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 concerns 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 hat we confine ourselves to for-profit businesses, the goal of financial t is tor make money and add value for the owners. This goal, however, 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. Assuming tl management is a little vague and a.more ‘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. Scanned with CamScanner4 Chapter 1 The:stated goal considers the fact that the shareholders in a firm are the residual owners. By this, we -mean that they are entitled only to what is left after : employees, supplier, creditors and anyone else with a legitimate claim are paid their due. If any of these groups, go wnpaid, the shareholders or owners get nothing. So, if the shareholders are benefiting in the sense that the residual portion is growing, it must be true that everyone else is being benefited too. Because the goal of financial management is to maximize the value of the share(s), there is 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). 7 Finally, our goal does not imply that the financial manager should take illegal or 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. _ SCOPE OF FINANCIAL MANAGEMENT Traditionally, financial management. is primarily concerned with acquisition, financing and management of assets of business coricern 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, as well as, generating returns to. the business concern. Briefly, the traditional view of Financial 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 funds through financial instruments such as equity shares, preference shares, debentures, bonds, notes, and so forth 3. Compliance. with legal and regulatory. provisions relating to_funds procurement, use and distribution as well-as coordination of the finance function with the accounting function : ; Scanned with CamScannerNatire, Purpose and Scope of Financial Management 5. 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 réforms 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 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 lias 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 responsibilities in the organization. Financial management has assumed a much greater significance and the role of the finance managers has been given a fresh perspective. i 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 * ¢. 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 Dividend decisions All these decisions aim to maximize the. shareholders’ wealth through : maximization of the firm’s wealth. Scanned with CamScanner6 Chapter 1 INVESTMENT DECISIONS The investment decisions are those which determine how scarce or limited resources in terms of funds of the business firms are committed to projects. Generally, the firm should select only those capital investment proposals whose net present value is positive and the rate of returi exceeding the marginal cost of capital. It should also consider the profitability of each individual project proposal that will contribute to the overall profitability of the firm.and lead to the creation of wealth. 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. If the 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 shouild 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, Bi Scanned with CamScanner6 Chapter 1 INVESTMENT DECISIONS The investment decisions are those which determine how scarce or limited resources in terms of funds of the business firms are committed to projects, Generally, the firm should select only those capital investment proposals whose net present value is positive and the rate of return exceeding the marginal Cost of capital. It should also consider the profitability of each individual project proposal that will contribute to the overall profitability of the firm. and lead to the creation of wealth. 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. If the 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 fetain 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, Scanned with CamScannerNature, Purpose and Scope of Financial Management _7 SIGNIFICANCE OF FINANCIAL MANAGEMENT i The importance of financial management is known for the following aspects: BROAD APPLICABILITY Any organization whether motivated with eaming 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 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 so 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 ‘orrsound 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 eam a reasonable return on his investment. The owners of business try to maximize their wealth. Financial management studies the risk-return perception of the owners and the time value «of money. It considers the amount of cash flows expected to be generated for the benefit of owners, the timing of these cash flows and the risk attached to these cash flows. The greater the time and risk associated with the expected cash flow; the greater is the rate of return required by the owners. : Scanned with CamScanner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 too 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. 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. 2 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. Scanned with CamScannerNature, Purpose and Scope of Financial Management 9 FINANCIAL MANAGEMENT AND ECONOMICS The finance manager must be familiar with the microeconomic and macroeconomic environment aspects of business. 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 niarkets. 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, foreign 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. Scanned with CamScanner10 Chapter 1 REVIEW QUESTIONS AND PROBLEMS 1. Questions 1 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? Il. Multiple Choice Questions Ly 2. What is the primary goal of financial management? a. _ Increase earnings b. Maximizing cash flow c. 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 app! off between risk and return should be determined. c. _ the firm should earn highest return possible. d. . the firm should value future profits more highly than cut profits. ropriate trade- rent Scanned with CamScannerNature, Purpose and Scope of Financial Management il 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 ¢. 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 dd. Sanging financial institutions A financial manager’s goal of maximizing current or short-term earnings 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.’ © c. _ earnings are subjective; they can be defined in various ways such as accounting or economic earnings. d. All of the given choices. Scanned with CamScannerCHAPTE) : - F FINANCIAL RELATIONSHIP O! i OBJECTIVES TO qn STRATEGY AND OBJEC I LEARNING OBJECTIVES After studying Chapter 2, you should be able to: 4. Discuss the importance of objective setting ina business enterprise. 2. Describe the primary financial objectives of a 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. Pe ate ate ote ate afe afe afo fe oho Scanned with CamScannerCHAPTER 2 RELATIONSHIP OF FINANCIAL OBJECTIVES TO ORGANIZATIONAL STRATEGY AND OTHER ORGANIZATIONAL OBJECTIVES INTRODUCTION 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 because of the firm’s many constituents who include shareholders, managers, employees, labor unions, customers, creditors, and suppliers. There are those who claim. that the firm’s goal is to maximize sales or market share; others believe the role of business is to provide quality products and service; still others feel that the firm-has a responsibility for the welfare of society at large. .For example, the objective may be stated in such broad terms as: «It isthe goal of the company to be a leader in technology in the industry. or 3 © Toachieve profits through a high level manufacturing efficiency, or © Toachieve a high degree of customer satisfaction. Scanned with CamScannerWA cag oe opie japter 2 d degree of control, a 4 an eer For the purpose though of measuring performance e objectives dre i ise terms. Th necessary to set objectives or goal in more, Liber a frame. The setting of usually in quantitative terms and are set within a shi i jod would provide the physical targets to be accomplished within a set tie pee basis of coriversion of the targets into financial objec lives. STRATEGIC FINANCIAL MANAGEMENT Strategic planning is long-range in scope and has its focus on the eee . a whole. The concept is based on an objective and comprehensive , eve the present situation of the organization and the setting up of targs a . achieved in the context of an intelligent and knowledgeable anticipation o! 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. to provide a basis and information for dustry. The firm’s strategic financial d competition, and it would The responsibility of a finance manager is strategic positioning of the firm in the in planning should ‘be able to meet the challenges an 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 of funds requirement, identification of business and financial risk, and so forth. » The strategic financial planning is likewise needed to counter the uncertain and imperfect market conditions and highly competitive business environment. While framing financial strategy, shareholders. should be considered as one of the constituents of a group of stakeholders, debenture holders, banks, financial institutions, government, managers, employees, suppliers and customers. The strategic planning should concentrate on multidimensional objectives like 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 achie ng 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 di tthe Prospective business opportunities and threats to its advantage “Therefore, : ite Scanned with CamScannerRelationship of Financial Objectives to Organizational Strategy and ..__15 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 ai 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 plarining 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 planned 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 ¢ — Maximization of return on capital employed or return on investment © Growth in earnings per share and price/earnings ratio through maximization of net income or profit and adoption of optimum level of leverage i * Minimization of finance charges © Efficient procurement and utilization of short-term, medium-term, and long-term funds Scanned with CamScanner16 “Chapter 2 LONG-TERM res through maximization of ‘ F 4 ity shat * Growth in-the market value of the equity dividend to shareholders the firm’s market share and sustained growth in © 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 hold 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’s wealth and -give ‘only secondary consideration to other stakeholders’ welfare. * Adam Smith, an 18" century economist-was one of the first and well: known proponent of this viewpoint. He argued that, in capitalism, an individual pursuing his own- interest tends also to promote. the good of his comriunity. He also pointed out that acting through competition and the free price system, only those activities most efficient and beneficial to society as a whole would’survive in. the long run. 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 stakeholders are necessarily secondary to the objective that shareholders give to their hired managers. The financial manager fnust have some goals or objectives to guide decision involving the management of the firm’s assets, liabilities and equity. Hence, priorities must be set to resolve conflicting goals, Scanned with CamScannerRelationship of Financial Objectives to Organizational Strategy and .._17~ To reiterate, the primary financial goal of the firm is to maximize the wealth of its 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 target 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 * It considers all future cash flow, dividends and earnings per share * 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 * 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 objecti narrow and ignores the concept of wealth maximization of society since society's resources 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 of the economy which should ultimately jlead to maximization of economic welfare of the society. RESPONSIBILITIES TO ACHIEVE THE FINANCIAL OBJECTIVES INVESTING The finance manager is responsible for determining how scarce resources or funds are committed to projects. The investing function deals with managing the firm’s assets. Because the firm has numerous alternative uses of funds, the financial manager strives to allocate funds wisely within the firm. This task Scanned with CamScanner18° Chapter 2 5 ix refers to the Tequires both the mix and type of assets to hold. The asset mix amount of pesos invested in current and fixed assets. sets only when they are ble return which is also whether the money de elsewhere on The investment decisions should aim at investments in as expected to earn a return greater than a minimum acceptal called as hurdle rate. This minimum return should consider raised from debt or equity nieets the returns on investments mat 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 d. Funds allocation and its rationing e. Determination of the levels of investments in working capital (i inventory, receivables, cash, marketable securities and its management) f. Determination of fixed assets to be acquired g. Asset replacement decisions h. Purchase or lease decisions i. 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. Fhe 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 tates on the firm, and so forth. Scanned with CamScannerRelationship of Financial Objectives to Organizational Strategy and..._19 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 best capital structure or mixture of debt and equity financing ©. Procurement of funds through the issuance of financial instruments such as equity shares, prefetence shares, bonds, long-term notes, and so forth d. Arrangement with bankers, suppliers, and creditors for its working capital, medium-term and other long-term funds requirement €. 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.e., 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. Sotirce 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.¢., should the firm purchase its raw materials or merchandise on credit or should it borrow in the short-term and pay cash?) Scanned with CamScanner20_Chapter 2 ENVIRONMENTAL “GREEN” POLICIES AN! FOR THE MANAGEMENT OF THE ECONOM nd cooperation and at the same the environment sufficiently? In D THEIR IMPLICATIONS Y AND FIRM ae Property rights can promote prosperity ° ‘ime protect the environment, but do they protect i recent years, people have increasingly turned to the government oat ms additional environmental improvements. Sometimes, Peuatablo for the government because property rights failed to hold polluters account At the Costs they were imposing on others. In these “external cost cases’, Boveitimen may be able to improve accountability and protect rights more efficiently, by regulation. In other instances, people with strong desires d wilderness 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 uncertaintiés that they generate. Scanned with CamScannerRelationship of Financial Objectives to Organizational Strategy and..._21 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, or 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, and can do the same with benefits from its programs. There is little reason, however, to expect a net increase in efficiency when the government steps in. ‘That is true in environmental matters, as well as in many other areas of citizen concern, 4 : 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 Kyote 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 uncertairities 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. Governmént 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“ emphasize financial results 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 de most big business establishments that they have adopted well-laid environmental-saving strategies that can observe stich as recycling programs, pollution control,’ tree-planting activities and so forth. The bénefits come a little at a time but one can be sure they will add up. If an investor wants wealth maximization, management that minimizes wastes might do the other little things right that make a company well-run and profitable. Scanned with CamScanner22 IL Chapter 2 REVIEW QUESTIONS AND PROBLEMS Questions 1. of a not-for-profit business (a Suppose you were the financial manager a, think would be not-for-profit hospital). What kinds of goals do y appropriate? Evaluate the following statement: Managers should not foes 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? 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 stockholdei’s equity”. Later in the report, the following announcements were made: a. The company contributed P1.5 million to the symphony orchestra. Scanned with CamScannerRelatioriship of Financial Objectives to Organizational Strategy and ..._ 23 b. The company is spending P500 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. 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? LL. Muttiple Choice Questions 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 financial management. 4 : d. ‘There are some serious problems with the financial goal of maximizing the earnings of the firm. Corporate social responsibility is a. _ effectively enforced through the controls envisioned by classical economics. b. 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. Scanned with CamScanner24 Chapter 2 involvement socialh 3. A common argument against corporate Inve 2 responsible behavior is that «on in decision making. a. Itencourages government intrusion In fr its con ut. b. asa legal person, a corporation is account c. It creates goodwill. osts that dina cc tive market, such behavior incurs © place the company at a disadvantage. 4, Which of the following statements is false? ede profitability in a. als can imps Because socially desirable go id not try to operate under the many instances, managers shou! assumption of wealth maximization. : As finance emerged as a new field, much emphasis was placed on mergers and acquisitions. a ; Timing is a particularly important consideration in financial decisions. During the 1930s, the government assumed a much greater role in regulating the securities industry. 5 Which of the following statements is false? a. a9 In the mid 1950s, finance began to change to a more analytical, decision oriented approach. Recently, the. emphasis of financial management has been on the relationships between risk and returns. Inflation has led to phantom profits and undervalued assets. For as long as satisfactory level of profit is.earned, the financial manager need not be concerned with unethical behavior. Scanned with CamScannerCHAPTER FUNCTIONS OF FINANCIAL MANAGEMENT LEARNING OBJECTIVES 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. Scanned with CamScannerCHAPTER 3 FUNCTIONS OF FINANCIAL MANAGEMENT ROLE OF FINANCE MANAGER : é developments, Having examined the field of finance and some of its more seat Pp let us turn our attention to the functions of the financial manager. Figure 3-1 shows the financial manager’s role in achieving the primary goal of the firm. Financial Manager Makes Decisions Involving | ¥. ¥. u = Analysis ‘Acquisition Utilization and Planning of Funds of Funds ¥ Impact on Risk and Return 7 y Affect the Market Price of Common Stock y Lead to Shareholder’s Wealth Maximization Figure 3-1. The financial manager’s role in achieving the goal of the firm Scanned with CamScannerFunctions of Financial Management _27 In striving to 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 riate dividend policy within the context of the firm’s objectives. The daily ies 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 President of Finance or some other Chief Finaricial Officer (CFO). Figure 3-2 is a simplified organizational chart that highlights the finance activity in a large firm. As shown, the Vice President of finance coordinates the activities of the treasurer and the controller. The Controller’s office handles cost and financial accounting, tax payments, and management information systems. The Treasurer’s office is responsible for managing the firm’s cash and credit, its financial planning, and its capital expenditures. Scanned with CamScanner28 Chapter 3 Board of Directors Chairman of the Board and Chief Executive Officer (CEO) President and Chief Operations Officer (COO) Vice President Marketing Vice President Finance (CFO) Vice President : Production . ‘Treasurer [ere fen seen | Cash Credit Manage Manage Capital Financial Expenditure Planning cc Oo Controller [ Tax Cost Manage Accounting Manager . [ Financial ~ Data Accounting, Processing Manager Manager Figure 3-2. A Sample of Simplified Organizational Chart RELATIONSHIP WITH OTHER KEY FUNCTIONAL MANAGERS IN THE ORGANIZATION Finance is one of the major functional areas of a busi functional areas of business operations for a manufacturing, marketing, and finance. Manufacturing 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 iness. For example, the typical manufacturing firm are Scanned with CamScanner=>. Functions of Finaricial Management _29 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 ae \ Inside the company Board of Directors Qutside the Company Stockholders > Auditors >| Managers Analysts” Bankers - Credit Agencies Se Government SEC. BIR, BSP Figure 3-3. Corporate Governance Monitors The monitors inside a public firm are the board of directors, who are appointed to represent shareholders’ interest. The board hires the CEO, evaluates management, and can also design compensation contracts to tie management's salaries to firm performance. Scanned with CamScanner30 Chapter 3 analysts, investment banks, and ‘ itors, , js The monitors outside the firm include audito ine the firm’s accounting systems credit rating agencies. External auditors on irly represent the firm’s finangjg, and comment on whether financial statements fair!y . ance, conduct thej, ce e firm’s perform: eir Position. Jnvestment analysts keep tract of the "0" ies. and report to the own evaluations of the company’s busin hich help firms access Capital investment community. Investment banks, whicl malysts examine a firm’, markets, also monitor: firm performance. Credit ar nt also monitors busines financial strength for its debt holders. The Governmel ission (SEC), Bureay oe activities: through the Securities and aia aE aiid so forth: Internal Revenue (BIR), Bangko Sentral ng Pilipinas ¢ A ; ETHICAL BEHAVIOR Ethics are of primary importance in any practice of i 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 portfolios. ‘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 Sorth. Nevertheless, as with any profession with millions of practitioners, a few are bound to act unethically. In a number of Governments all over the world have Passed laws ensure compliance with ethical codes of behavior, And appropriately, governments have set uy abuse. Ultimately, financial manager owners/shareholders the very best decisioy ns to protect and fi holder interests, but they also have a broader ob] igation to Society as ie ve and regulations meant to if professionals do not act Scanned with CamScannerFunctions of Financial Management _31 REVIEW QUESTIONS AND PROBLEMS I. Questions lL 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 charge 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 2007 alone and’$550 million over the 2003-2007 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 respective fields earn at least as much, if not a great deal more. Why should effective corporate governance be in place? Distinguish the role of an external auditor from the role of an internal auditor. Distinguish the functions of a controller from the functions of the treasurer. Scanned with CamScanner» 32 Chapter 3 Il. Multiple Choice Questions ions of the financial manager except All of the following are functi he company’s performance. a. Analyzing and planning th Meise b. Anticipating the company’s es stock €. Assigning the market price ofthe company * d. — Allocating funds to the most profitable : fl 2 Which of the following statements is false? , ne fi a. The-financing decision involves the process of allocating funds for investment in competing assets. out b. The treasurer would be responsible for. anttieesnguch as managing cash balances, : granting credit 0 cust i issuit scurities. managing the process of issuing new se cand és ¢. The optimal capital structure is the best combination of long. term debt and equity. fupsites d. 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... do nothing since she has a duty of loyalty to the organization. consult the audit committee. b. > ¢ present the matter to the next higher managerial level. d. 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)? i a. “Actively or passively . subvert the attainment of the organization’s legitimate and ethical objectives.” “Communicate unfavorable as well as favorable information.” ¢., . “Condone the commission of such acts by others within their organizations.” d. All of the answers are correct. * Scanned with CamScannerFunctions of Financial Management _33 Integrity is an ethical requirement for all financial managers. One aspect of integrity requires a. b. c. d. performance of professional duties in accordance with applicable laws. avoidance of conflict of interest. refraining from improper use of inside information. maintenance of an appropriate level of professional competence. 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, b. @ d. the immediate superior, who reports to the chief executive Officer, knows about the situation but refuses to correct it. the immediate superior assures the financial manager that the problem will be resolved, j the immediate superior reports the situation to his/her superior. the immediate superior, the firm’s chiéf executive officer, knows about the situation but refuses to correct it. Scanned with CamScannerCHAPTER FORMS OF BUSINESS ORGANIZATION. LEARNING OBJECTIVES After studying Chapter 4, you should be able to: 1. Explain the basic legal forms of business organizations such as, sole proprietorship, partnership and corporation. . _Know the advantages and disadvantages of adopting the a. Sole proprietorship b. Partnership c. Corporation i form of business organization. Determine the form of business organization most , adaptable to an enterprise. Pe oe ae he aM ae ao ae afo ofe Scanned with CamScannerCHAPTER 4 FORMS OF BUSINESS ORGANIZATION THE ORGANIZATION OF THE BUSINESS FIRM The business firm is an entity designed to organize raw miaterials, labor, and machines with the goal of producing goods and/or services, Firms 1. purchase productive resources from households and other firms, 2. transform them into a different commodity, and 3. sell the transformed Product or service to consumers For business firms engaged in retail or trading activites, transforming purchased B00ds into a different commodity does not necessarily take place. Every: society, no matter what type of economy it has, relies on business firms to organize resources and transform them into products. In market economies, most firms choose their own price, output level, and methods of production. They get the benefits of sales revenues, but they also must pay the costs of the resources they use. : Business firms can be organized in one of three ways: as a proprietorship, a partnership, or a corporation. The structure chosen determines how the owners share the risks and liabilities of the firm and how they participate in making decisions. LEGAL FORMS OF BUSINESS ORGANIZATION PROPRIETORSHIP A sole proprietorship is'a business owned by a single person who has complete control over business decisions, This individual owns all the firm’s assets and is responsible for all its liabilities. More businesses are sole proprietorship than any form of business organization. From a legal point of view, the owner of a Scanned with CamScanner36 Chapter 4 pusiness and iS personally | ne m the bus! proprietorship is not separable fro unting prospect debts of the business. From an acco! (proprietor). an entity separate from the owes rose assets statements of the business present on'y the business. . ble for al ive, however, the business is Therefore, the financiay and liabilities pertaining , Ages from the business: inated, the owner it These withdrawal, the business. S are i ther property from Sohie fs treated ag eduction of owner's eu o rani irest CF Me vcr in th i taxes. or business. The business itself does not pay ay Eee ‘cbimné tax: eetiira ae of the business is reported on the owner's person a supporting schedule. ° The owner cannot, be paid salary or wé Among the advantages of a sole proprietorship are: 1. Ease of entry and exit : A sole proprietorship requires no formal charter and is inexpensive to form and dissolve. . 2. . Full ownership and control The owner has full control, reaps all.profits and bears all losses. 3. Tax sivvings The entire income generated by the proprietorship passes directly to the owner. This may result in.a tax advantage if the owner’s tax rate is less than the tax rate of a corporation. 4, Few government regulations A sole proprietorship. has ‘the greatest freedom as compared with nay forin of business organization, : Major disadvantages of the proprietorship form include: 1.. Unlimited liability The owner is personally liable or responsible for any and all business debts. Thus, the owner's personal assets can be claimed by the creditors if the firm defaults on its obligations, Scanned with CamScannerForms of Business Organization _ 37 2. Limitations in raising capital Fund-raising ability is limited. Resources may be limited to the assets of the owner and growth may depend on his or her ability to borrow money. 3. Lack of continuity Upon death or retirement of the owner, the proprietorship ceases to exist. Therefore, the proprietorship may be an ideal form of business organization when the following conditions exist: * The anticipated risk is minimum and adequately covered by insurance. “The owner is either unable or unwilling to maintain the necessary Organizational documents and tax returns of more complicated business entities, * The business does not require extensive borrowing. PARTNERSHIP A partnership is a legal arrangement in which two or mores” d pr handled the marketing and distribution. Wi In early 2013, the sound marketing plan, the company SFO" Ot tepreneurial magazine, company was featured in a widely distri i in Best Desserts, a leading Later that, year, the company was feature red in Best Desserts, sales specialty food magazine. After the article appeal from all over the world, exploded and the company began receiving orders fro Because of the increased sales, Dee left Iris other job, Followed shorty by Lyn. The company hired additional workers to meet demand. Uni orsuately, the fast growth experienced by the company led to cash Flow and capacity problems. The company is currently producing as many cakes as possible With the assets it owns, but demand for its cakes is still growing. Further, the company has been approached by a national supermarket chain with a proposal to put four of its cakes in all of the chain’s stores, and a national restaurant chain has-connected the company about selling Super Delicious cakes without a brand name, Dee and Lyn have operated the company as a Sole proprietorship. They have approached you to help manage and direct the company’s growth. Specifically, they have asked you to answer the following questions. 1. What are the advantages and disadvantages of changing the company organization from a sole proprietorship to a limited partnership? 2. What are the advantages and disadvantages of changing the company organization from a sole proprietorship to a corporation? 3. Ultimately, what action would you undertake? Why? you recommend. the company Scanned with CamScanner