Chapter 1: The Goals and Activities of Financial Management

● Finance = closely related to:

○ Economics
➔ Risk analysis, pricing theory through demand and supply relationships,
comparative return analysis
➔ Provide broad picture of economic environment
➔ Federal Reserve System, commercial banking system, interrelationships
between sectors in the economy
➔ Economic variables: GDP, industrial production, disposable income,
unemployment, inflation, interest rates
○ Accounting
➔ Language of finance (Income Statement, Balance Sheet, Cash Flows)
➔ Using and interpreting financial statements to generate best return
possible

● Finance links economic theory with the numbers of accounting

● Financial manager = addresses various issues such as decisions on plant location,
raising capital, and knowing highest return possible in different transactions/ scenarios

EVOLUTION OF FINANCE
● 20th century = finance separated from economics
● 1930s = depression (preservation of capital, maintenance of liquidity, bankruptcy,
reorganization)
● 1950s = analytical finance
○ Decision-oriented process of allocating financial capital (money) for purchase of
real capital (long-term plant and equipment)
○ Cash and inventory management, capital structure theory, dividend policy
○ Shift to inside perception financial manager making day-to-day decisions
● MODERN ISSUES IN FINANCE
○ Focus on risk-return relationships and maximization of of return for a given
level of risk
■ Professor Harry Markowitz and William Sharpe = risk-return theories and
portfolio management
■ Professor Melton Miller = capital structure theory (relative importance of
debt and equity)
■ Eugene Fama = efficient market hypothesis
○ Hedging
○ Behavioral Finance
○ Inflation became important after 1965 when the annual rate of prices began to
increase and in 1970 inflation reached double digit levels
○ Inflation and deflation on financial forecasting, required rates of returned for
capital budgeting decisions, cost of capital
 ● The rapid expansion of the Internet has allowed the creation of many new business
models and companies such as Amazon, eBay, Facebook, Netflix and more.
○ For a financial manager, e-commerce impacts financial management because it
affects the pattern and speed with which cash flows through the firm

ACTIVITIES OF FINANCIAL MANAGEMENT

● It is the responsibility of financial management to allocate funds to current and fixed
assets, to obtain the best mix of financing alternatives, and to develop an appropriate
dividend policy within the context of the firm’s objectives
● Day-to-day basis

● Daily activities of financial management:

○ Credit management
○ Inventory control
○ Receipt and disbursement of funds
● Less routine functions:
○ Sale of stocks and bonds
○ Establishment of capital budgeting
○ Dividend plans

● The appropriate risk-return trade-off must be determined to maximize the market value
of firm (operational and financing mix)
● Functions carried out while balancing the profitability and risk components of firm

FORMS OF ORGANIZATION
➔ Sole proprietorship, partnership, and corporation
➔ Factors in choosing form of organizations:
◆ Number of people
◆ Liability of owners
◆ State and federal regulations
◆ Tax Cuts and Jobs Act
● Sole proprietorship, partnership and limited liability partnerships = taxed
at owner’s individual rate (pass-through businesses)

1. SOLE PROPRIETORSHIP
● Single person ownership
● Simplicity In decision-making
● Low operational and organizational cost
● Unlimited liability to owner
○ Few lenders are willing to advance funds to a small business without
personal liability commitment
 ● Profits or losses are taxed as though they belong to individual owner

2. PARTNERSHIP
● Two or more owners
○ Raises more capital and shared responsibilities
● Articles of Partnership
○ Ownership interest, methods of distributing profits, means of withdrawing
from partnership
● Profits or losses are allocated directly to the partners and there is no double
taxation
● Unlimited liability to owners
○ Offers an advantage though of sharing possible losses

Limited Liability Partnership

● One or more partners are designated as general partners and have unlimited liability for
the dents of the firm
○ Limited partners are liable only for their initial contribution
○ Limited partners are prohibited to being active in management of firm
● Example: Limited partners that are doctors, lawyers, CPAs and a general partner who is
a real estate professional

3. CORPORATION
● Unique legal entity unto itself
○ May sue or be sued, engage in contracts, acquire property
● Articles of incorporation (rights and limitations of entity)
● Limited liability (not greater than initial investment)
● Continual life (not dependent on any one shareholder)
● Easy divisibility of ownership interest by issuing shares of stocks
○ Shareholders interested is managed by Board of Directors
○ BOD =key management personnel and outside directors
● Taxes its own income (since separate legal entity)
● Double taxation of earnings (income and dividends)

S corporation
● Income is taxed as direct income to the stockholders thus is taxed only once as normal
income like partnership
Limited liability company
● Not technically a corporation butlike corporation provides limited liability to owners

● Corporate governannce
○ Sarbanes-Oxley Act
GOALS OF FINANCIAL MANAGEMENT
● Alternative Goals for financial manager:
1. Profit maximization
➔ “Earn highest possible profit”
➔ Drawbacks to this goal:
◆ A change in profit may also represent a change in risk
◆ Fails to consider timing of benefits
◆ Suffers accurately measuring key variable which is profit

● Valuation Approach
○ The ultimate measure of performance is not what the firm earns but how the
earnings are valued by the investor
○ Shareholder wealth maximization

● Social Responsibility and Ethical Behavior

○ Basic strength of private enterprise system: adopting policy that maximize values
in the market whilst consistent on social responsibility of firm
○ Socially desirable actions such as pollution control, equitable hiring practices and
fair pricing standards at times be inconsistent with earning the highest possible
profit or achieving maximum valuation of firm
○ There is evidence however that socially responsible behavior can be profitable
○ Insider trading
■ When someone uses information that is npt available to the public to
profit from trading in a company’s publicly traded securities
■ Illegal and protected against by SEC
■ Hurts average shareholders interest (uneven playing field for investors)

ROLE OF FINANCIAL MARKETS

● Financial markets are the meeting place for people, corporations and institutions that
either need money or have money to lend or invest
● Vast global network of individuals and financial institutions (lenders, borrowers, owners)
○ Public: state, local and national government
○ Corporate financial market: Coca-Cola, Ford, Nike
● Money Markets
○ Short-term securities (one year or lower)
○ Commercial papers and certificate of deposit
● Capital Markets
○ Securities with life of more than one year
○ Intermediate markets (1-10 years) and long-term markets (more than 10 years)
○ Common and preferred stock, corporate and government bonds
● When a company uses financial markets to raise new funds, called an initial public
offering (IPO), the sale of securities is said to be in the primary market by way of new
issues.
 ○ Raising of new funds as opposed to the trading of securities already in existence
● After the securities are sold to the public, they are traded in the secondary market
between investors.
○ Market for securities that have already been issued
○ Market in which investors trade back and forth with each other
○ Price changing (due to buy and sell)
○ Given feedback about company’s performance
● Companies with expectations for high return will have higher reactive common
stock prices than companies with poor expectations.
● Since the security’s prices in the market reflect the combined judgment of all the players,
price movements provide feedback to corporate managers and let them know
whether the market thinks they are winning or losing against the competition
○ Perform well = high-priced securities, able to raise funds at a lower cost
○ Money and capital markets allocate funds to the highest-quality companies at the
lowest cost and the lowest-quality companies the highest cost

Restructuring
● Sometimes and additional penalty for poor performance is a forced restructuring by
institutional investors seeking to maximize a firm’s shareholder value
● Can result in changes in the capital structure
● Can result in the selling of low profit margin divisions with the proceeds of the sale
reinvested in better investment opportunities
● Can result in removal of current management team or large reductions in workforce
● Has included mergers and acquisitions of gigantic proportions unheard