Chapter 1 - Overview of Financial Management

FINANCIAL MANAGEMENT DEFINITION

Financial Management means planning, organizing, directing and controlling the financial activities such as procurement
and utilization of funds of the enterprise. It means applying general management principles to financial resources of the
enterprise. Financial managers:
• Are responsible for the
First, let's recall the global financial crisis of 2008. financial health of an
The Great Recession (2007 - 2008 Global Financial Crisis) Explained in One Minute organization;
• produce financial reports,
This crisis has made the contribution and role of financial managers in so far as directing the firm's operation or more so, direct investment activities;
the nation's economic operation increasingly significant. To avoid such crisis to happen, the financial managers should and
be equipped with the necessary tools essential in finding ways and means to cushion or hedge the effects significantly • develop strategies and plans
negative outcomes of risk and among other things relating to borrowings, foreign exchange transactions, equity and for the long-term financial
debt transactions, and inflations. goals of their organization.

SCOPE/ELEMENTS
• Investment decisions - includes investment in fixed assets (called as capital budgeting). Investment in current
assets are also a part of investment decisions called as working capital decisions.
• Financial decisions - they relate to the raising of finance from various resources which will depend upon decision
on type of source, period of financing, cost of financing and the returns thereby.

GOALS OF FINANCIAL MANAGEMENT

Goals of Financial management could be synonymous to the goals of the enterprise which is to earn the highest possible
profit. But, while it is simple and highly desirable, it has some serious drawbacks or disadvantages if we just consider this
alone.

The goals of financial management could be categorized as follows:

1. Maximization of the value of the firm (Valuation Approach)
2. Maximization of shareholder's wealth
3. Social responsibility and ethical behavior

Valuation approach (maximization of profit) vs. maximization of shareholders' wealth.

Consider the table below showing two alternatives as to which a firm would consider investing to:

Earnings per Share

Year 2020 Year 2021 Total
Company A's Ordinary Shares 300.00 450.00 750.00
Company B's Ordinary Shares 450.00 300.00 750.00

If the company's sole objective is merely maximizing profit, one say that they can invest in either Company A or
Company B since they yield the same. However, Company B is a better option. Why? That is because Company B's
benefits occur earlier. This means that the company can reinvest the P150/share (P450-P300) difference between two
companies a year earlier than if it chose to invest in Company A.

Valuation approach emphasized that profit maximization is very important. However, the issue of accurate measuring of
profit is one of the drawbacks here for this is virtually impossible to achieve. There are various economic and accounting
definitions for profit. Each definition is subject to its own set of interpretations. Economic phenomena like inflation,
deflation, and foreign exchange transaction variables complicate the matter.

Maximization of shareholders' wealth is considered the expansive goal of the firm. The market value of stocks may not
necessarily be high even if the company proves to be profitable and stable. This is specially the case when stock market
prices are declining as influenced by economic, political, and social factors in the financial environment.

SOCIAL RESPONSIBILITY AND ETHICAL BEHAVIOR

Social responsibility means that businesses, in addition to maximizing shareholder value, must act in a manner that
benefits society. From 1984 to 2008, there were 10 financial crises around the world, an average of 1 major financial
crisis every 2.5 years. And the biggest threat in the financial system is said to be ethical failure.

A study on target market preferences found out that in deciding which company to patronize, consumers look at more
than the quality of a company’s products and services. The study says 9 out of 10 consumers expect companies not only
to make a profit, but also to operate according to high standards of corporate social responsibility (CSR). The study adds
that 84 percent of global consumers seek out products made according to prescribed procedures that contribute to
sustainable development, delivering economic, social, and environmental benefits for everyone.

Because of this, socially responsible measures and actions may not necessarily be too costly since they advertise heavily.

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Because of this, socially responsible measures and actions may not necessarily be too costly since they advertise heavily.
The costs are offset by the increase of income generated by increase in sales revenue because customers tend to buy
more from companies who are socially responsible.

AGENCY RELATIONSHIPS
Whenever a person or a group of persons (principal) employs another person or group of persons (agency), to render
service(s) and at the same time delegate decision-making authority to the agent, an agency relationship exists. However,
the agent is not fully responsible for the decision that is made. Since the agent and the principal may have different
goals, the agency relationship creates a potential conflict of interest.

Within the financial management context, the primary agency relationships are those:

• Between shareholders (the principal) and managers (the agent).

• Between debt-holders (the principal) and managers (the agent).

AGENCY CONFLICTS

Agency Problems: Stockholders Vs Managers

It is common knowledge that the shareholder's primary goal is wealth maximization. There could be a conflict of interest
if the manager is also a partial owner of the same firm. The manager's primary goal is to maximize the size of the firm by
stabilizing job security for himself and for all the employees of the firm, thus, the shareholder's primary goal might be
set aside.

Agency Problems: Shareholders (Through Managers) Vs. Creditors

Managers are the agent of both shareholders and creditors. Shareholders empower managers to manage the firm.
Creditors empower managers to use the loan. Being employed by the firm, managers are more likely to act in the best
interest of shareholders, not creditors.

Through their managers/agents, shareholders may maximize their wealth at the expense of creditors by:

• Taking riskier projects than those agreed to at the outset: Creditors lend money to a firm based on its perceived
business and financial risk. If shareholders take riskier investments, the shareholders receive the full benefit of
success, but the creditors may share the losses in case of failure.
• Borrowing more debt to significantly increase dividends or repurchase outstanding stock: The firm becomes riskier
because of increased leverage. Creditors are hurt because more debt ;will claim against the firm's cash flows and
assets.

To protect themselves against shareholders, creditors often include restrictive covenants in debt agreements. In the
long-run, a firm that deals unfairly with creditors may impair the shareholders' interest because the firm may:

• Lose access to the debt markets; or

• Be saddled with high interest rates and restrictive covenants.

Thus, as agents of both shareholders and creditors, managers must treat the two classes of security holders fairly.

Below images are examples of conflict of interest.

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AGENCY COST
➢ Costs incurred by shareholders to minimize agency problems
➢ an internal cost which arises from, and requires payment, to an agent who acts on behalf of a principal in some
situations.

Examples:
• Management incentives
• Monitor performance
• Owners protection
• Complex organization structures

References:
Fundamentals of Financial Management by Ma. Flordeliza L. Anastacio
https://www.academia.edu/13756452/Agency_Relationship_in_Financial_statement
http://www.myinvestment101.com/agency-relationships-in-financial-management/

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Chapter 1 learning activities

Concept Discussion

1. What is meant by maximization of the shareholders' wealth?

2. What are the drawbacks in considering that the utmost goal of a business entity is to yield the highest profit
possible for the firm?

3. Why is social responsibility and ethical behavior important in financial management?

Ethical Dilemma:

Your new job is as a bank loan officer; your partner’s job is as a construction engineer specializing in housing
developments. A young couple just like you apply for a mortgage in hopes of buying a house in one of the subdivisions
that your partner helped build. They don’t qualify for a standard mortgage or even a standard variable rate mortgage,
but they would qualify for a “subprime” package. You worry about them because you’ve discovered that there are a lot
of hidden costs in homeownership, which have made your financial life stressful. But you need a big year-end bonus to
cover those costs, and it will be based on the number and value of the mortgages you write. Turning them down would
reduce your bonus and make your shaky finances even shakier. What would you do? Would ethical considerations enter
into your decision making? Should they? Why or why not? What will you say when you explain your decision to your
partner?

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