UNIT I Overview of Financial Management Chapter 1 Nature, Purpose and Scope of Financial Management Relationship of Financial Objectives to Organizational Strategy and Other Organizational Objectives Functions of Financial Management Business Organization and TrendsCHAPTER NATURE, PURPOSE AND SCOPE OF FINANCIAL MANAGEMENT Expected, Learning Outcomes After studying Chapter 1, you should be able to: ie Describe the nature, goal and basic scope of financial management. Explain briefly the three major types of decisions that the Finance Manager makes. Discuss the importance or significance of * financial management. Describe the relationship between Financial Management and Accounting. Describe the relationship between Financial Management and Economics. OooCHAPTER 1 NATURE, PURPOSE AND SCOPE OF FINANCIAL MANAGEMENT _ NATURE OF FINANCIAL MANAGEMENT Financial Management, also referred to: as managerial finance, corporate ‘finance, and business finance, is a decision making process concerned with planning, acquiring and utilizing funds in a manner that achieves the firm’s desired goals. It is also described as the process for and the analysis of making financial decisions in the business context. Financial management is part of a larger discipline called FINANCE which is a body of facts, principles; and theories relating to raising and using money by individuals, businesses, and governments. This concems both financial management of profit-oriented business organizations particularly the corporate form of business, as well as, concepts. and techniques that are applicable to individuals and to governments. THE GOAL OF FINANCIAL MANAGEMENT Assuming that we confine ourselves to for-profit businesses, the goal of financial management is to make money and add value for the owners. This goal, however, isa little vague and a more precise definition is needed in order to have an objective basis for making and evaluating financial decisions. The financial manager in a business enterprise must make decision for the owners of the firm. He must act in the owners’ or shareholders’ best interest by making decisions that increase the value of the firm or the value of the stock. The appropriate goal for the financial manager can thus be stated as follows: The goal of financial management is to. maximize the current value per share . of the existing stock or ownership in a business firm. esa goal Considers the fact that the shareholders in a firm are the residual ces Bee ‘we mean that they are entitled'only to what is left after ‘employees, ANY Of these sors and anyone else with a legitimate claim are paid their due. If - ‘ese groups go unpaid, the shareholders or Owners get nothing. So, if thesharcholders are benefiting, in the sense that the residual portion ix growing, it mug be true that everyone else is being benefited too. Because the goal of Financing management is to maximize the value of the shares), there io A need to learn how to identify investments, arrangements and distribute satisfactory amount of dividends or share in the profits that favorably impact the value of the share(s), Finally, our goal does not imply that the financial manager should take illegal of unethical actions in the hope of increasing the value of the equity in the firm, The financial manager should best serve the owners of the business: by identifying goods and services that add value to the firm because they are desired and valued in the free market place. i SCOPE OF FINANCIAL MANAGEMENT Traditionally, financial management is primarily concerned with acquisition, financing and management of assets of business concern in order to maximize the wealth of the firm for its owners. The basic responsibility of the Finance Manager is to acquire funds needed by the firm and investing those funds in profitable ventures that will maximize the firm's wealth, a5 well as, generating returns to the business concern, Briefly, the traditional view of F inancial Management looks into the following functions that a financial manager of a business firm will perform: 1. Procurement of short-term as well as long-term funds from financial institutions 2. Mobilization of fuhds through financial instruments such as equity shares, preference shares, debentures, bonds, notes, and so forth "3. Compliance with legal and Fegulatory provisions relating to funds Procurement, use and distribution as well as Coordination of the finance function with the accounting function With modern business situation increasing in complexity, the role of Finance Manager which initially is just confined to acquisition of funds, expanded to judicious and efficient use of funds available to the firm, keeping in view the objectives of the firms and expectations of the providers of funds. More recently though, with the globalization and liberalization of world economy, tremendous reforms in financial’ sector evolved in order to promote more diversified, efficient and competitive financial system in the country. The financial reforms coupled with the diffusion of information technology have brought intense\ Nature, Purpose and Scope of Financial Management _5 competition, mergers, takeovers, cost management, quality improvement, financial discipline and so forth. Globalization has caused to integrate the national economy with the global economy and has created a new financial environment which brings new opportunities and challenges to the business enterprises. This development has also led to total reformation of the finance function and its responsil in the organization. Financial management has assumed a much greater significance and the role of the finance managers has been given a fresh perspective. In view of modern approach, the Finance Manager is expected to analyze the business firm and determine the following: a. The total funds requirements of the firm b. The assets or resources to be acquired and c. The-best pattern of financing the assets TYPES OF FINANCIAL DECISIONS The three major types of decisions that the Finance Manager of a modern business firm will be involved in are: 1, Investment decisions 2. Financing decisions 3 idend decisions All these decisions aim to maximize the shareholders’ wealth through maximization of the firm’s wealth. INVESTMENT DECISIONS The investment decisions are aout in terms of funds o ‘enerally, the firm should sel those which determine how scarce or limited f the business firms are committed to projects. lect only those capital it a n ul pital investment proposals whose Present value is positive and the rate of return exceeding the marginal cost of Capital, ‘ , ee consider the Profitability of each individual project proposal ie to the overall profitability of the firm and lead to the creation6 Chapter | FINANCING DECISIONS : . Financing decisions assert that the mix of debt and equity chosen to finance investments should maximize the value of investments made. The finance decisions should consider the cost of finance available in different forms and the risks attached to it. The principle of financial leverage or trading on the equity should be considered when selecting the debt-equity mix or capital structure decision. Ifthe cost of capital of each component is reduced, the overall weighted average cost of capital and minimization of risks in financing will lead to the profitability of the organization and create wealth to the owner. DIVIDEND DECISIONS The dividend decision is concerned with the determination of quantum of profits to be distributed to the owners, the frequency of such payments and the amounts to be retained by the firm. The dividend distribution policies and retention of profits will have ultimate effect on the firm’s wealth. The business firm should retain its profits in the form of appropriations or reserves for financing its future growth and expansion schemes. If the firm, however, adopts a very conservative dividend payments policy, the firm’s share prices in the market could be adversely affected. An optimal dividend distribution policy therefore will lead to the maximization of shareholders’ wealth. To summarize, the basic objective of the investment, financing and dividend decisions is to maximize the firm’s wealth. If the firm enjoys the stability and growth, its share prices in the market will improve and will lead to capital appreciation of shareholders’ investment and ultimately maximize the shareholders’ wealth. SIGNIFICANCE OF FINANCIAL MANAGEMENT The importance of financial management is known for the following aspects: BROAD APPLICABILITY Any organization whether motivated with earning profit or not having cash flow requires to be viewed from ‘the angle of financial discipline. The principles of finance are applicable wherever there is cash flow. The concept of cash flow is one of the central elements of financial analysis, planning, control, and resource‘Nature, Purpose and Scope of Financial Management _7 allocation decisions. Cash flow is important because the financial health of the firm depends on its ability to generate sufficient amounts of cash to pay its employees, suppliers, creditors, and owners. Financial management is equally applicable to all forms of business like sole traders, partnerships, and corporations. It is.also applicable to nonprofit organizations like trust, societies, government organizations, public sectors, and forth, REDUCTION OF CHANCES OF FAILURE A firm having latest technology, sophisticated machinery, high caliber marketing, and technical experts, and so forth may still fail unless its finances are managed on sound principles of financial management. The strength of business lies in its financial discipline. Therefore, finance function is treated as primordial which enables the other functions like production, marketing, purchase, and personnel to be effective in the achievement of organizational goal and objectives. MEASUREMENT OF RETURN ON INVESTMENT Anybody who invests his money will expect to earn a reasonable return on his Mvestment. The owners of business try to maximize their wealth. Financial management studies the risk-return perception of the owners and the time value of een It considers the amount of cash flows expected to be generated for the eel Owners, the timing of these cash flows and the risk attached to these cash The greater the time and risk associated with th r 1 expected cash flow, the Sreater is the rate of return required by the owners. .8 Chapter 1 RELATIONSHIP BETWEEN FINANCIAL MANAGEMENT, ACCOUNTING AND ECONOMICS FINANCIAL MANAGEMENT AND ACCOUNTING Just as marketing and production are major functions in an enterprise, Finance tog is an independent specialized function and is well knit with other functions, Financial management is a separate management area. In many organizations, accounting and finance functions are intertwined and the finance function is often considered as part of the functions of the accountant. Financial management is however, something more than an art of accounting and bookkeeping. Accounting function discharges the function of. ‘systematic recording of transactions relating to the firm’s activities in the books of accounts and summarizing the same for Presentation in the financial statements such as the Statement of Comprehensive Income, the Statement of Financial Position, the Statement of Changes in Shareholders’ Equity and the Cash flow Statement. Financial statements help managers to make business decisions involving the best use of cash, the attainment of efficient operations, the optimal allocation of funds among assets, and the effective financin, 8 of investment and operations. The interpretation of financial statements is achieved partly by using financial ratios, pro forma and cash flow statement. . The finance manager will make use of the accounting information in the analysis and review of the firm’s business Position in decision making. In addition to the analysis of financial information available from the books of accounts and records of the firm, a finance manager uses the other methods and techniques like capital budgeting techniques, statistical and mathematical models, and computer applications in decision making to maximize the value of the firm’s wealth and value of the owner’s wealth. In view of the above, finance function is considered a distinct and Separate function rather than simply an extension of accounting function, Itshould be pointed out that Statistical in r what appears in published financial statements. Thes? cially important in developing cash flow concepts for evaluating the “a's Of different investment projects. This information permits managers to determine incremental cash flows (an approach that looks at the net returns Siven project generates in comparison with alternative investments), thus enabling them to make more accurate assessments of the profitabilities of’ specifi¢Nature, Purpose and Scope of Financial Management _9 invesiments. It is the responsibility of managers to direct their accountants to prepare internal statements that include this information so that they can make the best investment decisions possible. Financial management is the key function and many firms prefer to centralize the function to keep constant control on the finances of the firm. Any inefficiency in financial management will be concluded with a disastrous situation. But, as far as the routine matters are concerned, the finance function could be decentralized with adoption of responsibility accounting concept. It is advantageous to decentralize accounting function to speedup the processing of information. But since the accounting information is used in making financial decisions, proper controls should be exercised in processing of accurate and reliable information to the needs of the firm. The centralization. or decentralization of accounting and finance functions mainly depends on the attitude of the top level management. FINANCIAL MANAGEMENT AND ECONOMICS, Financial managers can make better decisions if they apply these basic economic Principles. For example, economic theory teaches us to seek the best allocation of resources. To this end, financial managers are given the responsibility to find the best and least expensive sources of funds and to invest these funds into the best and most efficient mix of assets. In doing so, they try to find the mix of available Fesources that will achieve the highest return at the least risk within the confines ofan expected change in the economic climate. Good financial management has a Sound grasp of the way economic and financial principles impact the profitability of the firm. Financial managers do a better job when they understand how to respond effectively to changes in supply, demand, and prices (firm-related micro factors), as well as to more general and overall economic factors (macro factors). Learning to deal with these factors provides important tools for effective financial planning. The finance manager must be familiar with the microeconomi macroeconsi omic and ic environment aspects of business. When making j isi | Making investment decisions, financial managers consider the effects of chang . we Undertanai demand, end Price conditions on the firm’s performance. S @ nature of these fa stvanagouso aes factors helps managers make the most lecisions. Also, managers should determine when it is best issue equi “* Sauity shares, bonds or other financial instruments,3 10 Chapter 1 = it depends heavily on how well managers are able tg a ee ce ea nl conditions. Supply Considerations relate specifically to the control of production costs, where the key element is to hold costs down so that prices can be set at competitive levels. The best machinery mus, be bought; and the most qualified product workers available must be hired. The goal is to squeeze out the biggest possible profit under given supply Conditions, Maintaining a low-cost operation will enable the firm to charge competitive prices for its products and maintain its market share while still obtaining a reasonable return. Knowledge of economic principles can be useful in generating the highest sales possible. Understanding and appropriately responding to changes in demand allows financial managers to take full advantage of market conditions. To accomplish this, the best managers develop and adopt reliable, workable statistical techniques that forecast demand and pinpoint when directional changes in sales take place. Microeconomics deals with the economic decisions of individuals and firms..It focuses on the optimal operating strategies based on the economic data of individuals and firms. The concept of microeconomics helps the finance manager in decisions like pricing, taxation, determination of capacity and operating levels, break-even analysis, volume-cost-profit analysis, capital structure decisions, dividend distribution decisions, profitable product-mix decisions, fixation of levels of inventory, setting the optimum cash balance, pricing of warrants and options, __ interest rate structure, present value of cash flows, and so forth, Macroeconomics looks at the economy as a whole in which a particular business Concern is operating. Macroeconomics provides insight into policies by which economic activity is controlled. The success of the business firm is influenced by the overall performance of the economy and is dependent upon the money and capital markets, since the investible funds are to be procured from the financial markets. A firm is operating within the institutional framework, which operates on the macroeconomic theories. The government’s. fiscal and monetary policies will influence the strategic financial planning of the enterprise, The finance manager should also look into the other macroeconomic factors like rate of inflation, real interest rates, level of economic activity, trade cycles,. market competition both from new entrants and substitutes, international business conditions, foreig exchange rates, bargaining power of buyers, unionization of labor, domestic Savings rate, depth of financial markets, availability of funds in capital markets, growth rate of economy, government's foreign policy, financial intermediation, banking system, and so forth,Nature, Purpose and Scope of Financial Management _11 FINANCIAL MANAGEMENT AND PUBLIC RESPONSIBILITY Finance is a very challenging and rewarding field. Financial managers are given the responsibility to plan the future growth and direction of a firm which can greatly affect the. community in which it is based. The decisions reached by a financial manager ultimately represent a blend of theoretical, technical and judgmental matters that must reflect the concerns of society. The primary goal for managers of publicly owned companies implies that decisions should be made to maximize the long-run value of the firm’s equity shares. At the same time, managers know that this does not mean maximize shareholder value “at all costs”. Managers have the obligation to behave ethically and they must follow the law and other society-imposed constraints. Financial managers have certain obligations to those who entrust them with the running of the firm. They must have a clear sense of ethics and must avoid pay offs or other forms of personal gain. Managers should not engage in practices that can damage the image of the firm but should articulate as much as possible in social activities to demonstrate that they are cognizant of the importance of the. community and those who buy their products or services. In short, financial managers must reconcile social and environmental requirements with profit-making motive. Adherence to social values may not produce the most efficient use of assets or the lowest costs, but it will enhance the image of the firm. Looking after the interest in community, setting up of training facilities, casing for the safely and the welfare of the workers, providing free college education for the dependents of the employees can produce long-term benefits in the form of higher Productivity and more harmonious relationships between labor and Management. Although there may be conflict between promoting socially responsible programs and the profit motive, maintaining some concern for social needs when pursuing the goal of maximizing the wealth of the firm is a primary responsibility of a firm.12 Chapter 1 REVIEW QUESTIONS Questions s - What environmental considerations - best results in terms of cost control and Profitability? Explain what this . What are some of the micro- . What three accounting stateme |. What are some of the nonfinancial What is the purpose of financial management? Describe the kinds of activities that financial management deals with. What is the difference in perspective between finance and accounting? Explain the shareholder wealth maximization goal of the firm and how it can be measured. Make an argument for why it is a better goal than maximizing profit. + Name and describe as many corporate stakeholders as you can. What conflicts of interest can arise between managers and stockholders? What are the three types of financial management decisions? For each type of decision, give an example’ of a business transaction that would be relevant. What goal should always motivate the action of a firm’s financial manager? : What do financial managers try to maximize, and what is their second objective? In trying to achieve optimum profits, what may a firm, ignore? . State the kinds of assurances that investors and creditors seek froma firm. Prevent the firm from achieving the means. ) and macro-economies factors that influence the decisions of a firm? nts help the manager monitor a firm's performance? What can the balance Sheet tell the firm about its assets and financial structure? aspects of the manager’s role in society, such as responsibility toward workers, treatment of monitories, and dealing with gender problems?Nature, Purpose and Scope of Financial Management _13 15. Besides maximizing the wealth of the firm, what are some of the other goals of financial management? Multiple Choice Questions 1 What is the primary goal of financial management? a. _ Increase earings b. Maximizing cash flow ¢, Maximizing shareholders’ wealth d, Minimizing risk of the firm Proper-risk return management means that a. _.the firm should take as few risks as possible. b. consistent with the objectives of the firm, an appropriate trade- off between risk and return should be determined. ¢. the firm should earn highest return possible. d. the firm’ should value future profits more highly than current profits, Which of the following is not a major area of concern and emphasis in modern financial management? a. Inflation and its effect on profits b. Stable short-term interest rates c. Changing international environment d. Increased reliance on debt - Which of the following is not a major area of concern and emphasis in modern financial management? a. Marginal analysis b. Risk-return trade-off ¢c. Commodity trading c d. Changing financial institutions A financial manager’s goal of: maximizing current or short-term - farnings may not be appropriate because a it fails to consider the timing of the benefits. b. increased earnings may be accompanied by unacceptably higher levels of risk, carnings are subjective; they can be defined in various ways such 4s accounting or economic earnings. All of the given choices. cTER : oe RELATIONSHIP OF FINANCIAL OBJECTIVES TO ORGANIZATIONAL STRATEGY _ AND OBJECTIVES Expected, Learning Outcomes After studying Chapter 2, you shouldbe able to: 1. Discuss the importance of objective setting in a business enterprise. 2. Describe the primary financial objectives ofa business firm. , 3. Explain the responsibilities of a Finance Manager to achieve the firm's financial objectives, 4. Understand the nature of environmental (“green”) policies and their implications for the management of the economy and firm. oOo4CHAPTER 2 RELATIONSHIP OF FINANCIAL OBJECTIVES TO ORGANIZATIONAL STRATEGY AND OTHER ORGANIZATIONAL OBJECTIVES INTRODUCTION ‘At one time or another, most people have had occasion to hire agents to take care of a specific matter. In doing so, responsibility is delegated to another person. For example, when suing for damages, individuals may represent themselves or may hire a lawyer to plead their case in court. As an agent, the lawyer is given the assignment to get the highest possible award. And so, it is with shareholders when they delegate the task of running a firm to a financial manager who acts as an agent of the company. Obviously, the goal is to achieve the highest value of an equity share for the firm’s owners. But there are no standard rules that indicate which course of action should be followed by managers to achieve this. The ultimate guideline is how investors perceive the actions of managers. A good way to motivate managers is to offer them lucrative share options linked to performance. Finance permeates the entire business organization by providing guidance for the firm’s strategic (long-term) and day-to-day decisions. For long range planning and management control, a business firm establishes its overall objectives. Such objectives are developed by the top management and they usually consist of _ general statement or a series of statements in general terms stating what the company expects to achieve. Objective setting is thus, an important phase in the business enterprise since upon Correct objectives setting will the entire structure of the strategies, policies and plans of a company rest. Firms have numerous goals but not every goal can be attained without causing conflict in reaching other goals. Conflicts often arise Epi of es firm’s many constituents who include shareholders, managers, plain nce oe Po unions, customers, creditors, and suppliers. There are those who role of bus irm’s Boal is to maximize sales or-market share; others believe the Ness is to provide quality products and service; still others feel that the__ ~~ 16 Chapter 2 responsibility for the welfare of society at large. For example, the Pe a pe stated in such broad terms as: It is the goal of the company to be a leader in technology in the industry, or . * Toachieve profits through a high-level manufacturing efficiency, or e Toachieve a high degree of customer satisfaction. . For the purpose though of measuring performance and degree of control, it is necessary to set objectives or goal in more precise terms. The objectives are usually in quantitative terms and are set within a time frame. The setting of physical targets to be accomplished within a set time period would provide the basis of conversion of the targets into financial objectives. STRATEGIC FINANCIAL MANAGEMENT Strategic planning is long-range in scope and has its focus on the organization as a whole. The concept is based on an objective and comprehensive assessment of the present situation of the organization and the setting up of targets to be achieved in the context of an intelligent and knowledgeable anticipation of changes in the environment. The strategic financial planning involves financial planning, financial forecasting, provision of finance and formulation of finance policies which should lead the firm’s survival and success. + The responsibility of a finance manager is to provide a basis and information for strategic positioning of the firm in the industry. The firm’s strategic financial planning should be able to meet the challenges and competition, and it would lead to firm’s failure or success. The strategic financial planning should enable the firm to judicious allocation of funds, capitalization of relative strengths, mitigation of weaknesses, early identification of shifts in environment, counter possible actions of competitor, reduction in financing costs, effective use of funds deployed, timely estimation © funds requirement, identification of business and financial risk, and so forth. The strategic financial planning is likewise needed to counter the uncertain ee imperfect market conditions and highly competitive business environment. framing financial strategy, shareholdefs should be considered as ee eral constituents of a group of stakeholders, debenture holders, banks, fin Sh institutions, government, managers, employees, suppliers and customer’ ike Strategic planning should concentrate on multidimensional objectiv®Relationship of Financial Objectives to Organizational Strategy and... _17 profitability, expansion growth, survival, leadership, business success, positioning of the firm, reaching global markets and brand positioning. The financial policy requires the deployment of firm’s resources for achieving the corporate strategic objectives. The financial policy should align with the company’s strategic planning. It allows the firm in overcoming its weaknesses, enables the firm to maximize the utilization of its competencies and to direct the prospective business opportunities and threats to its advantage. Therefore, the finance manager should take the investment and finance decisions in consonance with the corporate strategy. A company’s strategic or business plan reflects how it plans to achieve its goals and objectives. A plan’s success depends on an effective analysis of market demand and supply. Specifically, a company must assess demand for its products and services, and assess the supply of its inputs (both labor and capital). The plan must also include competitive analyses, opportunity assessments and consideration of business threats. : Historical financial statements provide insight into the success of a company’s strategic plan and are an important input of the planning process. These statements highlight portions of the strategic plan that proved profitable and, thus, warrant additional capital investment. They also reveal areas that are less effective and provide information to help managers develop remedial action. Once strategic adjustments are plannéd and implemented, the resulting financial statements provide input into the planning process for the following year, and this process begins again. Understanding a company’s strategic plan helps focus our analysis of the company’s short-term and long-term financial objectives by placing them in proper context. SHORT-TERM AND LONG-TERM FINANCIAL OBJECTIVES OF A BUSINESS ORGANIZATION Among are the primary financial objectives of a firm are the following: SHORT AND MEDIUM-TERM ° seinen of return on capital employed or return on investment eae in earnings per share and price/earnings ratio through Suzation of net income or profit and adoption of optimum level of Minimization of. finance charges~e7~-”™-—Cehfse 18 Chapter 2 e Efficient procurement and utilization of short-term, medium-term, and long-term funds LONG-TERM quity shares through maximization of wth in thi ‘ket value of the e cera d growth in dividend to shareholders the firm’s market share and sustaine Survival and sustained growth of the firm There have been a number of different, well-developed viewpoints concerning what the primary financial ‘objectives of the business firm should be. The competing viewpoints are: © The owner’s perspective which holds that the only appropriate goal is to maximize shareholder or owner's wealth, and; © The stakeholders’ perspective which emphasizes social responsibility over profitability (stakeholders include not only the owners and shareholders, but also include the business's customers, employees and local commitments). While strong arguments speak in favor of both perspectives, financial practitioners and academics now tend to believe that the manager’s primary responsibility should be to maximize shareholder’ wealth and give only secondary consideration to other stakeholders’ welfare. Adam Smith, an 18" century economist was one of the first and well known propofient of this viewpoint. He argued that, in capitalism, an individual pursuing his own interest tends also to promote the good of his community. He also pointed out that acting through competition and the free price system, only thosé activities most efficient and beneficial to society as a whole would survive in the long fu". Thus, those same activities would also profit the individual most. Owners of the firm hire managers to work on their behalf, so the manager is morally, ethically. and legally required to act in the owners’ best interests. Any relationships between the manager and other firm stakehold i t lers are necessarily s jective that shareholders give to their hired managers, Seay asccarosne 8 eerie manager must fave some goals or objectives to guide decision Pet ‘ment of the firm’s assets, liabiliti i jence Priorities must be set to resolve conflicting goals. liabilities and equity. H? Relationship of Financial Objectives to Urgantzationat strategy anc .. 19 To reiterate, the primary financial goal of the firm is to maximize the wealth ofits existing shareholders or owners. Therefore, the overriding premise of financial management is that the firm should be managed to enhance owner(s) well-being. Shareholder’s wealth depends on both the dividends paid and the market price of the equity shares. Wealth is maximized by providing the shareholders with the attainable combination of dividends per share and share price appreciation. While this may not be a perfect measure of shareholders’ wealth, it is considered one of the best available measures. The wealth maximization goal is advocated on the following grounds: « Itconsiders the risk and time value of money * Itconsiders all future cash flow, dividends and earnings per share e It suggests the regular and consistent dividend payments to the shareholders © The financial decisions are taken with a view to improve the capital appreciation of the share price ‘e Maximization of firm’s value is reflected in the market price of share since it depends on shareholder’s expectations regarding profitability, long-run prospects, timing difference of returns, risk distribution of returns of the firm : . Critics of the wealth maximization objective however say that, this objective is narrow and ignores the concept of wealth maximization of society since society’s Tesources are used to the advantage only of a particular firm. The optimal allocation of the society’s resources should result in capital formation. and growth ofthe economy which should ultimately lead to maximization of economic welfare of the society. : RESPONSIBILITIES TO ACHIEVE THE FINANCIAL OBJECTIVES INvestinc The F , soe manager is responsible for determining how scarce resources or funds assets. Besant eae The investing function deals with managing the firm’s ager strives pen has numerous alternative uses of funds, the financial & '0 allocate funds wisely within the firm. This task requires both ae mix and invested j type of assets to hold, The asset mix refers to the amount of pesos ' current and fixed assets.20 Chapter 2 ‘The investment decisions should aim at investments in assets only when they are expected to earn a return greater than a minimum acceptable return which is also called as hurdle rate. This minimum return should consider whether the money raised from debt or equity meets the returns on investments made elsewhere on similar investments. The following areas are examples of investing decisions of a finance manager: a. Evaluation and selection of capital investment proposal b. Determination of the total amount of funds that a firm can commit for investment c. Prioritization of investment alternatives = Funds allocation and its rationing Determination of the levels of investments in working, capital (ie. inventory, receivables, cash, marketable securities and its management) Determination of fixed assets to be acquired Asset replacement decisions e. Purchase or lease decisions Restructuring reorganization mergers and acquisition j. Securities analysis and portfolio management FINANCING The finance manager is concerned with the ways in which the firm obtains and manages the financing it needs to support its investments. The financing objective asserts that the mix of debt and equity chosen to finance investments should maximize the value of investments made. Financing decisions call for good knowledge of costs of raising funds, procedures in hedging risk, different financial instruments and obligation attached to them. In fund raising decisions, the finance manager should keep in view how and where to raise the money, determination of the debt-equity mix, impact of interest, and inflation rates on the firm, and so forth. The finance manager will be involved in the following finance decisions: a. Determination of the financing pattern of short-term, medium-term and long-term funds requirements b. Determination of the Get best capital structure or mixture of debt and equityRelationship of Financial Objectives to Organizational Strategy and... _24 ¢. Procurement of funds through the issuance of financial instruments such as equity shares, preference shares, bonds, long-term notes, and so forth ‘Q._ Arrangement with bankers, suppliers, and creditors for its working capital, medium-term and other long-term funds requirement e. Evaluation of alternative sources of funds OPERATING This third responsibility area of the finance manager concerns working capital management. The term. working capital refers to a firm short-term asset (i.¢., inventory, receivables, cash, and short-term investments) and its ‘short-term liabilities (i.e., accounts payable, short-term loans). Managing the firm’s working capital is a day-to-day responsibility that ensures that the firm ‘has sufficient resources to continue its operations and avoid costly interruptions. This also involves a number of activities related to the firm’s receipts and disbursements of cash. Some issues that may have to be resolved in relation to managing a firm’s working capital are: a. The level of cash, securities and inventory that should be kept on hand b.. The credit policy (i.e., should the firm sell on credit? If so, what terms should be extended?) c. Source of short-term financing (i.e., if the firm would borrow in the short- term, how and where should it borrow?) d. Financing purchases of goods (i.e., should the firm purchase its raw materials or merchandise on credit or should it borrow in the short-term and pay cash?) FS ONMENTAL “GREEN” POLICIES AND THEIR IMPLICATIONS MANAGEMENT OF THE ECONOMY AND FIRM we moray rights can promote prosperity and cooperation and at the same recent years Ie So onmiet but do they protect the environment sufficiently? In Additional ery eee le have increasingly turned to the government to achieve use prope nmental Improvements. Sometimes, people turned to government imposing on es failed tohold polluters accountable for the costs they were Tove accounta ti In these external cost cases”, government may be able to lity and protect rights more efficiently by regulation. In other22_Chapter 2 instances, people with strong desires for various environmental amenities (for example, green spaces, hiking trails and wilderness lands) want the government to force others to help pay for them. Courts help owners protect their property against invasions by others, including polluters. In some cases however, it is difficult — if not impossible — to define, establish and fully protect property rights. This is particularly true when there is either a large number of polluters or a large number of people harmed by the emissions, or both. In these large numbers of cases, high transaction costs undermine the effectiveness of the property rights - market exchange approach. For example, consider the air quality in a large city such as Manila or Quezon City. Millions of people are harmed when pollutants are put into the air. But millions of people also contribute to the pollution as they drive their cars. Property rights alone will be unable to handle large-number cases like this efficiently. More direct regulations may generate a better outcome. Although government regulation is an alternative method of protecting the environment, the regulatory approach also has a number of deficiencies. First, government regulation is often sought precisely because the harms are uncertain and the source of the problem cannot be demonstrated, so relief from the courts is difficult to obtain. But when the harms are uncertain, so are the benefits of reducing them. Second, by its very nature, regulation overrides or ignores the information and incentives provided by market signals. Accountability of regulators for the costs they impose is lacking, just as accountability for polluters is missing in the market sector when secure and tradable property rights are not in place. The tunnel vision of regulators, each assigned to oversee a small part of the economy, is not properly constrained by readily observable costs. Third, regulation allows special interests to use political power to achieve objectives that may be quite different from the environmental goals originally announced. The global warming issue illustrates all of these problems and the uncertainties that they generate. People turn to government to get what they cannot get in markets. In many cases, they are seeking to get what they want with a subsidy from others. Government can provide protection from harms, as in regulation that reduces pollution, oF production of goods and services, as in the provision of national parks. Government can indeed shift the cost of services from some citizens to others, al can do the same with benefits from its Programs. There is little reason, however» to expect a ne‘ increase in efficiency when the government steps in. That is true in environmental matters, as well as in many other areas of citizen concern.1 Relationship of Financial Objectives to Organizational Strategy and ... 23 When it is difficult to assign and enforce private property rights, markets often result in outcomes that are inefficient. This is often the case when large numbers of people engage in actions that impose harm on others. Government regulation has some premise but also poses some problems of its own. Global warming could exert a sizeable adverse impact on human welfare, but there is considerable uncertainty about both its cause and the potential gains that might be derived from regulations such as those of the Kyoto treaty. Global temperature changes have been observed previously. We do not know that the current warming is the result of human activity. We do not even know whether on balance, a warming would exert an adverse impact. These uncertainties increase the attractiveness of adaptation as an option to regulation. Market-like schemes can reduce the costs of reaching a chosen environment goal, but the programs provide little help in choosing the right goal. Government ownership of national parks, as with other lands, has brought troublesome results along with benefits, but there seems to be progress in moving, closer to market solutions that provide better information and incentives for government managers. Given that stock market investors emj phasize financial .Tesults and the maximization of shareholder value, ‘one can wonder if it makes sense for a company to be socially responsible. Can companies be socially responsible and oriented toward shareholder wealth at the same time? Many businessmen think so and so do most big business establishments that they have adopted well-laid environmental-saving strategies that can observe such as recycling programs, eer control, tree-planting, activities and so forth. The benefits come a little at a) but one can be sure they will add up. If an investor wants wealth ‘Maximization, mi ‘anagement that minimizes wastes might do the other little thin; Tight that make a company well-run and profitable. z24 Chapter 2 REVIEW QUESTIONS Questions ie Suppose you were the financial manager of a not-for-profit business (a not-for-profit hospital). What kinds of goals do you think would be appropriate? What kinds of conflicts confront the financial managers as an agent of the firm? How can a firm attract the best managers? Does knowledge of financial theory and statistical approaches give a manager all the answers in solving financial problems? Explain. Evaluate the following statement: Managers should not focus on the current stock value because doing so will lead to an overemphasis on short-term profits at the expense of long-term profits. If a company’s board of directors wants management to maximize shareholders’ wealth, should the CEO’s compensation be set as a fixed amount, or should the compensation depend on how well the firm performs? If it is to be based on performance, how should performance be measured? Would it be easier to measure performance by the growth rate in reported profits or the growth rate in the stock’s intrinsic value? Which would be the better performance measure? Why? Should stockholder wealth maximization be thought of as a long-term or short-term goal? For example, if one action increases a firm’s stock price from a current level of P1,000 to P2,000 in 6 months and then to P3,000 in 5 years but another action keeps the stock at P1000 for several years but then increases it to P4,000 in 5 years, which action would be better? Think of some specific corporate actions that have these general tendencies. What are some actions that stockholders can take to ensure that management’s and stockholders’ interests are aligned?Relationship of Financial Objectives to Organizational Strategy and 2s 8, The president of Southern Tagalog Corporation (STC) made this statement in the company’s annual report: “STC’s primary goal is to increase the value of our common stockholder’s equity”. Later in the report, the following announcements were made: a, The company contributed P1.5 million to the symphony orchestra. b. The company is spending PS00 million to open a new plant and expand operations. No profits will be produced by the operation for 4 years, so earnings will be depressed during this period versus what they would have been had the decision been made not to expand. c. The company holds about half of its assets in the form of government treasury bonds, and it keeps these funds available for use in emergencies. In the future, though, STC plans to shift its emergency funds from treasury bonds to common stocks. Discuss how STC’s stockholders might view each of these actions and how the actions might affect the stock price. 9. Miguel Enterprises recently made a large investment to upgrade its technology. While these improvements won’t have much effect on performance in the short run, they are expected to reduce future costs significantly. What effect will this investment have on Miguel Enterprises’ earnings per share this year? What effect might this investment have on the company’s intrinsic value and stock price? Multiple Choice Questions 1. Which of the following statements is true? a. The higher the profit of a firm, the higher the value of the firm is assured of receiving in the market. b. Social responsibility and profit maximization are synonymous. ©. Maximizing the earnings of the firm is, the primary goal of 4g, fiancial management. There are some serious problems with the financial goal of maximizing the earnings of the firm,26 Chapter 2 : ial responsibility is . a CE ee through the controls envisioneg by Classic db. the ‘obligation to shareholders to earn a profit. c. the duty to embrace service to the Public interest. d. _ the obligation to serve long-term organizational Interests, 33 A common argument against corporate involvement in Socially responsible behavior is that ; .. a, It encourages government intrusion in decision making. b. asa legal person, a corporation is accountable for its Conduct, c. It creates goodwill. d. in acompetitive market, such behavior incurs Costs that place the company at a disadvantage. 4. Which of the following statements is false? a. Because socially desirable goals can impede Profitability in many instances, managers should not try to operate “under the assumption of wealth maximization. b. As finance emerged as a new field, much emphasis was placed on mergers and acquisitions, ©. Timing is a Particularly important consideration in financial decisions, ‘ d. During the 1930s, the Bovernment assumed a much greater role in regulating the securities industry. 5." Which of the following Statements is false? ‘cal 2D the mid 1950s, finance began to change to a more analytical, ‘cision oriented approach, the b Recently, the emphasis of financial management has been 0” F Ieeeosties between risk and returns, on a. Shon has led to phantom Profits and undervalued ass : ani or as long as Satisfactory level of profit is earned, the fin manager need not be Concerned with unethical behavior-CHAPTER FUNCTIONS OF FINANCIAL MANAGEMENT Expected Learning Outcomes After studying Chapter 3, you should be able to: 1. Describe the role of Finance Manager in achieving the primary goal of the firm. 2. Understand how finance fits in the organizational structure of the firm. 3. Enumerate the fundamental activities of the Treasurer and the Controller. 4, Explain how the finance function relates to the other functional areas of a business, 5. Learn the importance of corporate governance in achieving the goals of a business organization. 6. Appreciate the importance of ethics in finance. O04CHAPTER 3 FUNCTIONS OF FINANCIAL MANAGEMpy, | ROLE OF FINANCE MANAGER ing examined the field of finance and some of its More recent develo, fi sci our attention to the functions of the financial manager, Prien, Figure 3-1 shows the financial manager’s role in achieving the Primary 80a of th firm. Financial Manager Makes Decisions Involving Acquisition of Funds Impact on Risk and Return Affect the Market Price of Common Stock Lead to Shareholder’s ‘ealth MaximizationFunctions of Financial Management _29 In striving i maximize owners’ or shareholders’ wealth, the financial manager makes decisions involving planning, acquiring, and utilizing funds which involve a set of risk-return trade-offs, These financial decisions affect the market value of the firm’s stock which leads to wealth maximization. In the short run, many factors affect the market price of a firm’s shares which are beyond management’s control. Some of the changes in market price do not reflect a fundamental change in the value of the firm. In the long run, increased prices of the firm’s stock reflect an increase in the value of the firm: Hence, financial decision making should take a longer-term perspective. 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. The daily activities of financial management include credit management, inventory control, and the receipt and disbursement of funds. Less routine functions encompass the sale of stocks and. bonds and the establishment of capital budgeting and dividend plans. . The appropriate risk-return trade-off must be determined to maximize the market value of the firm for its shareholders. The risk-return decision will influence not only the operational side of the business (capital versus labor) but also the financing mix (stocks versus bonds versus retained earnings). THE FINANCE ORGANIZATION ° . The financial management function is usually associated with a top officer of the firm such as a Vice President of Finance or some other Chief Financial Officer (CFO). Figure 3-2 is a simplified organizational chart that highlights the finance raed ina large firm. As shown, the Vice President of finance coordinates the aes of the treasurer and the controller. The Controller’s office handles cost The ee accounting, tax payments, and management information systems. oe pa S office is responsible for managing the firm’s cash and credit, its ‘al planning, and its capital expenditures.30 Chapter3 Board of Directors Chairman of the Board and Chief Executive Officer (CEO) President and Chief Operations Officer (COO) Vice President Finance (CFO) Vice President Production Cost Accounting Manager Tax Manager Data Processing Manager Financial Accounting ManagerFunctions of Financial Management 31 ELATIONSHIP WITH OTHER KEY FUNCTIONAL MANA\ ee ORGANIZATION NAGERS IN Finance is one of the major functional areas of a business. For example, the functional areas of business operations for a typical manufacturing firm are manufacturing, marketing, and finance, Manuf icturing deals with the design and production of a product. Marketing involves the selling, promotion, and distribution of a product. Manufacturing and marketing are critical for the survival of a firm because these areas determine what will be produced and how these products will be sold. However, these other functional areas could not operate without funds. Since finance is concerned with all of the monetary aspects of a business, the financial manager must interact with other managers to ascertain the goals that must be met, when and how to meet them. Thus, finance is an integral part of total management and cuts across functional boundaries. CORPORATE GOVERNANCE Corporate governance is the process of monitoring managers and aligning their incentives with shareholders goals. In reality, because shareholders are usually inactive, the firm actually seems to belong to management. Generally speaking, the investing public does not know what goes on at the firm’s operational level. Managers handle day-to-day operations, and they know that their work is mostly unknown to investors. This lack of ‘supervision demonstrates the need for monitors. Figure 3-3 shows the people and organizations that help monitor corporate activities, Monitors at Inside the company Board of Directors Qutside the Company Stockholders |< > Auditors ~<____ | Managers Analysts Bankers Credit Agencies > Government SEC, BIR. BSP Figure 3-3. Corporate Governance MonitorsChapter 3 - / es aa lic firm are the board of directors, who are ppointeg The monitors inside @ Laeese The board hires the CEO, evaluates Manageme, i F ; . represent See earn contracts to tie management’ salaries tg firm and can also performance. i i nalysts, investment banks, i ide the firm include auditors, al i y , and be eee External auditors examine the firm’s accounting systems Seamed on whether financial statements fairly represent the firm’s financial 3 ition. Investment analysts. keep tract of the firm 's performance, Conduct their ia evaluations of the company’s business activities, and report to the investment community. Investment banks, which help firms access capital _Markets, also monitor firm performance. Credit analysts examine a firm’s financial Strength for its debt holders. The Government also monitors business activities through the Securities and Exchange Commission (SEC), Bureau of Internal Revenue (BIR), Bangko Sentral ng Pilipinas (BSP), and so forth. to JOBS IN FINANCE Finance prepares students for jobs in banki ng, investments, insurance, corporations and the government. Accounting students need to know finance, marketing, management and human resources; they-also need to understand finance, for it affects decisions in all those areas. For example, marketing people propose advertising programs, but those Programs are examined by finance people to judge the effects of the advertising on the firm’s Profitability. So to be effective in marketing, one needs to have a basic knowledge of finance. The same holds for management — indeed, most important Management decisions are evaluated in terms of their effects on the firm’s value. It is also worth noting that finance is im je ortant to indivi of their Jobs. Some years ago, most businesses Pr ‘0 individuals regardless ; : t Provided pensions to their employees, S° managing one’s personal investments was not critically important. That’s 1° en firms today Provide what’s called “defined contribution” into an account that bel gach year the company puts a specified amount of money funds are to be inves rea ofthe employee, The employee must decide how those Money funds and h wrist much should be divided among stocks, bonds . Ow risky the equity shares and bonds should be. These decisions id effect on people’s |; js a Improve decision-making sae lives, and the Concepts covered in this book ¢wa Functions of Financial Management _33 ETHICAL BEHAVIOR Bihics are of primary importance in any practice of finance. Finance professionals commonly manage other people’s money. For instance, corporate managers control the stockholders’ firm, bank employees perform cash receipts and disbursements functions and investment advisors manage people’s investment rtfolios. ‘These fiduciary relationships oftentimes create tempting opportunities for finance professionals to make decisions that either benefit the client or benefit the advisors themselves. Strong emphasis on ethical behavior and ethics training and standards are provided by professional associations such as the Finance Executives of the Philippines (FINEX), Bankers Association of the Philippines, Investment Professionals, and so forth. Nevertheless, as with any profession with millions of practitioners, a few are bound to act unethically. In a number of instances, the corporate governance system has created ethical dilemmas and has failed to prevent unethical managers from stealing from firms which ultimately means stealing from owners or stockholders. Governments all over the world have passed laws and regulations meant to ensure, compliance with ethical codes of behavior..And if professionals do not act appropriately, governments have set up strong punishment for financial fraud and abuse. Ultimately, financial manager must realize that they owe the owners/shareholders the very best decisions to protect and further shareholder interests, but they also have a broader obligation to society as a whole.aM Chapter 3 REVIEW QUESTIONS Questions In a large corporation, what are the two distinct groups that report to the chief financial officer? Which group is the focus of corporate finance? Can our goal of maximizing the value of the equity shares conflict with other goals, such as avoiding unethical or illegal behavior? In Particular, do you think subjects like customer and employee safety, environment and general good of society fit in this framework, or are they essentially ignored? Think of some specific scenarios to illustrate your answer, Would our goal of maximizing the value of the equity shares be different if we were thinking about financial management in a foreign country? Why or why not? Critics have charged that compensation to top managers in the United States is simply too high and should be cut back. For example, focusing on large corporations, Ray Irani of Occidental Petroleum has been one of the best-compensated CEOs in the United States, earning about $54.4 million in 20X7 alone and $550 million over the 20X3-20X7 period. Are such amounts excessive? In answering, it might be helpful to recognize that superstar athletes such as Roger Federer, top entertainers such as Justin Bieber and Manny Pacquiao and many others at the top of their Fespective fields earn at least as much, if not a great deal more. Give your opinion on this practice, Why should effective Corporate governance be in place? Distinguish the role of an external auditor from the role of an internal auditor, Distinguish 1 he functions of a controller from the functions of the treasurer,— Functions of Financial Management _35 tiple choice Questions i All of the following are functions of the financial manager except a. b. a d. Analyzing and planning the company’s performance. Anticipating the company’s financial needs. Assigning the market price of the company’s stock Allocating funds to the most profitable asset. Which of the following statements is false? a. b. The financing decision involves the process of allocating funds for investment in competing assets. The treasurer would be responsible for activities such as managing cash balances, granting credit to customers and managing the process of issuing new securities. The optimal capital structure is the best combination of long-term debt and equity. It is necessary to determine the appropriate risk-return trade-off to maximize the market value of the firm for its shareholders. Regine is a financial manager who has discovered that her company is violating environmental regulations. If her immediate superior is involved, her appropriate action is to a. b. ic d, do nothing since she has a duty of loyalty to the organization. consult the audit committee. present the matter to the next higher managerial level. confront her immediate superior. If .a financial manager discovers unethical conduct in “his/her organization and fails to act, he/she will be in violation of which ethical: standard(s)? a. “Actively or passively subvert the attainment of the organization’s legitimate and ethical objectives.” b. “Communicate unfavorable as well as favorable information.” ° “Condone the commission of such acts by others within their A Organizations,” All of the answers are correct._ Chapter 3 os Integrity is an ethical requirement for all financial managers. One aspect of integrit juires a. supe eis on professional duties in accordance with applicable laws. 5 b. avoidance of conflict of interest. c. refraining from improper use of inside information. d. maintenance of an appropriate level of professional competence. 6. A financial manager discovers a problem that could mislead users of the firm’s financial data and has informed his/her immediate superior. He/she should report the circumstances to the audit committee and/or the board of directors only if a. the immediate superior, who reports to the chief executive . Officer, knows about the situation but refuses to correct it. b. the immediate superior assures the financial manager that the problem will be resolved. c. the immediate superior reports the situation to his/her superior. d. — the immediate superior, the firm’s chief executive officer, knows about the situation but refuses to correct it. :