Chapter 1

THE FINANCIAL MANAGEMENT

FUNCTION AND ENVIRONMENT- THE
OVERVIEW

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Learning Objectives (1 of 2)
1. Understand the importance of finance in your
personal and professional lives and identify the
three primary business decisions that financial
managers make.
2. Identify the key differences among the three
major legal forms of business.

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Learning Objectives (2 of 2)

3. Understand the role of the financial manager

within the firm and the goal for making financial
choices.
4. Explain the five principles of finance that form
the basis of financial management for both
businesses and individuals.

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1.1 FINANCE: AN OVERVIEW

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What is Finance?
Finance is the study of how people and businesses
evaluate investments and raise capital to fund them.

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Three Basic Questions Addressed by the
Study of Finance:
1. What long-term investments should the firm
undertake? (capital budgeting decision)
2. How should the firm raise money to fund these
investments? (capital structure decision)
3. How can the firm best manage its cash flows as
they arise in its day-to-day operations? (working
capital management)

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1.2 THREE TYPES OF BUSINESS ORGANIZATIONS

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Business Organizational Forms

Business
Forms

Sole
Partnerships
Proprietorships Corporations

General Limited

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Sole Proprietorship—Meaning
• It is a business owned by a single individual who
is entitled to all of the firm’s profits and is also
responsible for all of the firm’s debt.
• The sole proprietors typically raise money by
investing their own funds and by borrowing from a
bank.

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Sole Proprietorship—Advantages

• Advantages:
– Easy to form
– No need to consult others while making decisions
– Profits are taxed at the owner’s tax rate

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Sole Proprietorship—Disadvantages

• Disadvantages:
– Personally liable for the business debts
– The business ceases on the death of the proprietor
– Limited access to external sources of financing

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Partnership—Meaning
A general partnership is an association of two or
more persons who come together as co-owners for
the purpose of operating a business for profit.

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Partnership—Advantages & Disadvantages

• Advantages:
– Relatively easy to start
– Taxed at the personal tax rate
– Access to funds from multiple partners

• Disadvantages:
– Partners jointly share unlimited liability
– It is not always easy to transfer ownership

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Limited Partnerships
• In limited partnerships, there are two classes of
partners: general and limited.

• The general partner runs the business and faces

unlimited liability for the firm’s debts, whereas the
limited partner is liable only up to the amount the
limited partner invested. The life of the partnership
is tied to the life of the general partner.

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Corporation
• If very large sums of money are needed to build a
business, then the typical organizational form chosen
is the corporation. Corporation legally functions
separately and apart from its owners (the
shareholders). Corporation can individually sue and
be sued and can purchase, sell, or own property.
• The corporation is legally owned by its current set of
stockholders, or owners. The Board of directors are
elected by the shareholder, and the board appoints
the senior management of the firm.

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Corporation—Advantages
• Advantages
– Liability of owners is limited to invested funds
– Life of corporation is not tied to the status of the
investors
– Easier to raise Capital

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Corporation—Disadvantages
• Disadvantages
– Greater regulation
– Double taxation of dividends

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Not-for-Profit Organization
• Created with specific objectives of promoting a
social cause

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Not-for-Profit Organization – Advantages
• Either exempt from taxes or pay lower taxes than
corporations
• Surplus from operations possible but not primary
criterion

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Not-for-Profit Organization –
Disadvantages
• Required to manage risk and evaluate projects
nevertheless

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Co-operative
• Owned and governed by its members, usually
also its buyers

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Co-operative – Advantages
• Favorable regulations in many countries to
promote them

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Co-operative – Disadvantages
• Cannot issue shares to external investors
• Require special financing methods to raise capital

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Figure 1.1 How the Finance Area Fits into a Corporation

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1.3 THE GOAL OF THE FINANCIAL MANAGER

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The Goal of the Financial Manager
• The goal of the financial manager must be
consistent with the mission of the corporation,
which is to maximize shareholder’s wealth.
• While shareholder wealth maximization is included
in Coca-Cola’s vision statement, it also includes
other broader goals (such as social responsibility)
that will ultimately benefit shareholders in the
long-run.

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Coca-Cola’s Vision Statement
To achieve sustainable growth, we have established a vision
with clear goals for:
– Profit
– People
– Portfolio
– Partners
– Planet

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Corporate Mission
• While managers have to cater to all the
stakeholders (such as consumers, employees,
suppliers etc.), they need to pay particular
attention to the shareholders.
• If managers fail to pursue shareholder wealth
maximization, they will lose the support of
investors and lenders. The business may cease to
exist and ultimately, the managers will lose their
jobs!

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The Sarbanes—Oxley Act (SOX)
• SOX Act was passed in 2002 “to protect investors
by improving the accuracy and reliability of
corporate disclosures made pursuant to the
securities laws, and for other purposes”.
• SOX Act mandates senior executives to take
individual responsibility for the accuracy and
completeness of the firm’s financial reports.

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1.4 THE FIVE BASIC PRINCIPLES OF FINANCE

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Principle 1: Money Has a Time Value
• A dollar received today is worth more valuable
than a dollar received in the future.
• We can invest the dollar received today to earn
interest. Thus, in the future, we will have more
than one dollar, as we will have earned interest on
the investment.

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Principle 2: There is a Risk—Return
Trade—off
• Investors tend to be risk-averse and prefer certain
return to an uncertain return. Investors will hold
risky investments if they expect to be
compensated with additional return.
• Higher the risk, higher will be the expected return.
Note expected return may not be equal to the
realized rate of return. Thus higher risk does not
guarantee higher rate of return.

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Figure 1.3 There is a Risk-Return Trade—off

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Principle 3: Cash Flows Are the Source of
Value
• Profit is an accounting concept and measures a
business’s performance. Cash flow is the amount
of cash that can actually be taken out of the
business.
• Company’s profits can differ dramatically from its
cash flows. It is possible for a company to report
profits without generating any cash.

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Incremental Cash Flow
Financial decisions in a firm should consider
marginal, or “incremental”, cash flows i.e. the
difference between the cash flows the company will
produce with the potential new investment and the
cash flows that would be produced without the
investment.

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Principle 4: Market Prices Reflect
Information
Investors respond to new information by buying and
selling their investments. The speed of investor
reaction and speed of price adjustment determines
the efficiency of market.

Release of Good News ==> Higher stock prices

Release of Bad News ==> Lower stock price

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Principle 5: Individuals Respond to
Incentives
Managers (as agents) respond to incentives they
are given in the workplace.
If the incentives are not properly aligned with those
of the firm’s stockholders (the principal) they may
not make decisions that are consistent with
increasing shareholder value leading to agency
costs.

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Mitigating Agency Costs
The agency problems/costs can be mitigated
through:
1. Compensation plans that reward managers when they
act to maximize shareholder wealth
2. Monitoring by the board of directors
3. Monitoring by financial markets (such as auditors,
bankers, security analysts, credit agencies)
4. The underperforming firms seeing their stock prices fall
and face threat of being taken over and have their
management teams replaced.

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