Chapter 1

Part A: Foundations

Finance concepts and the finance function

Last updated November 20267 sectionsabout 7 min read

Key takeaways

Every finance decision falls into one of four categories: investment, financing, dividend and liquidity decisions.
Accounting looks backward to record and report what has already happened; finance looks forward, using the same data to decide what to do next.
Maximising shareholder wealth, proxied by the market value of the ordinary shares, is the primary financial objective; profit maximisation is weaker because it ignores the timing, risk and financing of profit.
An agency problem arises when a principal delegates authority to an agent whose interests differ, and information asymmetry lets the agent act on that difference.
Remedies realign incentives or narrow the information gap: performance-related pay and share options, monitoring, disclosure, lending covenants, the market for corporate control and governance codes.

Finance is the discipline of raising funds and deploying them to create value for the organisation's owners. This chapter sets out the decisions that discipline actually comprises, and the tension, agency theory, that sits underneath nearly every one of them.

The four finance decisions

Every finance decision an organisation makes falls into one of four categories.

Investment decisions

Deciding which assets and projects to commit the organisation's funds to, evaluated using the capital budgeting techniques in the chapter on project appraisal.

Dividend decisions

Deciding how much of the profit earned to distribute to shareholders versus retain for reinvestment (see the chapter on the dividend decision).

Financing decisions

Deciding the mix of debt and equity used to fund the organisation's investments (see the chapter on sources of business finance), which in turn determines its cost of capital (see the chapter on the cost of capital).

Liquidity decisions

Deciding how to manage short-term assets and liabilities so the organisation can meet its obligations as they fall due (see the chapter on working capital management).

Accounting and finance

Similarities and differences

Both draw on the same underlying transaction data, but accounting is chiefly concerned with recording and reporting what has already happened, while finance is chiefly concerned with using that data to decide what to do next; accounting looks backward to inform, finance looks forward to decide.

Cost accounting

Supplies the detailed cost data (per unit, per department) finance needs to evaluate a project's likely cash flows.

Financial accounting

Supplies the audited historical statements finance uses to assess an organisation's existing financial position before making a new decision.

Management accounting

Supplies forward-looking budgets and variance analysis finance draws on for planning and control alongside its own techniques.

Finance functions

Routine

The day-to-day administrative finance activities: processing payments, managing cash receipts, record-keeping and routine reporting.

Non-Routine (Managerial)

The higher-level decisions this paper is built around: investment appraisal, financing structure, dividend policy and working capital strategy, requiring judgement rather than routine processing.

Objectives of the firm

Financial

Maximising shareholder wealth is the primary financial objective assumed throughout this paper, typically proxied by maximising the market value of the firm's ordinary shares; profit maximisation is a related but weaker objective, since it ignores the timing, risk and financing of that profit.

Non-financial goals

Employee welfare, customer satisfaction, environmental and social responsibility, and long-term survival, objectives a firm also pursues alongside its financial goal.

Overlaps and conflicts among the objectives

Financial and non-financial goals often reinforce each other (satisfied customers and employees support long-term financial performance), but can also conflict in the short term, spending on staff welfare or environmental measures can reduce reported profit even while supporting the firm's long-term value.

Agency theory

Key definitions

Principal

The party who delegates authority and whose interests are meant to be served, shareholders in the classic corporate example.

Agent

The party appointed to act on the principal's behalf, management in the classic corporate example, who may not always act purely in the principal's interest.

Agency theory studies the problems that arise wherever a principal delegates decision-making authority to an agent whose own interests do not perfectly align with theirs, the central tension behind separating ownership (shareholders) from control (management) in a modern company.

Agency relationships

Ordinary shareholders and management

Shareholders want value maximised; management may instead pursue growth, job security, or perks that serve their own interests first.

Shareholders and debenture holders

Shareholders may favour riskier projects that benefit equity if they succeed, while lenders bear the downside without sharing the upside, a conflict debt covenants exist to manage.

Shareholders and external auditors

Shareholders rely on the auditor for an independent check on management's own reporting, a relationship that only works if the auditor's independence from management is genuinely maintained.

Shareholders and Government

Government (as tax authority and regulator) wants compliance and its due share of profit; shareholders want returns maximised, which can create an incentive toward aggressive tax or regulatory positions.

Agency conflicts and remedies

Every agency relationship above shares the same root cause: information asymmetry (the agent knows more than the principal) combined with a genuine divergence of interest. The standard remedies work by realigning incentives or narrowing that information gap.

Performance-related pay and share options, tying management's own reward to shareholder value
Monitoring, through the board, audit committee and external auditor
Disclosure and reporting requirements, narrowing the information gap directly
Covenants and security in lending agreements, protecting debt holders' position
The market for corporate control, an underperforming management team risking takeover
Corporate governance codes setting expected standards of board conduct

Exam tip

Whenever a scenario question describes a manager acting in their own interest at shareholders' expense, name it explicitly as an agency problem (or agency cost) and pair it with a specific, matching remedy from the list above, rather than a generic answer.

Self-check

(a) State the four categories of finance decision. (4 marks)

(b) A CEO expands the company into an unrelated new market that increases their own prestige but destroys shareholder value. Identify the agency relationship affected, and state two remedies that could address it. (5 marks)

(d) Distinguish routine finance functions from non-routine (managerial) finance functions. (2 marks)

Show worked answer

(a) Investment decisions; financing decisions; dividend decisions; liquidity decisions (4 marks).

(b) The shareholders-and-management agency relationship. Any two of: performance-related pay and share options tying management's reward to shareholder value; monitoring through the board, audit committee and external auditor; the market for corporate control, since an underperforming management team risks takeover; corporate governance codes setting expected standards of board conduct (5 marks).

(c) Profit maximisation targets the highest accounting profit, ignoring timing, risk and financing; shareholder wealth maximisation targets the highest market value of shareholders' investment, the primary financial objective assumed throughout this paper, since it properly accounts for the timing and risk of returns that profit alone ignores (3 marks).

(d) Routine functions are day-to-day administrative activities, processing payments, managing cash receipts, record-keeping; non-routine (managerial) functions are the higher-level decisions requiring judgement, investment appraisal, financing structure, dividend policy and working capital strategy (2 marks).