Introduction to Financial Management U1

UNIT 1 i
The scope of corporate finance

Unit 1

BBF 201/05

Introduction to Financial
Management

The Scope of
Corporate Finance

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BBF 201/05 Introduction to Financial Management

COURSE TEAM

Course Team Coordinator: Mr. Lee Kian Tek Jason
Content Writers: Mr. Tee Chwee Ming and Dr. Hooy Chee Wooi
Instructional Designer: Ms. Michelle Loh Woon Har
Academic Member: Mr. Ravindran A/L Raman

COURSE COORDINATOR

Mr. Lee Kian Tek Jason

EXTERNAL COURSE ASSESSOR

Professor Datin Dr. Ruhani Ali, Universiti Sains Malaysia

PRODUCTION

Editor: Penerbitan Pelangi Sdn. Bhd.
In-house Editor: Ms. Michelle Loh Woon Har
Graphic Designer: Ms. Leong Yin Ling

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First revision 2020

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UNIT 1 iii
The scope of corporate finance

Contents 1
3
Unit 1 The Scope of Corporate 4
Finance
5
Course overview
Unit overview 5
Unit objectives 5
5
1.1 The role of corporate finance in modern 6
business
7
Objectives 10
Introduction
Maximising shareholder value 11
The dynamic relationship between finance and 11
non-finance areas 11
Corporate finance, capital markets and investments 11
Suggested answers to activity 15
19
1.2 Fundamentals of corporate finance 20
20
Objectives 22
Introduction 22
Basic functions of corporate finance
The 10 principles of finance
Equity capital
Debt capital
Financial intermediation
The growing importance of financial markets
Maximising profits

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BBF 201/05 Introduction to Financial Management 23
23
Maximising shareholder wealth 25
Maximising stakeholder wealth
Agency costs 29
Implication of Sarbanes-Oxley Act on Malaysian
corporate sector 31
Suggested answers to activity 31
31
1.3 Types of business organisations 31
31
Objectives 32
Introduction 36
Sole proprietorship
Partnerships 37
Corporations 39
Suggested answers to activity 43

Summary of Unit 1
Suggested answers to self-tests
References

UNIT 1 1
The scope of corporate finance

Course Overview

This is a five-credit, one-semester, introductory-level basic major course designed
for students who are enrolled in the Graduate Diploma in Banking and Finance
programme. There are a total of five units in this course.

Essentially, this course is designed to serve as a preparatory course for higher level
finance courses that you are required to take later on in this programme. Thus, the
main purpose is to provide you with a good grasp of the key fundamental financial
theories and concepts before taking any higher level finance courses.

Unit 1 begins with explaining the typical roles and basic functions of corporate
finance in businesses and also how financial managers interact with other business
function personnel in a company. Then, you will be brought to observe the various
forms of business organisations available and their respective advantages and
disadvantages.

In Unit 2, basic accounting concepts and principles are introduced. You will be
exposed to an overview of the main sources of accounting information of companies,
i.e., financial statements. It has been said that the numbers in the financial statements
are just a bunch of numbers unless the users put an effort to interpret the numbers
to make them become useful information for the users. To do that, you need to
understand the analytical tools available to you, i.e., financial ratios.

In Unit 3, you will be introduced to the basic concept of time value of money that
lays the foundation behind some important valuation methods in finance, such as
valuation of bonds and stocks. Simply put, the actual value of a dollar today is not
the same as the value of a dollar in the future. Therefore, in terms of fair value, all
future cash flows must be converted back to today’s value for valuation purpose.

Unit 4 provides you with a basic understanding of the measurements of risk and
returns, and the risk-return trade-off relationship. In this unit, you will learn how
to quantify risk and returns and understand the common phrase “high risk, high
return” and vice versa.

Finally, Unit 5 concludes with a topic on capital budgeting, where various investment
criteria methods of evaluating investment projects are discussed. You are expected
to learn the various techniques of evaluating investment projects in order to make
sound decisions.

By the end of this course, you should be able to:

1. Describe the basic roles and functions of corporate finance in modern
business.

2. Discuss the financial implications of the different forms of business
organisations.

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3. Compute and interpret financial ratios for financial statement analysis.
4. Demonstrate a good knowledge of present value and future value concepts.
5. Compute present value and future value of a single sum and a stream of
cash flows.
6. Demonstrate a good knowledge of the trade-off relationship between risk
and returns.
7. Compute measurements for risk and returns.
8. Compare and contrast the investment criteria methods in making capital
budgeting decisions.
9. Apply investment criteria methods to evaluate proposed investment projects.

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The scope of corporate finance

Unit Overview

Corporate finance is simply a study of any financial or monetary activities that deal
with corporations’ decisions involving the use of financial tools and analysis. In
corporate finance, it is said that the primary goal of a corporation is to maximise
shareholder value. Given that shareholder value is mainly tied to the stock value of
the firm, the goal of the firm is to maximise its common stock price. This goal will
then serve as a performance evaluation benchmark for all financial decisions made
in a corporation.

In section 1.1, you will be introduced to the role of corporate finance in the
modern business environment. In today’s complex, globalised and dynamic markets,
it is important for finance function to interact closely with other non-finance
functions within the firm such as marketing, operations, research and development,
communication, etc. Each function can no longer work as a stand-alone unit in its
planning process because the activities in each of these functions will have an impact
on other functions. For example, an effort undertaken to improve the efficiency
of supply chain management may help to lower costs and in turn increase profit
margins of the company. While lowering costs makes the product or services of the
company more competitive, it must not compromise on quality. With the better
costing structure, marketing department can execute its function more effectively in
order to increase the company’s sales and market share. As a result of the improvement
in the efficiency of supply chain, costs are lower, sales and revenues are higher, and
cash and profitability are likely to be increased. This simple example has illustrated
the connection between activities in the various non-finance functions and the
finance function in a company.

Section 1.2 discusses the major functions of corporate finance, the important role
and the process of financial intermediaries, and the rationale of shareholder value
maximisation. Five major functions of corporate finance will be discussed. First,
external financing - the external financing sources available for a company’s fund-
raising activities, e.g., equity and debt issuing. Second, financial management - the
optimisation of the company’s working capital, cash flow and profitability. Third,
capital budgeting - the process of investment appraisal in ensuring a profitable
and sustainable project is selected. Fourth, corporate governance - good corporate
governance practices and ethics that deals with the issue of creating shareholder
value. Fifth, risk management - the quantification of risk exposure to achieve the
desired risk-return trade-off and in turn maximise the shareholder value.

In this section, you will also be exposed to the functions of financial intermediation.
The process of financial intermediation involves the transfer of funds from savers
to borrowers, also known as indirect finance, e.g., bank loan. This is important as
most companies require the services of financial intermediaries for their fund-raising
activity in the equity, bond and loan markets. At the end of this section, you will
be directed to observe some of the key criteria in ensuring that shareholder value
is maximised, and the internal and external governance mechanism to minimise
conflict of interests between the owner and the manager.

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Finally, section 1.3 discusses the different characteristics, advantages and
disadvantages of each of the three common types of business formations, namely,
sole proprietorship, partnership, and corporation.

Unit Objectives

By the end of Unit 1, you should be able to:
1. Discuss the scope of finance in modern business and how it interacts with
other business functions within the firm.
2. Describe the five basic functions of corporate finance.
3. Differentiate debt and equity capital.
4. Describe the process of financial intermediation.
5. Discuss the five functions of financial intermediary.
6. Compare and contrast profit maximisation, shareholder value maximisation
and stakeholder interest.
7. Discuss agency costs and implication on the management for the firm.
8. Compare and contrast between different forms of business organisations.

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The scope of corporate finance

1.1 The Role of Corporate Finance in
Modern Business

Objectives

By the end of this section, you should be able to:

1. Discuss the primary goal of company from the perspective of finance.

2. Discuss how finance interacts with other functional areas of business within
the firm.

3. Describe the three main areas of finance: financial management, capital
markets and investments.

Introduction

The origins of finance can be traced to the economics and accounting disciplines.
Economics introduces time value of money, whereby the present value of an
asset consists of a series of discounted future cash flow of the asset. Additionally,
information on the magnitude of future cash flow streams, risk and cost of capital
is taught in the accounting discipline. Thus, people working in the field of finance
are expected to master the economics and accounting discipline, as finance lies in
between both fields.

Maximising shareholder value

In modern finance, it is asserted that the company’s main goal is to maximise the
firm value or shareholder value. This value is best measured by the market value or
price of the company’s common stock, where stock price reflects the risk, timing,
and magnitude of the future cash flows of the company. This concept is in great
distinction with two other commonly known objectives, namely, profit maximisation,
and stakeholder value maximisation. Comparatively, it is argued that the profit
maximisation objective has some major flaws because it is highly associated with
backward-looking and excessive short-term focus at the expense of long-term benefits.
Although it seems to make a lot of sense for a company to maximise stakeholder
value, it could lose its competitiveness in the market. In fact, the shareholder
maximisation objective is not in direct contradiction with the stakeholder value
maximisation concept. The former concept has indirectly incorporated the other
stakeholder value, whereby the shareholders are the “residual claimants”. In the case
of liquidation, shareholders will always be the last to claim on the firm’s assets and
cash flows after other stakeholders.

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In the modern business, all employees, particularly financial managers, play an
important role in helping their company to achieve the ultimate goal of maximising
shareholder’s value. The financial managers are expected to be well equipped with
different sets of financial skills and expertise. Apart from managing the accounting
books and cash flow of the company, they are also tasked to ensure an efficient capital
allocation, optimal financing, risk management, etc. Hence, financial managers are
required to apply various financial tools to solve real business problems in their daily
decision-making process.

Web Reference

Please read the following article to find out more about shareholder
value — the definitions, history, criticism and alternative goal to
shareholder maximisation.

G Charreaux, P Desbrières (2001). Corporate Governance:
Stakeholder versus shareholder value. Journal of Management and
Governance. Springer.

The dynamic relationship between finance and non-finance areas

Financial personnel must interact closely with a diverse team of personnel from other
departments within the company to ensure smooth business operation. The best
way to understand the working relationship between a finance manager and other
non-finance personnel is through looking at a real case example.

Apple Inc. provides you with a good example to demonstrate the dynamic interaction
between finance managers and other non-finance areas in driving successful
businesses. Apple’s recent-year phenomenal growth since the late Steve Jobs took over
in 2004 in terms of profitability and product innovation has managed to capture
many people’s attention, particularly the consumers and investors. The great success
turnaround story has not only reflected its good management, but also the important
role of financial managers in creating value for shareholders of Apple Inc. Of course,
this is only possible if personnel with different backgrounds and skills from various
different departments work together towards achieving the common goals.

In the case of the new iPad product development process, the finance managers have
to work closely with their computer designers, engineers, scientists, and marketers to
analyse the business potential of iPad product. The areas of great interest to finance
managers are listed as follows:

1. The economics of downloading music over the Internet must be competitive
compared to conventional record purchases.

2. Developing a fee-based strategy that would be value added and attractive to
customer’s subscription.

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The scope of corporate finance

3. Negotiating licensing and royalty arrangement with the recording industry.

4. Solving technical issues to ensure that customers can seamlessly download
songs from the Internet.

In supporting the above four areas, Apple’s finance managers must perform the
following functions. First, its finance managers would need to communicate
effectively with their public relation professionals to convincingly answer journalists’
questions about the financial aspects of iPad as a new product. Second, finance
managers need to work closely with the accounting and information systems to
develop a workable and efficient payment system that allows the company to collect
large numbers of small denomination of credit card purchases. The business growth of
iPad services would ensure that Apple has sufficient cash flow to expand its business
by offering new services. Hence, finance managers are required to manage cash flows.

From this short case study, you would notice the importance of finance functions
within a firm that help to kick-off a new highly technological and market-driven
product. In fact, the financial managers’ involvement starts from the vey initial stage
of funding research and development activity, marketing and actual introduction of
iPad, to the subsequent cash management generated by the services and the capital
accumulation needed to expand the services in the future. In other words, it is like
saying that technology innovation is made possible by modern finance.

Corporate finance, capital markets and investments

Finance discipline can be broadly divided into three main areas, namely, financial
management, capital markets and investments. Financial management or sometimes
referred to as corporate finance is more concerned with the responsibilities of financial
managers in business. These financial managers are mainly tasked to perform
capital budgeting, asset management, financial forecasting, cash management, risk
management, investment appraisal, etc. These financial tasks are critical in achieving
the main objective of shareholder value maximisation.

A capital market is a market where private companies and government use it
as a public platform to raise long-term funds (in the primary market) in which
subsequently these issued financial assets or securities such as bond and equity
would be traded (in the secondary market). Simply put, the capital market acts as
a financial intermediary in channelling funds from savers (lenders or suppliers of
funds) to borrowers (users of funds). Financial regulators, such as the Securities
Commission of Malaysia (SC) will oversee the capital markets in their designated
jurisdictions to ensure that investors are protected against fraud, among other duties.

On the other hand, investments may refer to a number of activities:

1. Security analysis that deals with risk-return trade-off relationship and the
measurements of risk and return,

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2. Portfolio theory focusing on the construction of a portfolio consisting of
multiple assets as part of the diversification strategy. Rationale investors
will hold a portfolio of multiple assets in order to reduce risks,

3. Valuation analysis dealing with overvaluation and undervaluation of securities
in the financial market. This is essential in the asset allocation decision-
making process of the investment firm and

4. Behavioural finance, a new branch of finance, dealing with investor
psychology in price determination in the financial market.

Reading

Please read Smart and Graham (2017, pp. 6 – 10) on the career
opportunities in finance and the different specialised skills required
for different financial professional.

Activity 1.1

Choose the correct answer.

1. The finance manager must select those projects that help to
increase the firm’s value where:

A. Benefits are at least equal to the project’s costs.
B. Selecting a project that will increase the net tangible asset
of the firm’s common stock.
C. Selecting a project that will decrease the book value of the
firm’s outstanding debt.
D. All of the above.

2. Which type of capital in a typical firm is subject to the highest
business risk?

A. Retained earnings
B. Equity capital
C. Share premium
D. Goodwill

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The scope of corporate finance

3. Below are capital-raising sources for a firm except:

A. Primary market
B. Secondary market
C. Initial public offering
D. An overdraft from the bank

4. A financial manager of a firm should only take actions that:

A. Increase the value of the firm’s future cash flows.
B. They expect will increase the firm’s share price.
C. Have benefits which are at least as great as the cost of those
actions.
D. All of the above.

5. Which stakeholders have the highest motivation to take risky
but value-enhancing investments for the firm?

A. Suppliers
B. Creditors
C. Shareholders
D. A salaried CEO

Summary

In this section, you have been introduced to the concept of
shareholder value maximisation as a goal of the firm’s managers.
You have learned the disadvantages of setting profit maximisation
as the firm’s goal, and how stakeholder value maximisation could
erode the competitiveness of the firm. You then learned that financial
managers should seek to create value for the firm’s shareholders when
making financial decisions. Next, you have learned how important
it is for financial managers to interact closely with personnel from
non-finance departments in order to achieve the goal of maximising
shareholder value. Finally, you have also been exposed to three broad
categories of finance discipline, namely, financial management (or
corporate finance), capital markets and investment.

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Self-test 1.1
1. Explain the differences between maximising profits and
maximising shareholder value. Justify which one should be the
goal of a company.
2. Pick a public listed company in Malaysia. Discuss the working
relationship between its finance and non-finance departments
within the company.
3. Explain what the main function of a capital market is.

Suggested answers to activity

Feedback
Activity 1.1
1. A
2. B
3. B
4. D
5. C

UNIT 1 11
The scope of corporate finance

1.2 Fundamentals of Corporate Finance

Objectives

By the end of this section, you should be able to:

1. Describe the five basic functions of corporate finance.

2. Discuss the ten core principles of finance that influence the decision-making
of financial managers.

3. Differentiate between debt and equity capital.

4. Describe the process of financial intermediation.

5. Discuss the five functions of financial intermediary.

6. Compare and contrast profit maximisation, shareholder value maximisation
and stakeholder interest.

7. Discuss agency costs and the implications for the management of the firm.

Introduction

As businesses require funds to run their daily business operation and expansion,
corporate finance function is crucial in sourcing and managing the funds. This section
starts with the five basic functions of corporate finance followed by the differentiation
between equity and debt capital. The functions of financial intermediation are
discussed, as it involves channelling of funds from lender to borrowers. In most
of the large publicly traded firms, shareholders and top management are separate
individuals. Very likely, this would pose an agency problem when the manager
does not act in the best interests of the shareholders. Additionally, managers must
understand very well the implications of setting the company’s goal as either profit
maximisation, shareholder value maximisation or stakeholder interest.

Basic functions of corporate finance

A comprehensive framework of corporate finance involves the following areas, namely,
external financing, capital budgeting, financial management, corporate governance
and risk management. Mastering these five areas is essential for financial managers
to operate effectively in today’s dynamic and complex business environment. The
following brief discussion shall provide an introduction and overview of the above
stated five functions.

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External financing

Generally, there are two methods for businesses to raise funds for the working
capital to sustain the daily business operation and/or the future expansion plans.
The first method is known as external financing. In this method, issuing equities
to shareholders and debt securities to creditors is among the most common avenues
to raise the funds needed by the firm. Normally, these fund-raising options are only
available to publicly listed corporations, but not to the private firms (usually smaller
in size). However, the private firms can “go public” through the issuance of initial
public offering (IPO) of their firms’ equities to raise the funds in such a way as
well. This will involve selling equities to outside investors via subsequent listing on
the stock exchange market. For example, in 2011, AirAsia X Sdn. Bhd. announced
that it plans to raise approximately 863 million ringgit through the issuance of
IPO mainly to finance the purchase of new planes for its business expansion plan.
Moreover, after a few years down the road, the public listed firms can have the option
of raising more funds through rights issue for any further financial needs such as
for business expansion purposes.

Alternatively, companies can also use the internal financing method to raise the
funds needed. In this method, companies simply need to retain their profits for
reinvestment purposes when the business opportunities arise. A good example is
Maybank Berhad. In 2008, Maybank announced that it will not be making the
anticipated capital repayment and in fact it slashed its dividend payouts to its
shareholders for that particular financial year. Instead, the company used the internal
funding from profits to purchase substantial equity stakes in Bank International
Indonesia for RM3.8 billion and MCB Bank in Pakistan for RM2.17 billion. These
cross-border acquisitions were part of Maybank’s business expansion strategy to
increase its market share and presence globally.

Capital budgeting

From time to time, companies may need to make critical decisions on some capital
investments. For example, a manufacturing company may need to decide whether
to replace or repair its old machines. It is the job of financial managers to perform
such analysis of capital budgeting in order to help the company to make sound
decisions. This analysis is very important for two reasons. First, because of the
usual huge amounts of investments involved, capital budgeting assessment process
must be treated seriously. Second, given the fact that there would be more than one
competing project, it is essential for finance managers to choose project(s) which
would help to maximise shareholder value and maintain the company’s business
competitiveness in the long run.

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The scope of corporate finance

Financial management

Managing the company’s operating cash flow efficiently and profitably is the main
function of financial management. This process involves two parts. The first part
requires finance managers to determine the optimum mix of debt and equity that
will lead to maximising shareholder value. In fact, a firm’s asset can be financed using
a combination of liabilities (debt) and equity which referred to as capital structure.
Thus, it is essential for finance managers to achieve an optimum mix of debt and
equity to minimise the overall cost of raising capital (cost of capital).

The second part requires finance managers to ensure that the company has sufficient
working capital for its daily operations. The management of working capital
involves managing operational expenses in the company, e.g., paying staff salary,
obtaining financing, stocking up inventories, paying suppliers, collecting payment
from customers, servicing debt, investing cash surplus and maintaining adequate
cash balance for daily operations. All these responsibilities require good cash flow
planning and maintaining good relationship with customers, suppliers and lenders.

Corporate governance

In the wake of the 1997/98 Asian Financial Crisis and US corporate scandal cases like
Enron and World Comm in 2001– 02, there has been swift attention to corporate
governance issues in the corporate world. It was strongly argued that weak corporate
governance system was partly responsible for the 1997/98 Asian Financial Crisis.
In Malaysia, we have our own share of corporate scandal, e.g., Transmile Group
Bhd. which allegedly overstated its revenue and assets going back to 2004 through
dubious invoicing. After all, it is argued that a strong corporate governance system
can help to motivate managers (CEOs) to act in the best interests of the shareholders.

The fact that shareholders want to receive good returns on their investment may be
in conflict with the private interests of managers, leading to the misalignment of
interests between the shareholders and the managers. This is because the CEOs are
motivated by some private financial gains that may be in conflict with shareholders
that want a good return on their investment. Thus, agency problem will arise
when there is a conflict of interest between shareholders and managers. Hence, it
is essential for companies to devise and adopt a corporate governance system that
will encourage the hiring and promotion of qualified and honest people, and also
motivate employees to achieve the company’s objectives through performance-based
compensation package. Additionally, a strong and independent board of directors,
including transparent remuneration, nomination and audit committee team can
greatly help to reduce agency problems.

Furthermore, strong legislations are necessary to ensure that the managers comply
with the existing laws at all time and provide stiff penalties for CEOs and directors
that breach corporate regulations. For example, the famous Sarbanes-Oxley Act
2002 (SOX) introduced in 2002 in the US after the Enron financial scandal is seen
as a benchmark for other countries in dealing with the integrity issues of financial
statements. Since the Enron scandal in 2001, securities regulators have consistently
introduced and implemented the best practices of corporate governance. In Malaysia,

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the codes and principles of corporate governance were first introduced in 2000 and
updated in 2007. In addition, Securities Commission of Malaysia continues in its
efforts to raise the standard of corporate governance in Malaysia by introducing a
new code of governance in 2012. Among the core principles of corporate governance
include a high degree of independence in board of directors, audit committee,
remuneration committee and auditor’s role. In countries like the US, hostile takeovers
or mergers and acquisition is seen as an external force pushing forward the good
corporate governance culture, whereby a weak and underperforming company can be
taken over by other companies. In short, corporate governance can be viewed from
five major dimensions as shown in Figure 1.1. The first four dimensions, namely,
board of directors, compensation packages, auditors and country legal environment
are considered internal governance mechanisms, while takeovers are considered
another dimension of (external) governance mechanism.

Dimensions of • Board of directors
corporate • Compensation packages
governance • Auditors
• Country’s legal environment -
in Malaysia, Securities Commission

Act 1993

The takeover market disciplines firms that do not govern themselves.

Figure 1.1 Corporate governance systems

Risk management

A company may have exposure to various types of risks, such as interest rate risk,
foreign exchange risk, market risk, commodity risk and credit risk in their businesses.
For example, an export-import trading company would be exposed to exchange rate
risk due to volatile market exchange rates. Appreciating and depreciating exchange
rates affect the company’s profitability and cash flow. A fluctuation in the interest rate
affects the company’s liquidity and leverage position. The computation and concept
of liquidity and leverage will be discussed in Unit 2 Ratio Analysis. However, for
a start, it is sufficient to know that these financial risks pose a serious threat if the
affected companies do not take any measures to reduce the risks. In finance, the
measure taken to reduce the financial risk is called hedging. The hedging activity
is mostly carried out using financial derivatives instruments, e.g., forward, futures,
swaps and options. Essentially, financial derivatives can be used as effective tools to
manage risk exposures of companies.

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The scope of corporate finance

Reading

Please read Smart and Graham (2017, pp. 10 – 13) to reinforce your
understanding on the five functions of corporate finance.

Reading

Please read Emir Zainul (Feb, 17, 2020). After 10 years of trial,
Transmile accounting scandal case nearing the end, The Edge,
which reported the financial fraud case of Transmile Group
Bhd. in Malaysia. This article highlights the problems of poor
corporate governance within the firm that could instantly wipe out
shareholder’s value.

The 10 principles of finance

There are ten core principles of finance that influence the decision-making of
financial managers.

Principle 1: The risk-return trade-off

Money is important for daily consumption. Any surplus is considered as savings
for future consumption. However, the main challenge is to identify the investment
opportunities available in the financial markets and institutions which provide
the investors with optimum return. As a general guideline, two principles should
be considered.

First, investors should demand compensation in the form of investment return
for any delays on consumption today, and this compensation (or return) must
be higher than the anticipated rate of inflation. This is indirectly an incentive for
investors to save for future consumptions at the expense of today’s consumption.
Second, investment alternatives have different levels of risk and expected return.
Thus, an investor should not solely focus on return. The investor should understand
the correlation between their expected investment returns and the risk that they
are exposed to. Figure 1.2 shows a positive relationship between risk and return
of various financial instruments. A commonly known phrase is: “high risk, high
return”. Common stocks potentially offer the highest return but it probably carries
the highest risk among all the financial instruments. In contrast, treasury bills and
bonds are the lowest in terms of both return and risk as they are considered the
safest among all the financial instruments listed in Figure 1.2.

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Return

Common stock

Treasury bonds Junk bonds

Investment Corporate bonds
grade bonds

Treasury bills

Risk

Figure 1.2 Risk-return relationship of various financial instruments

Principle 2: The time value of money

Intuitively, an investor understands that RM1 earned today is certainly worth
less in the future. The reason being is inflation or increasing cost of living always
expected to come in the future. Inflation will reduce money’s purchasing power. In
finance, real terms are used rather than nominal terms. This principle is even more
important today as we are living in an era of rising prices. Thus, future cash flow has
to be discounted to today’s value. The project should be accepted only if the present
benefits (present value) exceed the cost of the project. “Time value of money” will
be further discussed in more detail in Unit 3.

Principle 3: Cash is king, not profit!

In measuring wealth or value, financial managers will use cash flows, not accounting
profits. Investment to earn high return can only be made if the firm has cash. In
addition, only cash can be reinvested, not profit. Accounting profit is recorded when
they are earned or transacted, even though cash has not been received or paid. As
a result of this, only cash flows correctly reflect the timing of the benefits and cost
in investment appraisal.

Reading

Please read the following article that explains why cash flow is more
important than accounting profit.

Aretha Boex (2015). Why cash flow is more important than profit.
Publication of Nebraska Business Development Centre. www.nbdc.
unomaha.edu

UNIT 1 17
The scope of corporate finance

Principle 4: The importance of incremental cash flow

This principle extends the concept of cash flow to incorporate incremental cash flow.
The decision on project approval lies on incremental cash flow. A new project that
does not bring in incremental cash flow to the firm should be rejected. Likewise, a
new project with incremental cash flow should be accepted.

Principle 5: Markets are competitive

In a competitive market, extremely high rate of return or profit or cash flow cannot
possibly exist for a long time. This is because entry barriers are low, which implies that
high rate of return will decline as the number of entrants increases. Unlike monopoly
or heavily regulated markets, firms are entitled to enter and exit the market anytime.
Nevertheless, there are two commonly used strategies that can make markets less
competitive in order to reap potential higher rate of return.

First, product differentiation protects the product from competition. This allows the
firm to charge a premium price on its products and services. Product differentiation
can be in the form of superior quality, services, hard to imitate features, brand name
and patents.

Second, economies of scale and superior supply chain management allow the firm to
produce at a cost below its competitors. This will deter new entrants into the market.
The cost advantage is created through economies of scale, proprietary control and
monopolistic control on supply chain. Superior cost advantage prevents the entry
of new firms into the market.

In order to locate profitable investment projects, financial managers need to
understand how and where they exist in the competitive markets. In a perfectly
competitive market, extremely high rate of return will not last. Hence, it is important
for financial managers to take advantage of any imperfection in the market through
product differentiation or cost advantage.

Principle 6: Capital markets are efficient

In an efficient capital market, all publicly available information should be already
incorporated into the stock price. Any new information will result in dynamic price
adjustment, through market transactions until all profit opportunities are eliminated.
Investors competing for profits will ensure that security prices correctly reflect the
risk and expected future earnings of the company. There are two implications to the
investors. First, the price is always correct because it reflects all publicly available
information at all times. This means that no abnormal profits can be gained from
having the public information. Second, any accounting manipulation in the financial
reporting procedures will not have any impact on the stock prices. For example,
bonus issue or stock splits, which do not have any impact on the company’s actual
cash flow, should not affect the company’s valuation.

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Reading

Please read “Attention to Market Information and Underreaction
to Earnings on Market Moving Days” by Badrinath Kottimukkalur,
published by Journal of Financial & Quantitative Analysis in
Dec 2019, Volume 54(6), p 2493–2516, to reinforce your
understanding on capital market efficiency. This article is available
in the WOU MyDigitalLibrary.

Principle 7: Agency problem

The agency theory proposed by Jensen and Meckling (1976) postulates that
the conflict of interest between managers and shareholders may lead to agency
problems. In order to reduce agency problem, the interests of the managers should
be made aligned to the shareholders. One way is to offer equity-tied compensation
to CEOs and top directors, e.g., stock options. This may encourage the managers
to deliver shareholder value in terms of higher stock prices and dividend payouts to
the shareholders.

Reading

Please read Jensen, M. C. and Meckling, W H “Theory of Firm:
Managerial behavior, agency costs and ownership structure”. This
article is available in the WOU MyDigitalLibrary.

Principle 8: The impact of taxes on investment decision

It is important to consider corporate taxes in any business decision. The concept of
incremental cash flow described in Principle 4 is the after-tax incremental cash flow.
This shows the importance of taxes in the investment decision. Since taxes are part
of the costing structure, it is a contributing factor in the business decision-making
process. In other words, without considering taxes, it can lead to very bad business
decisions. In fact, corporate tax rate or tax incentives have always played a major
role in the consideration of international investment decisions.

Principle 9: Diversification

Principle 1 has described “risk” as one of the factors in the investment decision-
making process. Nevertheless, some risks can be diversified away. Generally, risk
can be divided into 2 types, namely, systematic and unsystematic risk. Systematic
risk cannot be diversified away through purchasing more assets. A good example is
economic business cycles and major natural disasters. However, unsystematic risk

UNIT 1 19
The scope of corporate finance

can be diversified away through the purchase of new assets. An example is when a
company’s CEO passes away. Diversification is only possible when two assets’ returns
have negative correlation or move in opposite directions.

Principle 10: Business ethics

Recently, the financial services sector is facing a reputational problem due to a series
of financial scandals and fraud. Being ethical is not only morally right, but also in
line with the objective of shareholder value creation. Ethics is very important in the
business world because it promotes goodwill and reputation among stakeholders
like customers, labour unions and suppliers. A company will collapse if the element
of trust is destroyed due to unethical practices. In the past 10 years, Enron,
Transmile and Arthur Andersen are good examples of firms that collapse due to
unethical practices.

Web Reference

To find out more about the impact of Madoff investment scandal
on business ethics, go to this website. The weblink below is also
available in WawasanLearn.

http://en.wikipedia.org/wiki/Madoff_investment_scandal

Equity capital

Normally, at the initial set up stage of the companies, the entrepreneurs are
expected to contribute equity capital from their own savings (besides borrowing
from family and friends). The equity capital contributed is expected to remain
invested throughout the lifespan of the firm. As the business expands, more equity
capitals are required. These entrepreneurs start to look for potential investors who
can contribute their capital in exchange for ownership shares. In other words, these
stockholders use their capital to purchase stocks of the company, and in return they
own shares of the company and become the “part” owners based on the percentage
of shares purchased. This ownership share is called equity, and the contribution is
called equity capital.

For large corporations, normally the public listed ones, equity capitals commonly
consist of common stocks and preferred stocks. The common stockholders would
bear the most financial and business risk. But at the same time, these equity holders
enjoy the most benefit from the firm’s stock price appreciation. However, in the
event of a firm’s liquidation, common stockholders will be the last party to be paid
from the assets sold. The creditors will be the first to be paid from the proceeds,
followed by preferred stockholders, with the common stockholders being the last.

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Debt capital

Entrepreneurs (or by virtue of the company) also borrow money and engage in other
liabilities such as accounts payable to finance the businesses. The capital obtained
from the borrowings is called debt capital. It consists of all types of borrowings by
the firm. It could be in the form of bank loans, issued bonds and money market
instruments. The duration could be as short as one month to more than 30 years
and it could be issued in domestic and foreign currency denominations. The issuer
of the debt security or borrower is obliged to pay interest, at a specified annual rate
on the full amount borrowed (also called the principal). Additionally, the borrower
will pay the full principal amount on maturity date. The regular payments must
be made according to the schedule or the creditor reserves the legal right to sue the
company to enforce the debt contract. In fact, a defaulting firm can be forced into
bankruptcy by the creditors so that the creditors can recover their loans. This can
be achieved by liquidating the firm’s asset to raise cash. In the event of the firm’s
liquidation, the creditor will be the first preference when it comes to repayments.
In technical terms, you can say that the debt holders have the most senior claim on
the firm’s asset.

Financial intermediation

The process of financial intermediation involves channelling funds from surplus
sector to deficit sector. This function is performed by a financial intermediary.
A surplus sector is also called lenders or savers because their income exceeds
expenditure. A deficit sector is also called borrowers because their income is less
than their expenditure. The process of financial intermediation is called indirect
finance. Let’s have a look at Figure 1.3. The lenders and savers consist of households,
business firms, government and foreigners. The borrowers consist of business firms,
government, households and foreigners. Notice that under indirect finance, financial
intermediaries channel funds from lenders to borrowers in the financial system.
Financial intermediaries consist of banks, insurance and mutual fund. Additionally,
notice that financial intermediaries channel funds into the financial markets. For
example, mutual funds purchase stocks and bonds in the financial markets. In direct
finance, the lenders or savers channel funds to the borrowers via financial markets.

UNIT 1 21
The scope of corporate finance

Direct finance

Lender-Savers Funds Financial Funds Borrower-Spenders
markets
1. Households 1. Business firms
2. Business firms 2. Government
3. Government 3. Households
4. Foreigners 4. Foreigners

Funds

Financial
intermediaries

Indirect finance

Figure 1.3 Financial intermediation

This leads to the second function of financial intermediary, which is the reduction of
transaction costs. Financial intermediary enjoys economies of scale because of their
large volume of transaction and networking. For example, it is more cost-effective
for banks to install ATMs that can perform multiple banking functions in their
branches than individual service counters as they enjoy economies of scale due to
their large numbers of customers. The usage of ATM and E-banking services can
lead to cost reduction in the long run, as there is less need to hire new manpower
to operate the bank. In the securities trading house, real-time price quotes and
trading platform costs can be spread among its large customer base, thus lowering
the average fixed costs.
Financial intermediary plays the third function by providing liquidity services to
their customers. Liquidity service is important as customers can withdraw cash on
demand at any time. Additionally, banks also provide checking services to customers
to pay for their goods and services. This is a unique banking service that enables
customers to conduct transactions easily.
The fourth function is risk diversification. Financial intermediary like banks and
mutual funds can help their customers diversify away their risk through the creation
of portfolio of assets. This is possible because banks and mutual fund firms have
large pools of funds compared to individual savers. Portfolio diversification reduces
risk among the held assets.
Financial intermediary plays the fifth function as asset transformer. As an asset
transformer, financial intermediary converts illiquid assets into liquid assets. This
service is very unique and beneficial to customers as they can acquire liquid assets
by placing a deposit with the bank. Subsequently, the bank converts the fund into
long term and illiquid loans and lends it to the borrowers.

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The growing importance of financial markets

The traditional role of financial intermediary such as commercial banks of providing
loans to businesses have slowly diminished over the years and has been replaced by
financial markets. The current trend shows that business organisations are sourcing
their funds from the equity and bond markets due to financial innovation, technology
and deregulation. Financial innovation results in proliferation of financial products
and services which allows business organisations to raise funds at effective cost,
while at the same time provide more investment options to investors to choose
from. Financial innovation is made possible by technology and deregulation by the
government. Both factors allow cross-border trading and fund raising.

In primary market transactions, business organisations sell securities directly to their
investors. For example, a firm sells its equities to a syndicate of underwriters in the
primary markets. These underwriters will then list this initial public offering (IPO)
in the secondary market. After that, multiple transactions take place on a daily basis.
Stock market transactions are secondary market trades.

Reading

Please read Smart and Graham (2017, pp. 14 – 15) to reinforce
your understanding of financial intermediation in modern finance.

Maximising profits

The Anglo-Saxon modern business theory postulates that the manager’s objective
should always try to maximise shareholder’s value. This is very much different from
European-Japanese’s stakeholder model which is more wholesome and inclusive.
Firms that practise the stakeholder model is expected to uphold corporate social
responsibility (CSR) by taking responsibility for the firm’s actions and making a
positive impact through its activities on the consumers, employees, communities,
environment, and all other members of the public who may also be considered
as stakeholders.

Thus, to maximise profits, managers should devise strategies to increase the firm’s
revenue and cut cost. From the practical point of view, this will translate into higher
earnings per share and dividend. The earning per share is defined as net profit
attributable to shareholders for each share held. We shall be addressing this issue in
Unit 2 Ratio Analysis. However, profit maximisation suffers from four disadvantages
as follows:

1. Earning Per Share (EPS) figures are historical and do not reflect future
performance. Thus, it is difficult to make an accurate forecast of the firm’s
future profitability.

UNIT 1 23
The scope of corporate finance

2. Emphasis on profit maximisation may ignore the timing of profits. This will
encourage firms to value short-term profits more than long-term, sustainable
profits.

3. In the preparation of corporate accounts, certain accounting principles that
focus on accrued revenues and costs are followed. A firm which is profitable
does not necessarily mean that it has sufficient cash flow to sustain its
business operations. In finance, more emphasis is placed on cash flow than
accounting profits.

4. Focusing only on earnings ignores risk. Finance requires risk-return analysis
to be performed as part of the investment appraisal process.

Maximising shareholder wealth

According to current finance theory, the maximisation of shareholder wealth or value
is measured by market stock price of the listed firm. The firm’s stock price essentially
incorporates elements like timing, magnitude and risk of the future cash flows of
the firm. Thus, financial managers should only consider investment projects that
will increase future cash flows of the firm. On the other hand, shareholders should
not focus too much on the firm value maximisation since they are the residual
claimants in the event of liquidation. Residual claimants are only entitled to the
remaining cash flow, after employees, suppliers, creditors, preferred stockholders and
government have been fully paid. Additionally, in accepting the residual claimant’s
role, a shareholder bears the highest financial and business risk of the firm. Thus,
investors would have less incentive to buy shares or provide equity capital if they
know that the firm is not going to maximise shareholder’s wealth.

Maximising stakeholder wealth

European-Japanese stakeholder model requires firms to contribute to the overall
well-being of the society while making private profits. This practice of corporate
social responsibility (CSR) is widely practiced in many countries, including Malaysia.
The decision to broaden the objective of maximising profit to incorporate other
stakeholders is now seen as a long term strategy to boost the firm’s shareholder
value. A firm with stakeholder’s focus consciously avoids actions that might be
detrimental to consumer, environment and employees. A good relationship with
other stakeholders minimises employee turnover, business conflicts, litigation risk
and preserves the good reputation of the firm. In the long run, this policy actually
leads to higher profitability and cash flow for the firm.

Agency costs

Berle and Means (1932) introduce the concept of separation of ownership and
management. The separation between ownership and management leads to
agency costs when the manager is not acting in the best interest of the owners
(shareholders). This principal (shareholder) - agent (manager) relationship is

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formally conceptualised as agency theory by Jensen and Meckling (1976). Agency
problem arises when there is a conflict of interest between manager and owner. This
agency problem can be overcome by shareholder through:

1. Market discipline, whereby, hostile takeovers and merger and acquisition
ensure managerial discipline. A takeover is defined as hostile when it is
done without the blessing of the top management. The form of takeovers
can be through open market bid or tender offer for the majority of the
target shares. One main reason for hostile takeover bid is poor financial
performance. This is because the company that launches the hostile takeover
believes that they can improve the current poor financial performance of
the targeted company. In addition, institutional investors have been playing
an active monitoring role in their invested company. As large blockholders,
they adopt a proactive monitoring role in the invested firm and are not
hesitant in removing poor performing CEO through voting rights, proxy
contest or selling their shares.
2. Incurring monitoring and bonding costs necessary to supervise managers.
Bonding expenditure insures the firm against potentially dishonest act by
the CEOs or directors. For example, a CEO can be asked to accept a delayed
compensation package that must be forfeited if they perform poorly or
commit acts of fraud that is detrimental to the company. Monitoring expenses
are audit fees incurred to ensure the truthfulness of the company’s account.
Most countries’ code of governance has incorporated an independent audit
committee structure and auditor as part of the internal monitoring
mechanism of the company.
3. Aligning the top director’s compensation with the performance of the
company. This is one of the most powerful and expensive tools to ensure
that managers perform to the expectation of the shareholder. Most of the
compensation package ties the manager’s fortune with the stock performance
of the company. This is achieved through option grants that can only be
exercised at a certain fixed price. Jensen and Murphy (1990) provide
empirical evidence of a positive association between CEO pay and
performance. However, the drawback of this system is it may encourage
short-term policies by top managers. Top managers will be inclined to pursue
projects that will bring only short-term benefits to the firm’s stock price. In
fact, to some extent, CEOs and top directors manipulate the company’s
account to meet or beat analyst estimates. Examples of corporate scandals
are Enron, World Com. and Tyco in the US.

Reading
Please read Smart and Graham (2017, pp. 21 –25) to reinforce your
understanding of the difference between profit maximisation and
shareholder wealth maximisation and agency costs. Also note how
agency costs can be controlled by shareholders through a series of
corporate governance measures.

UNIT 1 25
The scope of corporate finance

Implication of Sarbanes-Oxley Act on Malaysian corporate sector

Following the accounting fraud and collapse of Enron and Arthur Andersen in 2001,
the US Congress passed the Sarbanes-Oxley Act of 2002 (SOX). This act serves as
benchmark for good governance and transparent financial reporting around the
world. The implications of this act to Malaysia’s capital markets are:

1. Establish a new Public Company Accounting Oversight Board (PCAOB)
with the power to license audit firms and regulate accounting and audit
standards.

2. More powers are vested in the hands of the Securities Commission and
stock exchange to regulate, monitor and prosecute financial crimes. In
addition, code of corporate governance best practices are introduced and
enforced. In the case of Malaysia, the first code was implemented in 2000 and
revised in 2007. However, by 2012, a new set of code of corporate governance
will be introduced in Malaysia to take into consideration the dynamic
changes in the financial markets.

3. CEOs and CFOs are required to certify personally their company’s financial
statements in their annual report. In doing so, CEOs and CFOs can be held
personally liable for any questionable and misleading figures in the future.

4. The focus on audit committee’s independence and power.

5. Each member of the audit committee is also a director of the company.

6. At least one of the audit committee members is a financial expert.

7. Auditors are banned from accepting non-audit work such as consulting to
prevent conflict of interest with the company.

Web Reference

To find out more about the newly proposed code of corporate
governance in Malaysia, go to this website. The weblink below is
also available in WawasanLearn.

https://www.sc.com.my/api/documentms/download.ashx?id=
70a5568b-1937-4d2b-8cbf-3aefed112c0a

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Activity 1.2
Choose the correct answer.
1. All the following functions are the five basic corporate finance
functions except:

A. External financing function
B. Capital budgeting function
C. Risk management
D. Auditing

2. In Malaysia, the rules and regulations governing the corporate
governance activities for a corporation are:

A. The minutes of the audit committee meeting.
B. The corporate charter.
C. Malaysian Code of Corporate Governance.
D. The Malaysian Securities Commission securities act.

3. What is the name of the ultimate owner(s) of a company?
A. The state government
B. The debt holders
C. The equity holders
D. The CEO

4. What is the most appropriate definition of “agency costs”?
A. The costs associated with managing the resources of the
federal government.
B. The incurred costs when converting a legal entity from a
partnership to a corporation.
C. The costs that arise due to conflict of interest between owners
and managers.
D. All of the above.

5. An agent of a firm is:
A. 100% owner of the firm.
B. An auditor in charge of auditing the firm’s financial
statements.
C. An employee who does not have any shares in the firm.
D. A creditor of the firm.

UNIT 1 27
The scope of corporate finance

6. Shareholders can try to reduce agency problems by all except:

A. Incurring costs to monitor managers.
B. Paying CEOs a good salary.
C. Relying on market forces to exert managerial discipline.
D. Paying the manager a proportion of the profits that the firm
generates.

7. Which of the following is the most expensive method for the
firm to overcome agency costs?

A. Let the Securities and Exchange Commission inform the
firm of a problem.
B. Proper design of an executive’s compensation contract.
C. Monitor the executive’s work.
D. Require executives to own a large proportion of their firm’s
outstanding shares.

8. The main source of agency costs is due to:

A. Managerial power.
B. A manager owning too much of his firm’s stock.
C. A manager concerned with his personal well-being.
D. Government agency filing requirements.

9. Shareholders are said to be the residual owners of the firm’s
assets. What does this mean?

A. Shareholders have limited liability in their investment.
B. Shareholders do not receive any payoff from the firm until
all creditors are paid.
C. Shareholders are allowed to recover their investment first if
the firm experiences financial distress.
D. Shareholders have priority in electing the board of directors
of the firm.

10. Which of the following statements is FALSE regarding debt
capital?

A. Debt holders receive fixed interest payments at the specified
period.
B. Debt holders will be paid the principal at maturity date.
C. Firms can be forced into bankruptcy by debt holders if
interest payments are not paid.
D. Debt holders have voting rights for the firm’s board of
directors.

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11. Identify which of the following statement is FALSE regarding
equity capital?

A. Most of the firm’s business risk is borne by common stock.
B. Preferred stockholders receive a fixed annual payment on
their invested capital.
C. Common stockholders have voting rights.
D. A firm can be forced into bankruptcy by preferred
stockholders if dividend payments are not paid.

12. What should be the main goal of a firm’s manager?

A. Maximise shareholder wealth
B. Maximise net income or earnings
C. Minimise debt
D. Minimise expenses

13. What is the term used to refer to a firm that offers shares to the
general public for the first time?

A. Initial Public Offering
B. Initial Placed Offering
C. Investment Plan Offer
D. Investment of Public Offers

Summary

In this section, you have been introduced to the five basic functions
of corporate finance, namely, external financing, capital budgeting,
corporate governance, financial management and risk management.
You have also learned the ten principles of finance that influence the
decision-making of financial managers. After that, you have looked
at how firms can obtain capital through equity (selling ownership
shares) and debt (borrowing) issuance. Next, you have learned how
financial intermediation plays the role of transferring funds from
the suppliers of funds to the users of funds. Furthermore, you have
been introduced to the five basic functions of financial intermediary:
channelling funds from lender to borrowers, reducing transaction
costs, providing liquidity services, asset transformer and reduction of
risk. Then, you have observed the pros and cons of choosing either
profit maximisation, shareholder value maximisation, or stakeholder
value maximisation as the goal of the firm. Finally, you have seen
that agency costs exist when the managers do not act in the best
interest of the owners or shareholders.

UNIT 1 29
The scope of corporate finance

Self-test 1.2
1. Discuss the five basic finance functions.
2. Discuss the rationale for making corporate governance a finance
function.
3. In your own words, discuss whether risk-management function
has become more important in recent years.
4. Compare and contrast between profit maximisation and
shareholder wealth maximisation.
5. Define a corporate stakeholder.
6. Define groups that are considered as stakeholders.
7. In your own words, discuss why financial institutions have
steadily been losing market share to capital markets as the
principal source of external financing for corporations.

Suggested answers to activity

Feedback
Activity 1.2
1. A
2. B
3. C
4. C
5. C
6. B
7. B
8. C
9. B

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10. D
11. D
12. A
13. A

UNIT 1 31
The scope of corporate finance

1.3 Types of Business Organisations

Objectives

By the end of this section, you should be able to:

1. Describe the three general forms of business organisations.

2. Discuss the advantages and disadvantages of the three forms of business
organisations.

Introduction

Businesses are established with the purpose of making profits. The owners or
shareholders of the business must choose how they want their business to be
organised. There are a few legal structures of how the business can be organised.
Each type of these business organisation structures will have its own advantages
and disadvantages.

Sole proprietorships

This is a business with a single owner. It exists as long as the owner is alive and
chooses to operate the business. Additionally, all the assets belong to the owner and
bear the liabilities personally. In the business world, sole proprietorship is the most
common form of business organisation. The principal benefit of this type of business
is its simplicity and ease of operations. However, there are three disadvantages that
limit the firm’s long-term growth potential. First, proprietorship has limited life.
This means it will cease to exist when the owner dies or retires. Second, sourcing
of funds by sole proprietorships is limited to only reinvested profits and owner’s
personal loan. Third, the proprietor personally bears all its business liabilities.

Partnerships

A partnership can be formed when at least two owners join their skills and personal
wealth together. Compared to sole proprietorships, partnership businesses do not
cease after the death or retirement of one partner. Additionally, more capital can be
raised due to larger numbers of partners. However, partnerships have almost similar
disadvantages compared to sole proprietorship. First, firm’s lifespan can be short if
only a few partners are involved. The sustainability of the business is questionable
when partners leave the firm. Second, firms have limited access to funding unless
the remaining partners have the capacity to increase or expand their investment.
Third, it has unlimited personal liability. All partners are subject to joint and several
liabilities. This means all partners have to bear the firm’s liability if one of the partners
makes a big business mistake or misappropriate the firm’s money.

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Corporations

A legal entity owned by shareholders who hold its common stock is called public
corporation. A shareholder is entitled to vote on company’s proposal or resolution,
elect and remove CEOs and directors that sit on the board of directors. The company’s
charter contains voting procedures and other aspects of corporate governance of the
firm. By Malaysian law, a corporation is considered a separate legal entity. It has the
same economic rights and responsibilities as an individual. This means that public
corporations can be sued and sue, own property and draw and execute contracts in
their own name. This type of business organisation has many competitive advantages.
First, public corporations can have unlimited life, whereby they can exist perpetually
unless it is delisted or wound up by law. Second, limited liability clause ensures that
shareholders cannot be held personally liable for the firm’s debt. However, the Chief
Executive Officer (CEO) and Chief Financial Officer (CFO) can be held liable on
charges of fraud or misrepresentation of account. Third, a public corporation can
have unlimited access to capital, either sourcing it from the equity or bond market.
In fact, this is the most competitive advantage for this type of business organisation.
Its floated shares and bonds can be traded daily among investors. However, a public
listed company is subject to corporate governance laws that require more financial
and business disclosure to the investors. Figure 1.4 shows the basic organisational
structure of a typical large public corporation.

Stockholders Owners
Managers
elect
Board of Directors

hires
President (CEO)

Vice President Vice President Vice President Vice President Vice President
Human Manufacturing Finance (CFO) Marketing Information
Resources
Resources

Treasurer Controller

Capital Cash Manager Credit Manager Foreign
Budgeting Exchange
Manager Manager

Cost Tax Accounting Financial
Accounting Manager Accounting

Manager Manager

Figure 1.4 A typical organisational chart of a public listed company

UNIT 1 33
The scope of corporate finance

In summary, the advantages and disadvantages of each form of business organisation
are presented below:

Sole Partnership Corporation
Proprietorship
Advantages Simple to create Simple to create Limited liability of
owners
Owner has full Allows for the Ease of transfer of
control over sharing of skills ownership
operations among partners Increased access to
Owner receives all Increased access financing
profits to financing over
sole proprietorship Can have tax
Business due to increased advantages
information is number of owners
kept confidential, Better decision-
i.e., owner is not making
required to share
information Sharing risks Separate legal
Easy to dissolve entity

Disadvantages Easy to transfer Unlimited liability More expensive
ownership of each partner to create than
Unlimited liability partnerships
of the owner Difficult to transfer or sole
ownership proprietorships
Life of the Ownership is more
organisation is A partnership difficult to transfer.
limited to the life ceases upon the More ongoing
of the owner death of any of the administration
Limited access to partners and regulatory
financing. Limited capital reporting
May have a hard Divided authority May be subject to
time attracting higher taxes than
high caliber other business
employees forms
Owners do not
control the
organisation.
Lengthy decision-
making process

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Activity 1.3
Choose the correct answer.
1. Lim and Lee have decided to start a catering business called Tasty
Food. Both partners would form an organisation that will protect
their personal wealth from any legal claims by their customers.
If Lim and Lee are the only investors in this Malaysian domiciled
firm, propose a legal form of organisation which could best
protect Lim’s and Lee’s interest.

A. Sole proprietorship
B. Partnership
C. Limited partnership
D. Corporation

2. Which of the following is the weakness of a sole proprietorship?
A. Unlimited life
B. Easy to form
C. Limited liability
D. Limited access to capital

3. Which of the following is considered the strength of a sole
proprietorship?

A. Unlimited life
B. Easy to form
C. Limited liability
D. Limited access to capital

4. Which of the following is considered the strength of a
corporation?

A. Limited life of the business
B. Unlimited access to capital
C. Unlimited liability
D. Double taxation of income

5. Which of the following is NOT considered the strength of a
corporation?

A. Unlimited life of the business
B. Unlimited access to capital
C. Unlimited liability
D. Individual contracting

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The scope of corporate finance

6. A business with only one owner is called a:

A. Partnership
B. Sole proprietorship
C. Corporation
D. Limited liability company

7. It is said that a corporation is a separate legal entity from its
directors. What consequence does that have for the corporation?

A. It can sue and be sued
B. They can own property
C. None of the above
D. A and B

8. Which of the following is not true for a partnership?

A. Limited life
B. Limited access to capital
C. A single owner
D. Unlimited personal liability

Summary

In this section, you have observed the three common forms of
business organisations, namely, sole proprietorship, partnership, and
corporation. Sole proprietorship is simple to set up and operate,
but its lifespan depends on the owner’s lifespan and it lacks of
funding sources, i.e., capital markets. Partnerships consist of at least
two owners. It has almost the same advantages and disadvantages
as sole proprietorship. On the other hand, the setting up of
corporations can resolve the disadvantages faced by partnership and
sole proprietorship. Nevertheless its listing on the stock exchange
means it is subject to stringent securities law on financial reporting
and disclosures.

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Self-test 1.3
1. What are the costs and benefits of the three major business
organisational forms?
2. Why do you think the various hybrid forms of business
organisation have proven so successful?
3. Comment on the following statement: “Sooner or later, all
successful private companies that are organised as proprietorships
or partnerships must be corporations.”

Suggested answers to activity

Feedback
Activity 1.3
1. D
2. D
3. B
4. B
5. C
6. B
7. D
8. C

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The scope of corporate finance

Summary of Unit 1

Summary

In the first section, you have learned that modern business
environment requires finance function to interact with other non-
business functions to create shareholder’s value. The process involves
fund-raising activity, product roll out, cash flow management,
investment appraisal and further capital investment.

In the second section, you have learned about the complexity
of corporate finance, whereby external financing, financial
management, risk management, corporate governance and capital
budgeting form the core structure of finance function in the firm.
Additionally, the main distinction between equity and debt capital
is creditor and owner. In the modern financial system, financial
intermediary plays the role of channelling excess funds from lender
to borrowers efficiently. Additionally, due to the owner being
the residual claimant, profit maximisation and shareholder value
maximisation must be the main objective of the firm to encourage
investors to purchase shares. However, corporate social responsibility
is also crucial in achieving the long term goals of the firm. Agency
costs arise when the manager fails to act in the best interest of
the owner.

In the third section, costs and benefits of three types of business
organisations have been discussed. You should have noticed that
the main distinctions are lifespan of the company, access of capital,
transparency, accountability, governance, ethics and operational
flexibility.

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UNIT 1 39
The scope of corporate finance

Suggested Answers to Self-tests

Feedback

Self-test 1.1

1. Shareholder wealth refers to the value of the company generally
expressed in the value of the stock, whereas profit maximisation
refers to how much dollar profit the company makes. It might
seem like making as much profit as possible would yield the
highest value for the stock, but that is not always the case.

The goal of wealth maximisation is the value of an entity
expressed in terms of the market value of its common stock,
i.e., the current trading market price per share times the number
of common shares outstanding. Profit maximisation measures
the value of an entity in terms of the currency profits that it
makes. It assumes that the yield of highest value is making as
much profits as possible.

Also, if one is maximising profit, they are simply placing focus
on what can raise profit in the “short term”. If one is maximising
company value, they are looking from a different point of view
which is usually on what you can really sell the company for,
intangibles such as reputation, products in the works, workplace,
etc. (long term). A person would be looking towards the future
“long-term” outlook with this perspective.

Whether the company’s goal should be maximising shareholder
value or maximising profit is subject to debate. But in finance,
maximising shareholder value is more applicable. Many finance
theories recognise the importance of maximising shareholder
value more than maximising profit.

2. Please refer to the discussion of Apple Inc. in this module.

A capital market is a market for securities, where business
enterprises (companies) and governments can raise long-term
funds. It is defined as a market in which money is provided for
periods longer than a year, as the raising of short-term funds
takes place in other markets (e.g., the money market).

40 WAWASAN OPEN UNIVERSITY
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The functions of the capital market include the following:

a. Raise capital for industry.

b. Provide liquidity for financial instruments that trade in a
secondary market.

Self-test 1.2

1. A finance manager needs to know all five basic finance areas
because they are all related to his. While the manager’s primary
responsibilities may be raising money or choosing investment
projects, the manager also needs to know about capital markets
and debt/equity optimal levels, be able to manage risks of the
business and governance of the corporation.

2. The principle of corporate governance states that the manager
must act in the best interest of the firm’s shareholders.

3. New methods of managing risk have been developed in recent
years, and a manager must be aware of these in order to maximise
shareholder value. Additionally, the complexity of the financial
market introduces new risks for finance managers that might
affect the firm’s business.

4. Profit maximisation may come into conflict with maximising
shareholder wealth. For example, a company could accept very
high returns (and also very high-risk projects that do not return
enough to compensate for the high risk). Profits, or net income,
are accounting numbers and therefore subject to manipulation.
It would be possible to show positive profits when shareholder
wealth was actually being decreased.

5. Stakeholders include anyone with an interest in the company,
including stockholders.

6. Stakeholders are also the management, employees, the
government, the community, suppliers, customers, and lenders.
Stakeholder wealth preservation appears to favour socialism
more than capitalism. Stakeholder wealth, for example, keeping
on too many employees for the firm to be efficient, may be
preserved at the expense of stockholder wealth.

UNIT 1 41
The scope of corporate finance

7. A financial intermediary is an institution that raises capital by
issuing liabilities against itself, and then uses the funds so raised
to make loans to corporations and individuals. Borrowers, in
turn, repay the intermediary, meaning that they have no direct
contact with the savers who actually funded the loans. Capital
markets have grown steadily in importance, principally because
the rapidly declining cost of information processing has made
it much easier for large numbers of investors to obtain and
evaluate financial data for thousands of potential corporate
borrowers and issuers of common and preferred stock equity.

Self-test 1.3
1. Partnerships and proprietorships

Advantages Disadvantages
a. Easy to form a. Limited life
b. Few regulations b. Unlimited liability
c. No corporate income taxes c. Hard to raise capital
d. Being one’s own boss

Corporations

Advantages Disadvantages
a. Double taxation
a. Unlimited life b. Costly setup
b. Easy to transfer ownership c. Costly period reports
c. Limited liability required
d. Easier to raise capital


2. Hybrid forms are successful because they can combine the
advantages of several forms of organisations. For example, the
limited liability partnership has the advantages of a partnership,
without the disadvantages of unlimited liability.

3. The idea that all successful private companies organised as
proprietorships or partnerships must become corporations is
largely opinion. There are many proprietorships and partnerships
that remain so throughout their lives. However, if a business is
to grow, it probably will thrive as a corporation, with better
access to capital, less risk of losing everything (limited liability),
easy transferability, and unlimited life.

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UNIT 1 43
The scope of corporate finance

References

Aretha Boex (2015). Why cash flow is more important than profit. Publication
of Nebraska Business Development Centre. www.nbdc.unomaha.edu (Accessed
27 June 2020).

Brealey A. R., Myers, C. S., and Allen, F. (2014). Principles of Corporate Finance.
Global Edition. McGraw Hill.

Fathilatul Zakimi Abdul Hamid, Rohami Shafie, Zaleha Othman, Wan Nordin Wan
Hussin & Faudziah Hanim Fadzil (2013). Cooking the Books: The Case of Malaysian
Listed Companies. International Journal of Business and Social Science. 4(13).

Graham, J. R., Smart, S. B., Am, C. A., & Gunasingham, B. (2017). Introduction
to Corporate Finance. 2nd Asia — Pacific Edition. Cengage Learning.

Jensen, M C and Murphy, K J (1990) ‘Performance pay and top management
incentives’, Journal of Political Economy, 98(2):225 –264.

Jensen, M C and Meckling, W (1976) ‘Theory of the firm: Managerial behavior,
agency costs and ownership structure’, Journal of Financial Economics, 3(4):305–360.

Meggison, W. L., & Smart, B. S. (2009). Introduction to Corporate Finance, 2nd
Edition. South-Western, Cengage Learning.