Chapter

McGraw-Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

The Goals and Functions of Financial Management1

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Chapter Outline

• Introduction to Finance

• Risk-Return Tradeoff

• Forms of Organizations

• Corporate Governance

• Goals of Financial Management

• Social Responsibility and Finance

• Role of Financial Markets

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Financial Management

Financial Management or business finance is concerned with managing an entity’s money.

For example, a company must decide:− where to invest its money.− whether or not to replace an old asset.− when to issue new stocks and bonds.− whether or not to pay dividends.

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Relationship between Finance, Economics and Accounting

• Economics provides structure for decision making in many important areas.− Provides a broad picture of economic

environment.

• Accounting provides financial data in various forms.– Income statements, balance sheets, and

statement of cashflows.

• Finance links economic theory with the numbers of accounting.

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Evolution in the Field of Finance

• At the turn of the century: Emerged as a field separate from economics.

• By 1930s: Financial practices revolved around such topics as:– Preservation of capital.– Maintenance of liquidity.– Reorganization of financially troubled

corporation.– Bankruptcy.

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Evolution in the Field of Finance (cont’d)

• By mid-1950s: Finance becomes more analytical.– Financial Capital (accounting capital/ money)

was used to purchase Real Capital (economic capital/ long-term plant and equipment).

– Cash and inventory management– Capital structure theory– Dividend policy

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Recent Issues in Finance

• Recent focus has been on:– Risk-return relationships. – Maximization of returns for a given level of risk.– Portfolio management.– Capital structure theory.

• New financial products with a focus on hedging are being widely used.

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Recent Issues in Finance (cont’d)

• The following are significant to financial managers during decision making:– Effects of inflation and disinflation on financial

forecasting.– Required rates of return for capital budgeting

decisions.– Cost of capital.

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Advances in Internet and Finance

• Internet and its acceptance has enabled acceleration of e-commerce solutions for “old economy” companies.

• E-commerce solutions for existing companies− B2C− B2B

• Spurt in new business models and companies− Amazon.com− eBay

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Advances in Internet and Finance (cont’d)

• For a financial manager e-commerce impacts financial management because it affects the pattern and field through which cash flows through the firm.– B2C Model: Products are bought with credit

cards, credit card checks are performed, and selling firms get the cash flow faster.

– B2B: Orders can be placed, inventory managed, and bids to supply products can be accepted –all online.

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Functions of the Financial Manager

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Risk-Return Trade-Off

• Influences operational side (capital versus labor/ Product A versus Product B)

• Influences financial mix (stocks versus bonds versus retained earnings)− Stocks are more profitable but riskier.− Savings accounts are less profitable and less

risky (or safer)

• Financial manager must choose appropriate combinations

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Sole Proprietorship

• Represents single-person ownership

• Advantages:– Simplicity of decision-making. – Low organizational and operational costs.

• Drawback– Unlimited liability to the owner.– Profits and losses are taxed as though they

belong to the individual owner.

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Partnership

• Similar to sole proprietorship except there are two or more owners. – Articles of partnership: Specifies ownership

interest, the methods for distributing profits, and the means of withdrawing from the partnership.

– Limited partnership: One or more partners are designated as general partners and have unlimited liability of the debts of the firm; other partners designated limited partners and are liable only for their initial contribution.

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Corporation

• Corporation− Articles of incorporation: Specify the rights and

limitations of the entity.− Its owned by shareholders who enjoy the

privilege of limited liability. − Has a continual life.

− Key feature is the easy divisibility of ownership interest by issuing shares of stock.

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Corporation (cont’d)

• Disadvantage:– The potential of double taxation of earnings.

• Subchapter S corporation: Income is taxed as a direct income to stockholders and thus is taxed only once as normal income.

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Corporate Governance

• Agency theory– Examines the relationship between the owners

and managers of the firm.

• Institutional investors– Have more to say about the way publicly owned

companies are managed.− Public Company Accounting Oversight Board

(PCAOB)

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Sarbanes-Oxley Act of 2002

• Set up a five member Public Company Accounting Oversight Board (PCAOB) with responsibility for:– Auditing standards within companies– Controlling the quality of audits– Setting rules and standards for the

independence of the auditors.• Major focus is to make sure that publicly-

traded corporations accurately present their assets, liabilities, and equity and income on their financial statements.

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Goals of Financial Management

• Valuation Approach• Maximizing shareholder wealth (shareholder

wealth maximization)• Management and stockholder wealth

− Retention of position of power in long run is by becoming sensitized to shareholder concerns.

− Sufficient stock option incentives to motivate achievement of market value maximization.

− Powerful institutional investors are increasing management more responsive to shareholders.

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Social Responsibility

• Adoption of policies that maximize values in the market attracts capital, provides employment and offers benefits to the society.

• Certain cost-increasing activities may have to be mandatory rather than voluntary initially, to ensure burden falls equally over all business firms.

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Ethical Behavior

• Ethical behavior creates invaluable reputation.

• Insider trading

• Protected against by the Securities and Exchange Commission (SEC).

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The Role of Financial Markets

• Financial markets are indicators of maximization of shareholder value and the ethical or the unethical behavior that may influence the value of the company.

• Participants in the financial market range over the public, private and government institutions.– Public financial markets– Corporate financial markets

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Structure and Functions of the Financial Markets

• Money markets− Securities in this market include commercial

paper sold by corporations to finance their daily operations or certificates of deposit with maturities of less than 12 months sold by banks.

• Capital markets− Long-term markets− Securities include common stock, preferred

stock and corporate and government bonds.

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Stocks versus Bonds

• Stock = ownership or equity− Stockholders own the company

• Bond = debt or IOU− Bondholders are owed $ by company

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Allocation of Capital

• Primary market– When a corporation uses the financial markets

to raise new funds, the sale of securities is made by way of a new issue.

• Secondary market– When the securities are sold to the public

(institutions and individuals).– Financial managers are given a feedback about

their firms’ performance.

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Return Maximization and Risk Minimization

• Investors can choose risk level that meets their objective and maximizes return for that given level of risk.

• Companies that are rewarded with high-priced securities can raise new funds in the money and capital markets at a lower cost compared to competitors.

• Firms pay a penalty for failing to perform competitively.

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Restructuring

• Restructuring can result in: – Changes in the capital structure (liabilities and

equity on the balance sheet).– Selling of low-profit-margin divisions with the

proceeds of the sale reinvested in better investment opportunities.

– Removal or large reductions in the of current management team.

• It has resulted in acquisitions and mergers.

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Internationalization of Financial Markets

• Allocation of capital and the search for low cost sources of financing on the rise in global market.

• The impact of international affairs and technology has resulted in the need for future financial managers to understand − International capital flows.− Computerized electronic funds transfer systems.− Foreign currency hedging strategies.

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Technological Impact on Capital Market

• Consolidation among major stock markets and mergers of brokerage firms with domestic and international partners.

• Electronic markets have gained popularity as against traditional organized exchanges and NASDAQ.

• Resulted in the merger of NYSE with Archipelago and NASDAQ bought out Insinet from Reuters.