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Part 1. An Introduction

1. Finance - An Overview

Introduction

In a world of geo-political, social and economic uncertainty, strategic financial management is in a process of change, which requires a reassessment of the fundamental assumptions that cut across the traditional boundaries of the subject.

Read on and you will not only appreciate the major components of contemporary finance but also find the subject much more accessible for future reference.

The emphasis throughout is on how strategic financial decisions should be made by management, with reference to classical theory and contemporary research. The mathematics and statistics are simplified wherever possible and supported by numerical activities throughout the text.

1.1. Financial Objectives and Shareholder Wealth

Let us begin with an idealized picture of investors to whom management are ultimately responsible. All the traditional finance literature confirms that investors should be rational, risk-averse individuals who formally analyze one course of action in relation to another for maximum benefit, even under conditions of uncertainty. What should be (rather than what is) we term normative theory. It represents the foundation of modern finance within which:

Investors maximise their wealth by selecting optimum investment and financing opportunities, using financial models that maximise expected returns in absolute terms at minimum risk.

What concerns investors is not simply maximum profit but also the likelihood of it arising: a risk-return trade-off from a portfolio of investments, with which they feel comfortable and which may be unique for each individual. Thus, in a sophisticated mixed market economy where the ownership of a company's portfolio of physical and monetary assets is divorced from its control, it follows that:

The normative objective of financial management should be:

To implement investment and financing decisions using risk-adjusted wealth maximising criteria, which satisfy the firm's owners (the shareholders) by placing them all in an equal, optimum financial position.

Of course, we should not underestimate a firm's financial, fiscal, legal and social responsibilities to all its other stakeholders. These include alternative providers of capital, creditors, employees and customers, through to government and society at large. However, the satisfaction of their objectives should be perceived as a means to an end, namely shareholder wealth maximization.

As employees, management's own satisfying behaviour should also be subordinate to those to whom they are ultimately accountable, namely their shareholders, even though empirical evidence and financial scandals have long cast doubt on managerial motivation.

In our ideal world, firms exist to convert inputs of physical and money capital into outputs of goods and services that satisfy consumer demand to generate money profits. Since most economic resources are limited but society's demand seems unlimited, the corporate management function can be perceived as the future allocation of scarce resources with a view to maximising consumer satisfaction. And because money capital (as opposed to labor) is typically the limiting factor, the strategic problem for financial management is how limited funds are allocated between alternative uses.

The pioneering work of Jenson and Meckling (1976) neatly resolves this dilemma by defining corporate management as agents of the firm's owners, who are termed the principals. The former are authorized not only to act on the behalf of the latter, but also in their best interests.

Armed with agency theory, you will discover that the function of strategic financial management can be deconstructed into four major components based on the mathematical concept of expected net present value (ENPV) maximization:

The investment, dividend, financing and portfolio decision.

In our ideal world, each is designed to maximise shareholders' wealth using the market price of an ordinary share (or common stock to use American parlance) as a performance criterion.

Explained simply, the market price of equity (shares) acts as a control on management's actions because if shareholders (principals) are dissatisfied with managerial (agency) performance they can always sell part or all of their holding and move funds elsewhere. The law of supply and demand may then kick in, the market value of equity fall and in extreme circumstances management may be replaced and takeover or even bankruptcy may follow. So, to survive and prosper:

The over-arching, normative objective of strategic financial management should be the maximisation of shareholders' wealth represented by their ownership stake in the enterprise, for which the firm's current market price per share is a disciplined, universal metric.

 
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