Chapter 1

Part A: Foundations

Nature and purpose of finance

Last updated November 20266 sectionsabout 6 min read

Key takeaways

Finance is the management of money and value over time: raising funds, allocating them to the best available uses and returning them to those who supplied them.
Accounting is historical and asks whether performance was accurately measured; finance is forward-looking and asks whether a decision creates value, judged by cash flow and the time value of money.
Modern finance aims at shareholder wealth maximisation rather than profit maximisation, because it accounts for the amount, timing and risk of expected future cash flows.
A finance manager makes investment, financing and dividend decisions, and manages working capital, liquidity and risk.
The agency conflict between shareholders (principals) and managers (agents) is eased by performance-linked pay, board monitoring, the market for corporate control and debt as a disciplining device.

Finance is the discipline of managing money and value over time: raising it, allocating it to the best available uses, and returning it to those who supplied it. This chapter sets out finance's scope and purpose before the paper turns to its specific tools, markets, valuation and appraisal techniques.

Nature and scope of finance and investment

Finance

The management of money: how individuals, firms and governments raise funds, allocate them, and manage the risk and return that follow.

Investment

Committing money now with the expectation of a financial return in the future, the specific activity this paper builds toward.

Scope

Spans corporate finance (a firm's own financing and investment decisions), investment/asset management (managing portfolios of financial assets on behalf of others), and public finance (developed fully in CIFA Public Finance and Taxation).

Financial decision-making process

Identify the objective the decision must serve (the goals of the firm)
Identify and evaluate the available alternatives
Gather relevant financial data (the sources of market data)
Apply appropriate analytical tools, valuation and appraisal techniques
Make the decision and implement it
Monitor the outcome and feed the result back into future decisions

Relationship between accounting and finance

	Accounting	Finance
Orientation	Historical: records and reports what has already happened	Forward-looking: decides what should happen with future resources
Core question	Was performance accurately measured and reported?	Does this decision create value?
Basis	Accrual accounting, matching income and expense to the period earned or incurred	Cash flow and time value of money: a cash flow's timing, not merely its amount, drives its value

The two are complementary rather than competing: financial statements (accounting's output) are the primary data source finance uses in valuation and appraisal, but finance evaluates that data by its effect on cash and value, not by how it is classified for reporting.

Goals of a firm

Profit maximisation

A traditional but incomplete goal: it ignores the timing of profit, the risk taken to earn it, and its effect on the share price, all of which matter to shareholders.

Shareholder wealth maximisation

The goal modern finance actually optimises for: maximising the market value of shareholders' equity, which properly accounts for the amount, timing and risk of expected future cash flows, unlike profit maximisation alone.

Stakeholder wealth

A firm pursuing shareholder wealth over the long run must still satisfy other stakeholders, employees, customers, lenders, regulators, echoing the stakeholder theory of CIFA Professional Ethics and Governance; ignoring them undermines the very cash flows shareholder value depends on.

Roles of a finance manager

Investment decisions: deciding which assets and projects the firm should commit capital to
Financing decisions: deciding how to raise the funds needed, and in what mix of debt and equity
Dividend decisions: deciding how much of the firm's earnings to distribute to shareholders versus retain for reinvestment
Working capital and liquidity management: ensuring the firm can meet its short-term obligations
Risk management: identifying and managing the financial risks the firm is exposed to

Agency theory

Agency theory was introduced generally in CIFA Professional Ethics and Governance; in a finance context, the sharpest form of the conflict is between shareholders (principals) and the managers who run the firm on their behalf (agents), since managers may favour job security, empire-building acquisitions, or lower personal risk over the shareholder-wealth-maximising choice.

Performance-linked pay

Ties management compensation to share price or earnings performance, aligning managerial reward with shareholder outcomes.

Monitoring by the board

Independent directors and board committees (see CIFA Professional Ethics and Governance) oversee management decisions on shareholders' behalf.

The market for corporate control

The threat of a takeover disciplines management, since persistently poor performance depresses the share price and invites an acquirer who would replace underperforming management.

Debt as a disciplining device

Mandatory debt repayments reduce the free cash flow available for managers to misuse on low-value projects.

Exam tip

Shareholder wealth maximisation versus profit maximisation is a frequently tested distinction: the giveaway is that shareholder wealth explicitly accounts for the timing and risk of cash flows, which is exactly what the time value of money and risk/return chapters formalise.

Self-check

(a) Distinguish profit maximisation from shareholder wealth maximisation. (3 marks)

(b) State the five roles of a finance manager. (5 marks)

(c) Explain the agency conflict between shareholders and managers, and state two mechanisms used to resolve it. (4 marks)

(d) Distinguish accounting from finance by orientation and core question. (3 marks)

Show worked answer

(a) Profit maximisation ignores the timing of profit, the risk taken to earn it, and its effect on share price. Shareholder wealth maximisation maximises the market value of shareholders' equity, properly accounting for the amount, timing and risk of expected future cash flows.

(b) Investment decisions; financing decisions; dividend decisions; working capital and liquidity management; risk management.

(c) Managers (agents) may favour job security, empire-building or lower personal risk over the shareholder-wealth-maximising choice shareholders (principals) actually want. Any two of: performance-linked pay; monitoring by the board; the market for corporate control; debt as a disciplining device.

(d) Accounting is historical, recording and reporting what has already happened, and asks whether performance was accurately measured. Finance is forward-looking, deciding what should happen with future resources, and asks whether a decision creates value.