Chapter 1

The Role of Financial Management

Click to edit Master subtitle style
5/16/12 Sujit Dhanuka

After studying Chapter 1, you should be able to:

1. 2. 3. 4. 5. 6.

Explain the nature of finance and its integration with other management functions Evaluate the actions of a finance manager Describe the changing role of the finance manager and his/her position in the management hierarchy Discuss the shareholders wealth maximization (SWM) principles as an operationally desirable finance decision criterion Discuss agency problems arising from the relationship between shareholders and managers Describe the organization of the finance function

5/16/12

The Role of Financial Management

What is Financial Management? The Goal of the Firm Corporate Governance Organization of the Financial Management Function

5/16/12

What is Financial Management?

Financial management is that managerial activity which is concerned with the acquisition, financing, and management of assets 5/16/12 with some overall goal in

Finance Functions
The functions of raising funds, investing them

is assets and distributing returns earned from assets t the shareholders are known as financing decision, investment decision, and dividend decision respectively.

5/16/12

Investment Decisions
A Firms investment decisions involve capital expenditures and are called Capital Budgeting decision. It involves decision of allocation of capital or funds to long-term assets that would yield benefits (cash flows) in future. The two important aspects of Investment decision are

Evaluation of prospective profitability of new investment The measurement of a cut-off (required rate of return or opportunity cost of capital) against 5/16/12 which the prospective return could be compared

Financing Decisions
Determine how the assets (LHS of balance sheet) will be financed (RHS of balance sheet).

How and from where to acquire

funds Deciding for the best mix of debt and equity know as Capital Structure What is the best dividend policy (e.g., dividend-payout ratio)?
5/16/12

The change in the shareholders

return caused by the change in

Dividend Decision
The manager must decide whether the firm

should distribute all profits or retain them, or distribute a portion and retain the balance The proportion of profits distributed is called dividend-payout-ratio and the retained portion is called retention-ratio The optimum dividend policy one that maximises the market value of firms shares A firm may also issue shares to existing shareholders at zero charges known as bonus shares
5/16/12

Liquidity Decision
Current assets management that effects the

firms liquidity is yet another important function. Current assets should be managed efficiently for safeguarding the firm against the risk of illliquidity The profitability-liquidity trade-off requires that the financial manager should develop sound techniques of managing current assets
5/16/12

Asset Management Decisions

How do we manage existing assets

efficiently? Financial Manager has varying degrees of operating responsibility over assets. Greater emphasis on current asset management than fixed asset management.
5/16/12

Financial Managers Role

A financial manager is a person who is

responsible , in a significant way, to carry out finance functions. His role include
Fund Raising Funds Allocation Profit planning Understanding Capital markets

5/16/12

Financial Goal: Profit maximization vs. Wealth maximization

Maximization of Shareholder Wealth!

Value creation occurs when we maximize the share price for current shareholders.

5/16/12

Profit Maximization
Profit Maximization u Maximizing a firms earnings after taxes. u It implies that a firm either produces maximum output for a given amount of input or uses minimum input for producing a given output Problems u Ignores changes in the risk level of the firm. u Could increase current profits while 5/16/12 harming firm (e.g., defer maintenance,

Profit Maximization
Profit Maximization
u u

Maximizing a firms earnings after taxes. It implies that a firm either produces maximum output for a given amount of input or uses minimum input for producing a given output The underlying logic of profit maximization is efficiency

5/16/12

Objections to Profit Maximization

Definition of Profit: The precise meaning of profit

5/16/12

is unclear. It does not specify timing or duration of expected returns. It is unclear whether it mean total operating profit or profit accruing to shareholders Time value of Money: It does not make an explicit distinction between returns received in different time periods. It gives no consideration to time value of money Uncertainty or returns: Ignores changes in the risk level of the firm. Owners of the firm would prefer smaller but surer profits to a potentially larger but less certain stream of benefits

Shareholders Wealth Maximization (SWM)

It Means maximization the net present value

of a course of action to shareholders. Net Present Value of wealth of a course of action is the difference between the present value of its benefits ad the present value of its costs It emphasize that the benefits should be measured in terms of Cash Flows. Maximizing the shareholders economic welfare is equivalent to maximizing the utility of their consumption over time.
5/16/12

Need for Valuation Approach: SWM requires

Strengths of Shareholder Wealth Maximization

a valuation model. The financial manager must know or at least assume the factors that influence the market price of shares. Thus, share price serves as a barometer for business performance. Takes account of: current and future profits and EPS; the timing, duration, and risk of profits and EPS; dividend policy; and all other relevant factors.
5/16/12

Risk-return Trade-off : Financial decisions

Strengths of Shareholder Wealth Maximization

incur different degrees of risk. Risk and expected return move in tandem; greater the risk, the greater the expected return Return = Risk-free rate + Risk Premium Risk free rate is obtained from a risk-free government security Risk Premium is over and above risk free rate

5/16/12

Agency ProblemShareholders Managers Vs.

Goals

5/16/12

The Modern Corporation

Modern Corporation
Shareholder s Managemen t
There exists a SEPARATION between owners and managers.
5/16/12

Role of Management
Management acts as an agent for the owners (shareholders) of the firm.
An agent is an individual authorized by

another person, called the principal, to act in the latters behalf.

5/16/12

Agency Theory
u

Jensen and Meckling developed a theory of the firm based on agency theory.
relating to the behavior of principals and their agents.

Agency Theory is a branch of economics

5/16/12

Agency Theory
Principals must provide incentives so that management acts in the principals best interests and then monitor results. Incentives include, stock options, perquisites,
u
and bonuses.

5/16/12

Social Responsibility
Wealth maximization does not

preclude the firm from being socially responsible. Assume we view the firm as producing both private and social goods. Then shareholder wealth maximization remains the appropriate goal in governing the
5/16/12

Corporate Governance

Corporate governance: represents

the system by which corporations are managed and controlled. Includes shareholders, board of directors, and senior management. Then shareholder wealth maximization remains the appropriate goal in governing the firm.
5/16/12

Board of Directors
Typical responsibilities:
Set company-wide policy; Advise the CEO and other senior executives; Hire, fire, and set the compensation of the CEO; Review and approve strategy, significant investments,

and acquisitions; and Oversee operating plans, capital budgets, and financial reports to common shareholders.

CEO/Chairman roles commonly same person in US,

but separate in Britain (US moving this direction).

5/16/12

Organization of the Financial Management Function

Board of Directors
President (Chief Executive Officer)
Vice President Operations
5/16/12

VP of Finance

Vice President Marketing

Organization of the Financial Management Function

VP of Finance Treasurer
Capital Budgeting Cash Management Credit Management Dividend Disbursement Fin Analysis/Planning Pension Management Insurance/Risk Mngmt Tax Analysis/Planning
5/16/12

Controller
Cost Accounting Cost Management Data Processing General Ledger Government Reporting Internal Control Preparing Fin Stmts Preparing Budgets Preparing Forecasts

Glossary
Real Assets: Assets required by a firm, in form of fixed

assets and floating assets to carry on its business Share: A part or portion that represents the ownership rights of the holder Opportunity Cost of capital: The Expected rate of return that an investor could earn by investing money in financial assets of equivalent risk Capital Structure: The firms mix of debt and equity Bonus share : Shares issued to an existing shareholder free of cost Financial Manager: A person responsible for carrying out the finance functions of a firm Liquidity: The degree to which an asset 0r security can be bought or sold in the market without effecting the price of 5/16/12 the assets

Self Assessment Questions

1.

Fill in the blanks

1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 13. 14.

The Three most important activities of a business are production, marketing and ________ Plant, machinery, office, factory, furniture and building are all ______________ real assets _________ in investment arises because of uncertain returns The mix of debt and ___________ is known as the firms capital sturcture. The modern financial manager is mainly concerned with the __________________ The Change in profits due to the change in sales is referred to as _______________ Variable costs change in direct proportion to ___________ changes Profit planning anticipates the relationships between volume, costs and _______ and helps develop action plans to face unexpected surprises The underlying logic of profit maximization is _______________ The important ________________of the firm are customers, employees, government and society __________________are the principals of a company while managers are their agents The conflict between the interest of the shareholders and managers is referred to as _____________ problem Goals or _______________ directs the firms action The management is not only the agent of the owners, but also the _____________ for

5/16/12

Self Assessment Questions

1.

Fill in the blanks

1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12.

The Three most important activities of a business are production, marketing and finance Plant, machinery, office, factory, furniture and building are all tangible real assets Risk in investment arises because of uncertain returns The mix of debt and Equity is known as the firms capital sturcture. The modern financial manager is mainly concerned with the Efficient allocation of funds The Change in profits due to the change in sales is referred to as Operating leverage Variable costs change in direct proportion to Volume changes Profit planning anticipates the relationships between volume, costs and profits and helps develop action plans to face unexpected surprises The underlying logic of profit maximization is Efficiency The important stakeholders of the firm are customers, employees, government and society Shareholders are the principals of a company while managers are their agents

The conflict between the interest of the shareholders and managers is referred to 5/16/12 agency problem as

Self Assessment Questions

1.

True or false

1. 2. 3. 4. 5. 6. 7. 8. 9.

Preference share holders receive dividend at a fixed rate Share represent ownership rights of their holders The Existing shareholders are required to pay a nominal sum for bonus shares The optimum dividend policy is one that maximizes the market value of the firms shares Between mutually exclusive projects, the one with highest NPV should be accepted The return from government bonds is lower than from share The higher the risk of action, the lower is the risk premium The financial controller controls finances The main function of the treasurer is to manage the firms funds

5/16/12

Self Assessment Questions

1.

True or false

Preference share holders receive dividend at a fixed rate True 2. Share represent ownership rights of their holders True 3. The Existing shareholders are required to pay a nominal sum for bonus shares False 4. The optimum dividend policy is one that maximizes the market value of the firms shares True 5. Between mutually exclusive projects, the one with highest NPV should be accepted True 6. The return from government bonds is lower than from share True 7. The higher the risk of action, the lower is the risk premium False 8. The financial controller controls finances False 9. The main function of the treasurer is to manage the firms 5/16/12 funds True
1.