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Introduction to Corporate Finance Chapter 1

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Today, corporate finance managers must make
decision in a much more coordinated manner and
generally has direct responsibilities for a control
process. Because there are financial implications in
virtually all segments of business, she/he must have
knowledge of finance to work these sufficient
implications into the area

Learning objectives

After learning this chapter, you should be able to:

1. Understand the nature of corporate finance.
2. Understand financial management framework.
3. Identify the basic corporate finance goals.
4. Objectives and functions of corporate finance.

Introduction to
Corporate Finance
Chapter 1 Introduction to Corporate Finance

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Finance is the science of management of money and other assets. Therefore, if you think
that finance is about money and how to make profit especially when you running your own
business. Then, you are partly right as finance is much more than that. The understanding of
financial theories and practices are the essential elements in developing an effective and
efficient decision to meet the organizational goals and objectives. Even if you are not
managing any formal organization, the knowledge of finance is applicable in most of our day-
to-day decision making because modern economy cannot strive without the element of

Corporate finance involves in the management of the firm's resources to its full potential to
provide maximum benefits to the owners or the stockholders. It deals with:

An attempt to obtain and allocate financial resources effectively and efficiently to
achieve the firm's objective; that is to maximize the shareholders' wealth by
maximizing share price.

Thus, it represents a continuous process that focuses on accumulation and allocation of
scarce resources to generate revenues to fulfill the motive of establishing the business in the
first place; that is to get profits. The definitions also introduce the concept of wealth
maximization as the focus of decision-making that differs to some extends with maximization
of profits.

As a profit seeking entity, business organizations exist to produce goods and services
efficiently; and satisfy customers demands at a profit. The organization is therefore must:

1. Acquire or invest in real assets for the purpose of productions,
2. Search for ways and means to pay or finance them, and
3. Manage its day-to-day activities in production and distributions of goods and
They will continue to do so to ensure the firm is properly managed and remains as a viable
entity in the market place. This is what corporate finance is all about, that is the acquisition
and allocation of firms resources to maintain and create wealth through present and
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potential activities. Thus, the study of corporate finance deals with trying to provide answers

1. What long-term investment (assets) should the firm make? Investment decisions or
asset allocation.
2. Where will the firm get the funds or capital (debt and equity) to finance the
investment? Financing decisions or acquisition of resources.
3. How will then firms manage the short-term assets and liabilities? Working capital

Figure 1-1 outlined essential functions of corporate finance that directly provides answers to
capital budgeting question, the capital structure question, and the net working capital

Figure 1-1 Financial Management Framework



and decisions



Market or investors feedback


The development of the firm's primary financial goal is in line with the above financial
management concept as presented in Figure 1-1; that is:

To make and execute decisions that provides maximum benefits to the owners or
shareholders by maximizing owners' wealth through share price maximization.

The above statement seems to deviate main motive of business enterprise to gain maximum
profits. This leads to the basic differentiation between wealth maximization and profit
maximization approach. There are several arguments of why getting as much profit as
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possible will not ensure the firm's viability in the long-term. In contrast to wealth
maximization, the profit maximization holds on to the following views in term of:

1. Time Horizons. It focuses on short-term benefits and tries to gain as much profit as
possible regardless of the long-term effects.

2. Timing of Returns. It does not consider the timing of returns and thus time value of

3. Distributions of Income. It tends to ignore the owners wish to receive a portion of
earnings in the form of dividends.

4. Risk. It gives less consideration to risk in an attempt to maximize profits, as higher
risks will associate with higher return.

Other goals of the firm are essential to be stated to avoid any misunderstanding. In order to
achieve wealth maximization, the following goals are essentials:

1. Maximization of profits. To make profits is essential to provide stability and growth
in operations and rewards to individuals and institutions that contribute to the firm. It
is essential, however to consider the above constraints and the risk of making a
decision that is higher risk relates to higher return.

2. Maximization of sales. The efforts to maximize sales are in line with the effort to
maximize profits. Higher sales volume represents higher market control and would
ultimately increase profit.

3. Minimization of risk. The risk will act, as a control factor in maximization of profits
that is the firm should only venture in activities that provide profits more than
associated risks.

4. Maximization of share price. By keeping other factors constant, an increase in the
profits coupled with appropriate risk will lead to an increase in the market value of the
firm's common stock. Therefore, it is essential for the firm to maximize profits and
minimize risks simultaneously.

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The maximization of share price in reality not only depends on the profits and risks
associated with the firm as shown in Figure 1-1. A firm's stock price is generally dependent

1. External environments. These represent factors that are beyond the control of the
financial manager such as level of economic activity and taxes, general stock market
conditions, political and legal framework, and social values.

2. Strategic policy decisions. It represents the policy arms of the firm that will guide
the operations of the company and how it is managed. It will directly affect the
availability of internal resources to support the firm's activities, especially in financing
and investment decisions in an effort to achieve its stated goals.

3. Expected profitability and degree of risk. Any actions taken by the firm will lead to
certain level of expected return and risks. This will directly influence the market share
price as investors will continuously analyze and judge whether to purchase or not to
purchase the firm's share in the market. The supply and demand for the shares in the
market tends to influence the share price directly.

The approach to maximize wealth seems to show that management acts to maximize its
own welfare. Is this true? In most cases however, those actions that maximize the share
price are the same actions that benefit the society in general. For example, to achieve its
goals, the firm will (1) require efficient and low cost operations; (2) develop new
technologies, products and jobs; and (3) require efficient and courteous customer service. All
these actions will benefit the society as a whole in the long-term.


In the efforts to achieve the firm's goal, financial managers in reality have no free reign in
decision-making and in carrying out their duties and responsibilities. Several internal and
external constraints are at times beyond their control that they must observe. The financial
manager must continuously develop plans, monitor, and control the activities in consistent
with the achievement of the firm's short- and long-term objectives to ensure the attainment of
wealth maximization goal. The responsibilities include forecasting and planning, investment
decisions, financing decisions and dealing with the capital markets.

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1.3.1 Forecasting and Planning

The financial manager must work closely with other departments and
executives to guide and ensure the firm's growth and future viability is in line
with the stated goals. It is necessary to develop plans and strategies to
influence the future outcomes and at the same time forecast the expected
outcome of the present day decisions. In other words, it involves the
questions of:

1. What the firm is aiming to do?
2. How it proposes to do it?
3. When to do it?
4. What is the impact on the firms performance in future?

1.3.2 Investment Decisions

The investment decisions concerned with decisions regarding the firm's asset
or asset structure. It concerns with the determination of the appropriate mix in
the asset structure held by the firm, that is:

1. Determining the appropriate Ringgit to be invested in current assets
versus fixed assets,
2. Determining the optimal levels of investment in each type of current
assets, and
3. Recommending the acquisition new assets and disposal of existing
fixed assets.

The decisions on asset structure will directly influence the firm's size, growth,
and profitability. Consequently, it will determine the level of business risk, the
risk involved in dealing in any business activities that arises from the nature of
the business itself, and the returns that the firm could generate from

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1.3.3 Financing Decisions

The financing decisions will support the needs of the firm by accumulating
funds through a desirable combination of debt and equity financing; which
determines the firm's financial structure. It involves the determination of:

1. Appropriate mix of short-term and long-term source of funds for
2. Appropriate source of funds for specific investment in asset structure,
3. Appropriate dividend policy to ensure the availability of internally
generated funds for reinvestment.

These decisions will consequently influence the level of financial risk that is
the risk inherent in using a particular source of funds to finance the asset
base of the firm. It will also determine the level of financing cost that will
consequently determine the returns that the firm could generate.

1.3.4 Dealing with the Financial Markets

In order to execute their duties, the financial managers must deal with the
money and capital markets for financing and investment purposes. The two
essential responsibilities of the financial manager are investment and
financing decisions. Both investments and financing decisions affect the
firm's risk and return as manipulated by the management and as perceived
by the investors in the market place.

Thus, it directly influences the share price and hence the owner's wealth. In
turn, the share price movement will indicate investors' responses on the
decisions made. These responses will give management necessary
information and indication of approvals from stockholders as a reference for
controlling and developing plans to reinforce or rectify current or expected

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1.3.5 Dividend Policy

Another issue concerning the firm's financing and investment decisions worth
mentioning is the dividend policy. It has considerable importance to common
stockholders as it directly influences the amount of earnings available to
common stockholders that will be distributed as cash dividends and retained
earnings. In the event that the firm decided to give higher dividends or higher
dividend payout ratio, there will be less internally generated funds provided
through retained earnings to finance the company's operations.

Therefore, the company has to rely more on external financing that are more
expensive than internally generated funds. This represents a financial
decision tradeoff; that is to satisfy the needs of common stockholders for
dividends or the needs of the firm to reinvest the funds back in the company
to finance its operations. The dividend policy in essence is influenced by
several factors such as the needs of the stockholders, funds requirements,
growth rate of the company and liquidity of the firm that need to be
considered explicitly.

Role of the financial manager has gone through dramatic changes over the
Financial managers must make decisions concerning the investment,
financing and management of the companys assets.
The objective of financial decision making is the maximization of the wealth of
the owners.
Dividend policy determines the ultimate distribution of a companys earnings
between retention and cash dividend payments to its shareholders.

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1. Discuss the decisions that the financial manager needs to make.
2. Compare and contrast the goals of profit maximization and maximization of
shareholders wealth.

Chapter 1 Introduction to Corporate Finance

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