to
business managers to improve their performance.
The major key effects of the capital markets on a
firm's decisions include sound investmentdecisions that require accurate measurement of
the cost of capital, mergers and take-overs that
create threats and opportunities to be exploited,
limitations in the supply of capital that focus
attention on methods of raising finance and
externalities that require managers to determined
the appropriate role of organizations.
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Part II: Questions and Answers
(1) Question: What is the role of financial management in an
organization?
Answer : Financial management involves making careful choices in
the raising of finance ( the financing decision) and in the
investment of this finance in real assets (the capital budgeting
decision).
(2) Question: What are the objectives of shareholders?
Answer : The objectives of shareholders might be to obtain a
regular dividend, to make a capital gain and to maximize the
overall return on their investment.
(3) Question: How might the interests of a company's management be
aligned with those of the shareholders?
Answer : The interests of a company's management can be aligned
with those of the shareholders by linking the management's
remuneration to the performance of the company's shares. eg. A
share option scheme
(4) Question: What is the aim of the financial manager?
Answer : The aim of the financial manager is to increase the
market value of each shareholder's stake in the firm. This means
the financial manager aims to increase the company's share priceby undertaking profitable and appropriately financed investment
opportunities
(5) Question: What information does the capital market provide to
monitor the performance of the financial manager?
Answer : The capital market provides information about the
company's share price and the prices of the company's bonds.
These are indicators of the financial manager;s performance.
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Part III: Figures
Figure 1- The role of the financial manager
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Figure 2- Capital markets