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Financial Management Chapter 1

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75 views14 pages

Financial Management Chapter 1

Fm

Uploaded by

christina Quiamson
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© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF or read online on Scribd
ing Introduction to Financial Management Financial Management A finance manager plays a vital fole in a éompany's success. As cash flows into a company, _At the end of this chapter, the students the finance manager comes up with ways on howto _shtould be able to: ee eee ee area + discuss the primary objective of ics future generations. IF nance isthe cener ofall Sianenlmanagareent ‘company activites, its management can be difficult because the finance manager has to be involved in every activity. The finance manager has to be aware ofall the operations, marketing strategies, and overall + distinguish profit maximization from stockholders’ wealth maximization; + identify the primary functions of the strategic plans of the company. finance manager, + analyze problems that are applicable In the past, a finance manager only involves to finance; ? Hmelecl in simple bookkeeping tas auch # diterentinis ete picerimoranio’ as documentation, recordkeeping, preparation o! partnership, and corporation; and financial reports, and payment of company bills (Van Home, 2005). Through time, che task of a finance manager evolved, going deeply into the major aspects ‘of a company's activities. This critical development ee ee resulted in the emergence of financial management. + define the basic features, advantages, and disadvantages of the different 7 Financial management is often mistakenly associated with accounting; however, financial management {goes beyond accounting. Financial management is more concerned with raising, allocating, and controlling a ‘company’s funds. In times of financial trouble, the finance manager must find ways to control and improve company's financial position. The following are common questions finance managers have to tackle and answer: Should the company borrow money? Is ita short-or long-term need? Did the company generate enough resources to fund its activities? Does the company need to issue additional shares of stocks? “Ifa company has enough money, the finance manager again has to be knowledgeable about the way the company should allocate funds in order to generate wealth for stockholders. The finance manager must determine the best course of action a company should take to maximize financial opportunities such as investing in short- term marketable securities, paying company debts, or paying dividends to stockholders. A dividend policy decision is a significant aspect of financial management. The finance ae i : os able to suggest pies ahaa policy @ company should adopt. A company’s dividend policy a he uals attract investors; it determines the kind of investors the cor il i 5 Eines pany will have, as well as the kind of company it Scanned with CamScanner > | raven annener ret 's Goal The comes “oblem-—a fundamental theoretical principle in the operational dynamics of The economic Probie have unlimited wants or needs bu liited resources, Individuals ig economy—states Timid wants Seek to maximize the utilities of whatever resources they pose wan aly the lit provide satisfaction and pleasure However inorder to maximie wl Uilities are use et Md be able to produce savings out of them for whatever purpose. People alay, the people concernet SO" shat todo with their earnings; they can spend, sve, or invest immediatly have the option ro choose eres a chance of not maximizing the ules oftheir eatnings because the oa ta emareernngs st On te ahet hand, people wh chaos ro sve heir mony df opment of thei resources in hopes of earning more so that they can beter enjoy them in the fru, eople who save money fr investment could havea bette chanes of sarsfyng cheir wants and arava thee moneys uty The primary objective ofa company’ finance manager Isto maximize aaa enoney could offer to the people who trust the company. People who invest in the stock of: onic company wil conebute coward maximizing their investment’ ult, People who buy shares of stock become the common stockholders of a company and, therefore, callectvely own i. Meanwhile, finance managers are tasked with handling company operations maxi the value of their company’s common stock. They accomplish this task by increasing the market price or the eurrent price of the stock. They increase the value of their company by creating a good name in terms of profitable, liquidity, effectiveness of management, and sustainability ofthe operations. The company, in turn, must be able to play a major role in the economy and industry where it belongs. In doing so, the market forces favor the company and create value by increasing the demands for its shares of stock. ‘As the demand for their shares of stock increases, and with limited authorized capital stock to issue, the price ofits stock increases as well. In conclusion, the generally accepted goal of a company is to maximize the wealth of its common stockholders through the value of its common stock (Kolb & Demong, 1988). Intrinsic Value _ Intrinsic value refers to the estimated true value of a stock. On the other hand, its market value isthe ons resulting from a security analysis by a marginal investor. The intrinsic value ofa stock difles Person to person. As the intrinsic value is an estimated value, different people with different data and Perspective about the future will have differing intrinsic values of company stock. ‘The marginal investor determines if a stock is undervalued or overvalued by comparing its intrinsic rock is considered! overvalued when the actual market price is highet lued when the actual market price is lower than the intrinsic value. com termining the intrinsic value of a stock can -omputing the intrinsic value of Mee Hock can be a dificue task, There are several methods of ck, i eaae isaich eon ot is valuation alone will result in several intrinsic values imernatonal economy, hichallad toric cong eg Poll environment ofthe county, and be considered as well, Moreover, th aon ira of determining the intrinsic value of a stock, shou! cover, the extent of the involv ie ins stocks ned when conducting a seanty aes of these variables in a company and its stk Scanned with CamScanner Profit Maximization ; Finance and accounting profesional always argue about one point: the primary objective of condueting ‘business. The former always tend to recommend the maximization of stockholders’ wealth, whereas the later recommend the maximization of profits. Although financé and accounting are related, the disagreement ver which contributes better information and makes sound financial decisions exists among specialists. ‘The financial experts need accounting to have the necessary financial information for making quality decisions. In making an analysis, the financial and non-financial data are examined in order to make a decision. The financial experts also use tools and techniques that would make financial reports useful. Meanvhile, the accounting experts are more involved in the preparation of financial reports for both internal and external users, and their manner of reporting is based on certain accounting standards. ‘The following are some arguments raised about profit maximization not being the main objective in financial management: 1. Acchange in profit is also a change in risk. Profit maximization does not consider risks or uncertainties, whereas wealth maximization does (Shim & Siegel, 2006). For instance, a company, with a sales revenue of P 1,000,000 per year, ‘wants to attain a 20% increase in the succeeding year. To do so, the company decides to change its credie policy by prolonging its credit term from 30 to 45 days. With the increase in credit term, the buyer, who would benefit from such increase, will inevitably buy more from the seller and, in effect, the sales will increase due to the relaxation of the credit term. In this case, the seller, whose ‘main objective is to increase sales, overlooks the impact on its cash flow. The sales would increase, but the inflow of cash would be hampered because of an investment made on the receivables. In wealth maximization, before the increase in credit term is offered, the cost and benefit are measured. The company will try to answer questions such as the following: © Will relaxing the credie term bring more benefits than investing in accounts receivable? + Will che company benefit more compared to the cost of its capital investment in accounts receivable? If the answers to the aforementioned questions are yes, then the company will likely change its credit policy. 2. Ie fails to determine the timing of benefits. : In profit maximization, the timing of the benefits is noc considered. A company does not take the level of cash flow into account in the eatly years ofa project. Higher cash inflows in the early years would mean better benefits to a company because of its possibility of generating income from other potential sources. However, this is only true if the alternatives under consideration would give the same cash benefits over the same number of years. Example: Consider Projects A and B with their corresponding cash inflows per year. A company is choosing between the two options that could give them better benefits in a project that will rok five years. = Scanned with CamScanner 42 | tmrosevonto Financial Management increase in cash inflows from year 1 to year 5 from 1.50 to 3.50, financial management, the following analysis would have to take place befor making a decision: ' Consider that the rate of return for five years is 12%. SE rclensees pret Behn “Sout “150 : 134 400 357 Year2 200 159 3.00 239 Year 250 178 2.00 142 Year 250 159 2.00 127 Years 350 199 1.00 057 829 922 Based on the present values of the annual cash inflows for five years, Project B, whose preset value of cash inflows is 9.22, is better compared to that of Project A, with a valuc of 8.29. Likewise, the first two years of Project B will sill yield berter cash inflows due to a higher recovery of cash in che early years. With theses cash inflows, the company can have it invested activities that would help increase their net income. other earning Measurements of accounting profits can be inaccurate. ‘The reported accounting profi 4 ‘ : z ing profits are mere estimates of how mi ed fora articular period. The real accounting es uch net income is genera fits are onl} red at the end of the life of any. Onl iting prof ly measured at the end of the life of a company nm Se mee determine ifits entire operation was successful or not. It is for this samme sel deeement is more concerned with cash inflows rather than accounting Practicing financial manage Senet ash if sales connected to i are on credit Unlike wise wets secnnting » the cash inflows are measured, which could be used as investment ‘emphasized, 2 Risk or uncertainty is ignored 3. The timing of retus does not matter. ecessaty. Scanned with CamScanner i re 3 Pecos an shows adecline in cath inflows fom year Iwo year Som £0 | On thease on gmpany does not consider othe Factors in making a sound decison, chyeg.? 3 reece ire B does not make any difference. Besides, after five years, both projects wil oe a either Proj 5 them cath inflow of 2 a ; ges vear2— YearS— Year4—YearS Total Cash tnntows z L - ” 25 35 z 7 50 20 25 12.00 2 : 40 30 20 2.0 10 12.00 g z ke [Goat Objective Advanta Stockholders’ Achieve 1. Thelong-term wealth is "1. There sno clear relationship ‘wealth on emphasized. ‘between financial decisions and maximization market value stock price. market vale 2 isk or uncertainty is recognized. stock 3, The timing of returns is taken into . erent sresity are ™ iene may be experienced. 4. Stockholders’ retumn is considered. : Source: Shim, JK, 8 Siegel ].G. (2006). Shaums outline of fnancal management. (3d ed). New York: McGraw-Hill Book. Company. The Role of Financial Managers : The financial manager of a company plays a crucial role in the company's goals, policies, and success. The responsibilities of a financial manager include the following: 1. Investment decision This encails an outflow of resources with the expectation of benefiting in the form of cash inflows in the near future. The investment decision is the most important of the three types of decisions when it comes to value creation. Investment becomes a company’s life support in continuing its existence; thus, allocating funds must be done prudently. Moreover, since future benefits are uncertain, investment proposals must recognize the existence of risks. Investments have to be evaluated in terms of their expected returns and corresponding risks, which can affect the company’s valuation in the market. For a company to accept or reject an investment proposal, it may use two kinds of capital budgeting techniques: those that consider the time value of money (e.g,, discounted payback period, internal rate of return, net present value, and profitability index), or those that do not consider the time value of money (e.g., payback period and accounting rate of return). 2. Financing decision ‘A financial manager finds ways to fund the activites of a company. He/she must know where to outsource funds and consider the best possible financing mix or capital structure for a company— for example, short- ot long-term debt or equity financing—in order to meet the expected return © on investment. The capital structure is the combination of long-term liabilities and-equity that finances a company's resources. ‘ “The main goal of the financing decision is to look for resources that will give a company the x lowest weighted average cost of capital (WACC). WACC refers to the minimum required rate of return on an investment. A finance managers helps a company decide to maintain or increase its stock price from its current market price. There isa theory that in order to maximize the company’s stock price, the company must be able to determine its lowest WACC, 3. Dividend policy decision Ie is equally important to know what sound dividend policy is a good financial signal to the market that continually assesses the company. Companies with a good history of dividend payments have better potential of luring in investors. Dividend declaration reflects a profitable status for a ‘company. Meanwhile, companies with earning retention have more funds for investment, hence, Scanned with CamScanner E37 | ereduction to Finania Management _—_—_— te Sp | rocnncrat sennoennnT rs : sat ofa company. A company’s board of tector, with the pu itn poe Tanager wl dei the company wil pay aa fi eee erermines the kindof rockholders a company hat, Iacom Thad scolds are expected e aggresive a5 wl Agrees 2a gc ofthe nt income a Fines back to che company. On the other hand at sere stockholders are more in its net income. the treasurer, controller, and chief financial officer (CFO) carry out th, Te ease is responsible for managing corporate ak and Her agthe capital nancing the busines, formulating ace, and managing the investment portfolio. In other words, the treasurer handles external financing matters and managing te ne ena arts, most of wich iva inane and ot counng ay ‘budgeting, and control functions. ‘The CFO oversees the entire financial activity of a company and serves badger orn financial mates tothe board of directors. Ina large-scale industry, aforementioned financial espo Iiabilites, planning the finances, “The ole of finance in a typical corporate business organization is illustrated as fllows: The co i audit, ee the controller are the following: accounting and financial reporting, internal reporting, protection of assets ealcae planning for control, evaluation and consultation, governmet: are the following: acquisition of are appraisal. On the other hand, the treasurer's common functions management of ch dak, agking eh tee financial and invesement plannings capital budgeting: king relationships, and investor relations; and creditand collection. peaet Decisions and Risk—Return Trade-off It is important to note th: i i = A company can never be ceatin shone fetur is coupled by a corresponding increase in wi Possible risks and effects any financial decision can bring 2 cause. The finance manager's Naik ‘ager's obligation is mn ubiquitous. They could be in the femora that the risks are tolerable. Risks are como” Fie cake oe A h ame afro eee them in all franclal Rene political, and socal instability. AcomP2") er the aphorism, “the higher the eee tlle Apap laste tment in stocks has alway wer the risk: lowever, not all stocks pr For instance, invest get higher returns. Hi be Nays been a popular way to use excess cash a8 2 meat! ® de high returns. In face, many of them provide nest Scanned with CamScanner vTined co invest in companies that declare more dividends out g of a ti, a 7 ~ f returns. Nevertheless, when an investor demands for a higher return from investing in stocks, particularly in speculative stock or penny stock, he/she has to compensate for a higher level of risk. 2 The risk-return trade-off is also present in working capital management. A company that maintains a Jow level of inventory can expect a higher expected return because only a small portion of the company’s funds is invested in this type of current assets. However, such company also faces a greater risk of running ‘out of stocks, thereby losing potential sales or even clients. Types of Business Organizations The three major forms of business organizations are sole proprietorship, partnership, and corporation. Many companies start as a sole proprietorship, as itis the most simple of the three. Through time, sole proprietorships tend to evolve into partnerships ot corporations. Sole Proprietorship A sole proprietorship is a business owned by a single person. Typically, an individual proprietor originally finances the company by using his/her personal savings, supplemented by bank or government loans. The proprietorship form of organization is the simplest form in terms of legal aspects because formal procedures are not needed to establish the business. The owner is only required to comply with specific local licensing laws in order to start selling goods or services to the public. The business entity itself generally has no requirements and limitations that the owner does not have. As there is only one owner, the sole proprietorship provides total control over resources and operations. All profits belong to the owner. Moreover, the proprietor controls and facilitates the decision-making process because he/she does not have to deal with different opinions in day-to-day operations, and he/she has no co-owners to consult with in establishing policies or making other business decisions. The proprietorship is not by itself subject to taxation. However, income tax returns filed by the owner must include the income or loss of the business. Thus, the income tax rate applicable to the sole proprietorship is determined according to the owner's toral income from sources minus his/her total deductions. The two principal disadvantages of sole proprietorships are limited life and the unlimited liability of the owner. Upon the death or retirement of the owner, the current business must be dissolved inasmuch as there are normally no provisions for the continuity of the business. Furthermore, unlimited liability makes the owner of a sole proprietorship personally liable for the company’s actions and debts; hence, the owner's personal assets are legally available to satisfy business debts. ‘Another disadvantage of a sole proprietorship is that ic depends solely on its own operations and the financial capabilities of its owner. As the sole proprietorship is owned by one individual, it becomes difficult to raise large amounts of capital. With these drawbacks, itis almost impossible for a sole proprietorship to ‘expand rapidly. Itis difficule for an organization with a limited life and whose assets may serve as collateral for the owner's other businesses to borrow large sums of money. Advantages of a Sole Proprietorship 1. Ease of formation. A sole proprietorship is simple to establish. It does not require tedious documents similar to that of a partnership or corporation. Scanned with CamScanner A | eotuctontorinanciat Management dl as complete cont: There are no co-owners the owner has compl eae the decision-making Process. sof the business belong to the owner ject o less government regulations than a partnership 2, Control over operations operations, thereby speeding UP 3, No sharing of profits. All prof E t t 44. Simplicity. A sole proprietorship iss eee / However, the income or loss generated fr. neesitelfis not subject t0 t2X- , on 5 Ne elon ssa ofthe income generated by the owner, which i she usin shold De pane based onthe ta ncame ofthe axpye, subject ot torshi ; | Di ey fbeonmnsin te dain bebe, | 2. Unlimited liability, The owner is personally liable for the company’s debts and actions. (ficulty in raising capital. The. rapid expansion of asole proprietorship operation is very difficult to achieve because it has limited access to borrowing large amounts of money. 4, Limitation of skills. A proprietor, as compared to a partnership and corporation, has limitationsin aarti application, Ie is quite rare co se a proprietor who has all the skills involving finance, , and operations. marketit Partnership ‘Apartnership is composed of two or more persons who agree to contribute money, property, or services fos the purpose of dividing the profits berween or among themselves. At least tvo partners own the business in‘ partnership. Icis a more formal legal organization than a sole proprietorship but much less formal than ‘a corporation. ‘The Securities and Exchange Commission (SEC) requires the filing of the Articles of Partnership for the registration of a partnetship. The SEC is a government body that supervises the affairs of partnership and corporations. The following information is needed in the Articles of Partnership: 1. name of the partnership principal place of business “ date of effectivity and life of che partnership * 4.- paipose of the partnership 2 3. 4. 9. mimes, addresses, and contributions of the partners. agreement regarding the manner of management of the partnership 7. manner of dividing the profi f 8 the profits berween or among the partners 9. idating the partnership with the ri arbitration of disputes manner of liqui ights and duties of the partners “Like sole proprietorshi a <2, PeBulations. Ie ones a is simple to organize and is subject to only a few governme"* the dissolution of the business Similady, tse the dedth, bankruptcy, or withdrawal of a partner result in ° ew partner to an existing partnership, etbet the admission of a Scanned with CamScanner by contribution of capital or by acquisition of an interest from an old partnet, requires the formation of a ‘ew partnership. Each partner becomes personally liable for a partnership. Like a sole proprietorship, a partnership has unlimited liabilities. The partners are jointly and individually liable for the debts of a partnership. In the event that the partnership is unable to pay its debts, the partners’ personal assets will be used to satisfy creditors’ claims. However, for a limited partner, the liability is limited only to the extent of his/her capital contribution to the partnership, Partners can distribute profits or losses from a business in many different ways. The profits may be divided equally or based on some other ratios for which some pertinent factors such as a partner's capital contribution, goodwill contribution, and special ability and experience in the field are taken into consideration. ‘The tax for the partnership depends on whether the partnership is a general professional partnership or ‘an ordinary partnership. An ordinary partnership is subject to a 30% tax similar to that of a corporation. According to the National Internal Revenue Code Sections 20 and 24, a general professional partnership is tax-exempt for the sole purpose of exercising the partners’ common profession. Advantages of a Partnership 1. Convenient organization. A partnership is relatively easy to organize, as it is subject to only a few government regulations. 2. Manageability. It is easy to handle because a group of people who shares common expertise is running the business. 3. Good capitalization. The combined capital resources of partners offer better capitalization és compared to that of a sole proprietorship. Disadvantages of a Partnership "1, Limited life. The withdrawal, death, or bankruptcy of a partner will result in the dissolution of a partnership. Likewise, the admission of a new partner ends a previously existing partnership: 2. Unlimited liability. Each partner is personally liable to creditors for debts incurred by other partners acting for a partnership. 3, Mutual agency. Each partner is an agent of the company and can bind the partnership through his/her acts within the scope of the partnership business. 4, Difficulty in raising capital. Although it is relatively easier fora partnership to obtain the capital requited for expanding operations, itis still difficult to raise large amounts of partnership capital because the ability to do so is limited by each partner’ personal wealth and borrowing power. Corporation Section 2 of the Revised Corporation Code of the Philippines defines a corporation as an artificial being created by operation of law that has the right of succession and the powers, attributes, and properties expressly authorized by law or incidental to its existence. A corporation is an organization owned by several people that is recognized as a separate legal entity by law. Accordingly, it can enter into contracts and can sue or be sued, Asa corporation is treated asa legal person, a corporate officer signing a loan as an agent for Scanned with CamScanner © | tonoducicnto Financial Management = L MANAGEMENT | Part S | rcs fa eecronaile ti | naa A xrportion respons fri ovn as te xen a corporation isnot king 20Y PEON AT gers. Thus, one of the main reasons for incerporatig | ind , nos thos ofthe int tect the owners’ personal assets from losses beyond the amu its own assets only, eof the ine a partnership or sole proprietor? invested in the business. ' veste jon are called shareholders or stockholders. The ownership interest in ‘The owners ofa corporation $f rable shares of stock isued or sold. ‘The shareholders of corporation is evidenced BY fae a operations of the business by electing a board of directors why craton ni mangement te boston the pnt, directly manage the ; rite will run the day-to-day operations and establishes general corporate policies. Despite th, officers who will run a ; a copor

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