Part A: Foundations
Overview of finance
Key takeaways
- Finance is the management of an organisation's funds: how they are raised (the financing decision), invested, and returned to providers of capital (the dividend decision).
- Managerial functions are the strategic decisions on financing, investment and dividends; routine functions are day-to-day work such as cash handling, record keeping and credit control.
- Wealth maximisation, the highest market value of shareholders' investment, is preferred to profit maximisation because it accounts for risk and the timing of returns that accounting profit ignores.
- Agency theory explains why managers, as agents, may not act in shareholders' best interests; corporate governance exists largely to keep financial decisions aligned with the firm's goals.
- Ethical issues in finance include manipulating financial statements, insider trading, conflicts of interest and aggressive tax positions.
A Certified Secretary is not a financial manager, but sits close enough to board decisions on capital, dividends and investment that fluency in how those decisions are actually made matters. This closing paper builds that fluency.
What finance covers
Finance is the management of an organisation's funds, how they are raised (the financing decision), invested (valuation, capital structure and capital budgeting), and returned to providers of capital (the dividend decision), all aimed at the goals of a firm set out below.
Finance functions
Goals of a firm
Worked scenario: profit maximisation and wealth maximisation can disagree (not a decided case)
Mwangi's Bakery Limited's board is offered two one-year strategies. Strategy A raises this year's accounting profit to KES 5,000,000 by deferring essential oven maintenance and cutting the marketing budget. Strategy B holds profit at KES 4,200,000 this year but maintains the ovens and marketing spend, positioning the bakery for stronger, more reliable growth in later years.
A profit-maximisation lens favours Strategy A, since it reports the higher figure for the year in question. A wealth-maximisation lens asks what each strategy does to the present value of all future cash flows to shareholders, as the chapter on the time value of money shows: deferred maintenance risks a costly breakdown and lost sales next year, and a cut marketing budget risks losing customers to competitors, both of which could depress the bakery's value by more than this year's extra KES 800,000 of reported profit is worth.
This is exactly why the goals of a firm treat wealth maximisation as the preferred objective: it forces the comparison onto a basis, discounted future cash flow, that profit maximisation's single-year, accounting-based figure cannot capture.
Agency, stakeholders and governance
As Corporate Governance and Ethics covers in depth under its theories of governance, agency theory explains why financial managers (agents) may not automatically act in shareholders' (principals') best interests, and stakeholder theory broadens the firm's accountability beyond shareholders alone; corporate governance mechanisms (covered there under board models, the board of directors, internal documents and the governance of risk) exist largely to keep financial decision-making aligned with those goals despite this.
Ethical issues
- Manipulating financial statements to mislead investors or lenders (the red flags in the chapter on financial statement analysis)
- Insider trading on price-sensitive financial information (Financial Markets and Specialised Institutions, and Corporate Governance and Ethics)
- Conflicts of interest in investment or financing recommendations
- Aggressive tax positions that comply with the letter of the law but not its spirit (Principles of Accounting and Taxation, under tax evasion and avoidance)
Wealth maximisation is this paper's throughline
The profit versus wealth maximisation distinction drawn above underpins the rest of this paper, wealth maximisation is the objective virtually every technique in the chapters that follow is built to serve, keep it in mind as the paper's throughline, and expect a scenario like the worked example above whenever a question wants you to show you understand why the two can point in different directions.
Self-check
(a) Distinguish profit maximisation from wealth maximisation as objectives of a firm, stating one weakness of profit maximisation. (4 marks)
(b) Classify each of the following as a managerial or a routine finance function: (i) deciding whether to issue new debt; (ii) reconciling the daily cash book; (iii) appraising a new factory investment. (3 marks)
(c) State two ethical issues that can arise in financial management, with one example of each. (4 marks)
Show worked answer
(a) Profit maximisation targets the highest accounting profit; wealth maximisation targets the highest market value of shareholders' investment, accounting for risk and timing. Weakness of profit maximisation: it ignores risk, the timing of returns and cash flow, so it can favour a strategy that looks good on one year's accounts but destroys value over time (4 marks).
(b) (i) Managerial (a financing decision); (ii) Routine (day-to-day cash handling); (iii) Managerial (an investment/capital budgeting decision) (3 marks).
(c) Any two of: manipulating financial statements to mislead investors or lenders; insider trading on price-sensitive information; conflicts of interest in investment or financing recommendations; aggressive tax positions that comply with the letter but not the spirit of the law (4 marks).