25/01/2025

AN OVERVIEW OF
FINANCIAL
MANAGEMENT
Rhodilet B. Valdez, CPA

“Finance is the art and science of managing money”

• Finance is “the system that
includes the circulation of
money, the granting of credit,
the making of investments, and
the provision of banking
facilities” (Webster’s
Dictionary).

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Areas of Finance
Finance

Financial Capital
Investments
Management Markets
(Corporate Finance) (Investment Finance)
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Financial Management
• Also known as Corporate Finance,
• Is of daily concern to many
people who are employed in an
organization.
• Focuses on decisions like how
much and what type of assets to
acquire, how to raise the capital
needed to purchase the assets, and
how to run the firm to maximize
its value.

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Capital (Financial)
Markets
• Relate to the markets where
interest rates, along with
stock and bond prices, are
determined. Also studied
here are the financial
institutions that supply
capital to businesses.

Investments
Relate to decisions concerning stocks and
bonds and include a no. of activities.
• Investors use investment principles to
value the stock and bonds of many
companies (Security Analysis)
• Investors will then assess whether these
stocks and bonds at any given time are
priced “too high”, “too low” or “about
right” (Market Analysis)
• Then these investors choose which
stock and bonds to buy (Portfolio Theory)

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The Interrelation of the Areas of Finance

Financial Capital  Although we separate these
Management Markets
three areas, they are closely
interconnected.
 Financial managers can’t
work successfully while
Investments staying inside a bubble.

Finance versus
Economics and Accounting
• In a sense, the field of
Finance fits between the field
of economics and
accounting.
• Finance is the product of
economics and accounting.
• The primary economic
principle applied in finance is
the “cost-benefit analysis”

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Finance versus
Economics and Accounting
• Accounting – generally measures the
results of business past activities and
conveys its information through
financial statements to users.
• Finance – generally forward-looking (the
future is still unknown and filled with
risks and opportunities). Finance
principles must be used to decide which
path to choose from among many
competing future investment options.

Basic Principles of
Finance

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Time Value of Money

• The most fundamental concept in all of finance.
• The idea that a dollar received today is worth
more than a dollar that we expect to receive at
some date in the future.
• A dollar received today can be invested so that it
will grow in value over time. Thus, the future value
of a dollar is greater than a dollar. Today’s dollar
value is referred to as the present value.
• The relationship between future value and
present value is given by the following formula:

FV = PV (1 + i)
n

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 If $100 can be invested for one year and grown at an interest rate of 10 percent,
then the future value of that investment is $110.
FV = PV (1 + i)
n
=
$100 x (1+o.10)1
= $110
 If the $100 investment could earn 10 percent for 2 years, the future value of $100
two years from today is $221, as illustrated in the following timeline.

n=2 i = 10%
PV = $100 FV = $121

0 1 2

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 Future value equation can also be reorganized as present value equation as

follows:
1
PV = FV x
(1+i)n

 Thus, if an investor expects to receive $121 in 2 years while the interest rate is 10
percent, then the present value of the investment is $100.

n=2 i = 10%
PV = $100 FV = $121

0 1 2

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Time Value of Money;

Underlying Assumptions

• Compound interest – occurs when

interest is earned on prior
periods’ interest.
• Opportunity cost – the rate of
return that could be earned
on an alternative investment
of similar risk.

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Time Value of Money;

Emphasis on Cashflows
“Regardless of its profit or loss, a firm must have a
sufficient flow of cash to meet its obligations as they
come due. In Finance, Cash is King.”

• In Finance, little or no concern is given to

accrual income rather focus is given to cash
flows.
• Timing of cash outflows and cash inflows
which has important economic consequences.

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The Risk-Return Trade-Off

“To entice investors to take on more risk, you have
to provide them with higher expected returns”
• Risk is the chance that some
unfavorable event will occur or
the actual outcomes may differ
from those expected.
• Return is the total gain or loss
earned on an investment over a
given period.
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Sharing risk through

Diversification
“Do not put all your eggs in one basket”

• Diversification is combining
negatively correlated assets to
reduce or diversify risk.

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FORMS OF BUSINESS ORGANIZATION

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SOLE PROPRIETORSHIP
• A proprietorship is an unincorporated business
owned by one individual.
ADVANTAGES DISADVANTAGES
• Easy and inexpensive to
• Owner has unlimited
form (subject to few
liability
government regulations)
• Limited fund-raising
• Low organizational and
power tends to inhibit
operational costs
growth
• Lower income tax than • Lack of continuity when
corporations proprietor dies
• Simplicity of decision
making (Independence)

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PARTNERSHIP
• A Partnership is a legal arrangement between two
or more people who decide to do business
altogether.

ADVANTAGES DISADVANTAGES
• Can raise more funds • Owners have unlimited
than sole proprietorships liability
• Borrowing power • Partnership is dissolved
enhanced by more owners when a partner dies
• More available brain • Difficult to liquidate or
power and managerial transfer partnership
skill

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CORPORATION
• A Corporation is a legal entity created by the state,
separate and distinct from its owners and
managers.
ADVANTAGES DISADVANTAGES
• Owners have limited • Taxes are generally higher
liability (paying taxes twice)
• Indefinite life • More government control
• Ease of transfer of • Most costly to organize
ownership
• Ease of obtaining
additional capital

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Special forms of
organization
 S Corporations is a special
designation that allows small
businesses that meet qualifications to
be taxed as if they were a
proprietorship or a partnership rather
than a corporation.

“ S Corporations are meant to avoid paying taxes twice”

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Special forms of
organization (cont’d)
 Limited Liability Company (LLC) is
a hybrid partnership and corporation.

 Limited Liability Partnership (LLP)

is like an LLC but used for
professional firms in the fields of
accounting, law and architecture.

“ LLCs and LLPs; an escape to unlimited liability”

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PONDERING
THOUGHT:

What is the significance of

understanding the different forms
of business organization in
studying finance?

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A corporation is the best form of

organization, why or why not?
Corporations in terms of revenue and profits produced, are by far the
most important economic unit. Since it has a pervasive impact on our
economy.

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“When deciding on its form of organization, a

firm must trade-off the advantages of
incorporation against paying taxes twice. “
• Limited liability reduces the risk borne by
investors.
• A firm’s value is dependent on its growth
opportunities, which are dependent on its
ability to attract capital.
• Value of an asset also depends on its liquidity.
That is the time and effort to sell the asset for
cash at fair market value.

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Main Financial Goal

Creating Value for Investors

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Goal of the Financial Manager

Owners
Shareholders Principal

Act on Aligned
Delegate with the
behalf Relationship
goal
Financial
Manager Agent

 Therefore, the financial manager is on a fiduciary capacity with

the funds entrusted to it.

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Goal of the Financial Manager (cont’d)

• Illustrative Example:
Financial
Agent Assets 1,000,000
Manager
Liabilities 300,000
Equity 700,000

Maximize wealth Common stock 600,000

Retained Earnings 100,000
Equity 700,000
Shareholder value • Let’s say the company 70,000 shares
(residual claim) issued and outstanding shares.
A–L=E • Investor A holds 5,000 shares. The stock
currently sells at 5 peso per share.

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Determinants
of Value
(Stock Price)

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Determinants of Value
Managerial Actions, the Economic Environment,
Taxes, and the Political Climate

“True” Investor “True” “Perceived” Investor “Perceived”

Cash Flows Risk Cash Flows Risk

By “true” we mean the cash flows and “Perceived” means what investors
risk that investors would expect if they expect, given the limited information
had all the information that existed they have.
about the company.

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Determinants of Value (cont’d)

Managerial Actions, the Economic Environment,
Taxes, and the Political Climate

“True” Investor “True” “Perceived” Investor “Perceived”

Cash Flows Risk Cash Flows Risk

Stock’s
Intrinsic value is an estimate of a stock’s
Intrinsic Value “true” value based on accurate risk and
return data. The intrinsic value can be
estimated but not measured precisely.

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Determinants of Value (cont’d)

Managerial Actions, the Economic Environment,
Taxes, and the Political Climate

“True” Investor “True” “Perceived” Investor “Perceived”

Cash Flows Risk Cash Flows Risk

Market price is the stock value based on

Stock’s
perceived but possibly incorrect
Market Price
information as seen by the marginal
investor.

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Determinants of Value (cont’d)

Managerial Actions, the Economic Environment,
Taxes, and the Political Climate

“True” Investor “True” “Perceived” Investor “Perceived”

Cash Flows Risk Cash Flows Risk

Stock’s Stock’s
Intrinsic Value Market Price

Market Equilibrium

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More on Intrinsic Value

• Actual stock prices are easy to determine
and are published in newspapers and
other media everyday.
• Investing would be easy, profitable, and
essentially riskless if we knew all stock’s
intrinsic values.
• Intrinsic values is a long-run concept.
True long-run value is not equivalent to
current stock price.
• Management’s goals should be to take
actions designed to maximize the firm’s
intrinsic value, not its current market
price.

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Financial decisions and Stock Price

Financial
Increase Yes
Financial Decision Return?
stock Accept
Manager Alternative or Risk?
price?
Action

No

Reject

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Is maximization of Wealth
only applicable to
corporations?
- Pondering thought -

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What about other

stakeholders?
The stakeholder view does not alter the goal of minimizing
shareholder wealth. Such a view is often considered part of the
firm’s “social responsibility”. It is expected to provide long-term
benefits to shareholders by maintaining stakeholder relationships.

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Why it isn’t the main goal

is to earn the highest
possible profit?

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Drawbacks on Profit
Maximization
A change in profit is also a change
in risk.
• Profit maximization
disregards risk or
uncertainty, whereas
wealth maximization does
not.

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Drawbacks on Profit
Maximization (cont’d)
Failure to consider the timing of benefits
• In profit maximization, the firm
does not care if the cash flow is
higher or lower in the early years
of the project.
• However, in wealth maximization,
the receipt of funds sooner rather
than later is preferred.
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 Consider Projects A and B with their corresponding cash inflows per year. A firm is
choosing which of the two alternative five-year projects will give better benefits.

Year 1 Year 2 Year 3 Year 4 Year 5 Total

A 1.50 2.0 2.5 2.5 3.5 12.00

B 4.0 3.0 2.0 2.0 1.0 12.00

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 Consider the rate of return for five years is 12%

Net cash inflow PV of cash Net cash inflow PV of cash

(Project A) inflows (Project B) inflows
Year 1 1.50 1.34 4.00 3.57

Year 2 2.00 1.59 3.00 2.39

Year 3 2.50 1.78 2.00 1.42

Year 4 2.50 1.59 2.00 1.27

Year 5 3.50 1.99 1.00 0.57

TOTAL 8.29 9.22

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Drawbacks on Profit
Maximization
Accounting profits cannot be measured
reliably
• Mere estimates of how much
net income is generated.
• Computed net income does
not result to cash inflow
available to shareholders.
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Agency Problem (Conflict of interest)

Owners
Shareholders Principal

Act on Aligned
Delegate with the
behalf Relationship
goal
Financial
Manager Agent

 Agency problem is the likelihood that managers may

place personal goals ahead of corporate goals.

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Stockholder-manager conflict
• Managers’ personal goals may
compete with shareholder
maximization.
• They may pursue their benefits by
perquisite consumption,
overinvestment, or underinvestment.

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Stockholder-manager conflict;
Solutions:
Compensation packages – managers are
rewarded based on stock performance
over the long run not the stock price
on the option exercise date.
• Compensation packages should be
sufficient to attract and retain
managers.
• Classic examples of this method
are stock option plans.

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Stockholder-manager conflict;
Solutions: (cont’d)
Direct stockholder intervention– particularly
institutional investors (who hold
large block of a firm’s stock exerts
pressure on management to perform.
• They often threaten to exercise
their voting rights or liquidate their
holdings if the board does not
respond positively to their
concerns.

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Stockholder-manager conflict;
Solutions: (cont’d)
Takeover threat – if the firm’s stock is
undervalued then corporate raiders
will see it as a bargain and will
attempt to capture the firm in a
hostile takeover.
• “If you want to keep your job, never let your
stock become bargain.” – is a strong
incentive to maximize stock price.

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Stockholder-debtholder conflict
• Debtholders, which include the
company’s bankers and its
bondholders, generally receive fixed
payments regardless of how well the
company does, while the
stockholders do better when the
company does better.
• This situation leads to conflicts
between these two groups, to the
extent that stockholders are typically
more willing to take on risky
projects.

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REFERENCES:
Brigham E. F. (1989). Fundamentals of financial management (5th ed.).
Dryden Press.

Gitman L. J. & Zutter C. J. (2015). Principles of managerial finance

(Fourteenth). Pearson.

Block S. B. Hirt G. A. & Short J. D. (2000). Foundations of financial

management (5th Canadian). McGraw-Hill Ryerson.

Timbang, F. (2015). Financial Management. C&E Publishing, Inc.

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