Lesson 2 Chapter 1 Introduction Unit 1 Core concepts in financial management

After reading this lesson you will be able to understand the following: Objective of financial management. Separation of ownership & management Major decisions in financial management

In first semester you have read financial accounting and by now you have a little idea about financial management also so tell me what is the objective of financial management?

What is the objective of financial management?

“If you don’t know where you are going, it does not matter how you get there”

What do you think should be the objective? What do a finance manager do? Suppose he makes available the required funds at an acceptable cost and those funds are suitably invested and that every thing goes according to plan because of the effective control measures he uses. If the firm is a commercial or profit seeking then the results of good performance are reflected in the profits the firm makes. How are profits utilized? They are partly distributed among the owners as dividends and partly reinvested in to the business. As this process continues over a period

of time the value of the firm increases. If the share of the organization is traded on stock exchange the good performance is reflected through the market price of the share, which shows an upward movement. When the market price is more a shareholder gets more value then what he has originally invested thus his wealth increases. Therefore we can say that the objective of financial management is to increase the value of the firm or wealth maximization.

Objective: Maximize the Value of the Firm
Brealey & Myers: "Success is usually judged by value: Shareholders are made better off by any decision which increases the value of their stake in the firm... The secret of success in financial management is to increase value." Copeland & Weston: The most important theme is that the objective of the firm is to maximize the wealth of its stockholders." Brigham and Gapenski: Management's primary goal is stockholder wealth maximization, which translates into maximizing the price of the common stock. The Objective in Decision Making In traditional corporate finance, the objective in decision-making is to maximize the value of the firm. A narrower objective is to maximize stockholder wealth. When the stock is traded and markets are viewed to be efficient, the objective is to maximize the stock price. All other goals of the firm are intermediate ones leading to firm value maximization, or operate as constraints on firm value maximization.

The Criticism of Firm Value Maximization

Maximizing stock price is not incompatible with meeting employee needs/objectives. In particular: • - Employees are often stockholders in many firms • - Firms that maximize stock price generally are firms that have treated employees well. Maximizing stock price does not mean that customers are not critical to success. In most businesses, keeping customers happy is the route to stock price maximization. Maximizing stock price does not imply that a company has to be a social outlaw. Why traditional corporate financial theory focuses on maximizing stockholder wealth? Stock prices are easily observable and constantly updated (unlike other measures of performance, which may not be as easily observable, and certainly not updated as frequently). If investors are rational, stock prices reflect the wisdom of decisions, short term and long term, instantaneously. As it is, it is believed that market discounts all the information in the form of market price of the share.

Why not profit maximization?
Profitability objective may be stated in terms of profits, return on investment, or profit to-sales ratios. According to this objective, all actions such as increase income and cut down costs should be undertaken and those that are likely to have adverse impact on profitability of the enterprise should be avoided. Advocates of the profit maximisation objective are of the view that this objective is simple and has the in-built advantage of judging economic performance of the enterprise. Further, it will direct the resources in those channels that promise maximum return. This, in turn, would help in optimal utilisation of society's economic resources. Since the finance manager is responsible for the efficient utilisation of capital, it is plausible to pursue profitability maximisation as the operational standard to test the effectiveness of financial decisions.

Hence. (b) It Ignores Time Value factor Profit maximisation objective fails to provide any idea regarding timing of expected cash earnings. These drawbacks are: (a) It is Vague It is not clear in what sense the term profit has been used. Profit maximisation objective does not take cognizance of this vital factor and treats all benefits. if there are two investment projects and suppose one is likely to produce streams of earnings of Rs. . Profits in the short-run may not be the same as those in the long run. long-term consideration of profit cannot be neglected in favor of short-term profit. owner's funds. irrespective of the timing. Obviously. A firm can maximise its short-term profit by avoiding current expenditures on maintenance of a machine.However.000 in sixth year from now and the other is likely to produce annual benefits of Rs. Thus. Rate of profitability may again be in relation to Share capital. profit maximisation suffers in the long run for the sake of maximizing short-term profit. For instance. both the projects cannot be treated as equally useful ones although total benefits of both the projects are identical because of differences in value of benefits received today and those received a year two years after. The interest of the firm and its owners is affected by the time value or. profit maximisation objective suffers from several drawbacks rendering it an ineffective decisional criterion. Future earnings of different projects are related with risks of varying degrees. It may be total profit before tax or after tax or profitability rate. total capital employed or sales. as equally valuable. the word profit does not speak anything about the short-term and long-term profits. 90. 15. Choice of more worthy projects lies in the study of time value of future flows of cash earnings. the machine being put to use may no longer be capable of operation after sometime with the result that the firm will have to defray huge investment outlay to replace the machine. (c) It Ignores Risk Factor Another serious shortcoming of the profit maximisation objective is that it overlooks risk factor. But owing to this neglect.000 in each of the ensuing six years. Which of these variants of profit should the management pursue to maximise so as to attain the profit maximisation objective remains vague? Furthermore.

different projects may have different values even though their earning capacity is the same. The wealth maximisation objective when used as decisional criterion serves as a very useful guideline in taking investment decisions. The concept of cash flow is more precise in connotation than that of accounting profit. That is why we have Wealth Maximisation as an Objective Wealth maximisation objective is a widely recognised criterion with which the performance a business enterprise is evaluated. Risk element of a project is also dependent on the financing mix of the project. All these factors are well taken care of by wealth maximisation objective. It represents present value of the benefits minus the cost of the investment. which creates wealth or which. wealth maximisation is also stated as net present worth. It recognises that . an investor would provide less value to the former than to the latter. wealth is very clear. Therefore. Project largely financed by way of debt is generally more risky than the one predominantly financed by means of share capital. Naturally. In view of the above. Suitable and operationally feasible objective of the firm should be precise and clear cut and should give weightage to time value and risk factors. wealth maximisation objective as decisional criterion suggests that any financial action. which reflects their certainty or uncertainty. measuring benefit in terms of cash flows generated avoids ambiguity. This is because the concept of. Net present worth is difference between gross present worth and the amount of capital investment required to achieve the benefits. the profit maximisation objective is inappropriate and unsuitable an operational objective of the firm. A project with fluctuating earnings is considered more risky than the one with certainty of earnings. Thus. has a net present value above zero is desirable one and should be accepted and that which does not satisfy this test should be rejected. The wealth maximisation objective considers time value of money. Thus. The word wealth refers to the net present worth of the firm. Gross present worth represents the present value of expected cash benefits discounted at a rate.

This is why annual cash benefits of a project are discounted at a discount rate to calculate total value of these cash benefits. Where the time period is short and magnitude of uncertainty is not great. value maximisation and profit maximisation amount almost the same thing. The goal is not to maximize stakeholder well being. suppliers. suppliers are paid for the materials and services they provide. At the same time. customers purchase the firm's products or services. . it also gives due weightage to risk factor by making necessary adjustments in the discount rate. discount rate used to determine present value of future streams of cash earning reflects both the time and risk. Employees are paid for their labor.cash benefits emerging from a project in different years are not identical in value. Such a view is often considered part of the firm's "social responsibility. Stakeholders are groups such as employees. while lower discount rate applied to discount expected cash benefits of a less risky project. and owners who have a direct economic link to the firm. and owners provide equity financing. In this way. A firm with a stakeholder focus consciously avoids actions that would prove detrimental to stakeholders by damaging their wealth positions through the transfer of stakeholder wealth to the firm. creditors provide debt financing. It may be noted here that value maximisation objective is simply the extension of profit maximisation to real life situations. cash benefits of a project with higher risk exposure is discounted at a higher discount rate (cost of capital). Thus." . wealth maximisation objective is considered superior profit maximisation objective. customers. but to preserve it. in recent years many firms have broadened their focus to include the interests of stakeholders as well as shareholders. The stakeholder view tends to limit the firm's actions in order to preserve the wealth of stakeholders. creditors. In view of the above reasons. Objective redefined Although shareholder wealth maximization is the primary goal.

It is expected to provide long-run benefit to shareholders by maintaining positive stakeholder relationships. and litigation.rather than conflict with-its other stakeholders. . conflicts. Such relationships should minimize stakeholder turnover. Clearly. the firm can better achieve its goal of shareholder wealth maximization with the cooperation of.

The Four Major Decisions in Corporate Finance/Financial management The Allocation (Investment) decision Where do you invest the scarce resources of your business? What makes for a good investment? The Financing decision Where do you raise the funds for these investments? Generically. Finance functions call for skilful planning. Let us note at the outset hat shareholders are made better off by a financial decision that increases the value of their shares.To achieve the objective of financial management there are four major decisions that a manager takes. Thus while performing the finance function. They do not necessarily occur in a sequence. what mix of owner’s money (equity) or borrowed money (debt) do you use? The Dividend Decision How much of a firm’s funds should be reinvested in the business and how much should be returned to the owners? The Liquidity decision How much should a firm invest in current assets and what should be the components with their respective proportions? How to manage the working capital? A firm performs finance functions simultaneously and continuously in the normal course of the business. Whatever decision does a manger takes need to result in wealth maximisation of a shareholder. control and execution of a firm’s activities. . the financial manager should strive to maximize the market value of shares.

A decision maker should be aware of capital in practice from the available data and information. The mix of debt and equity is known as the firm’s capital structure. investment decisions involve risk. Investment proposals should. However. The firm’s capital structure is considered to be optimum when the market value of shares is maximised.Investment Decision Investment decision or capital budgeting involves the decision of allocation of capital or commitment of funds to long-term assets that would yield benefits in the future. Once the . A decision maker should be aware of these problems. When the shareholders’ return is maximised with minimum risk. Two important aspects of the investment decision are: (a) the evaluation of the prospective profitability of new investments. The financial manager must strive to obtain the best financing mix or the optimum capital structure for his or her firm. A proper balance will have to be struck between return and risk. there are problems in computing the opportunity cost of capital in practice from the available data and information. There is a broad agreement that the correct cut-off rate is the required rate of return or the opportunity cost of capital. The central issue before him or her is to determine the proportion of equity and debt. be evaluated in terms of both expected return and risk. therefore. The use of debt affects the return and risk of shareholders. where and how to acquire funds to meet the firm’s investment needs. Broadly. and (b) the measurement of a cut-off rate against that the prospective return of new investments could be compared. it may increase the return on equity funds but it always increases risk. Because of the uncertain future. Future benefits of investments are difficult to measure and cannot be predicted with certainty. Financing Decision Financing decision is the second important function to be performed by the financial manager. Besides the decision for investment managers do see where to commit funds when an asset becomes less productive or non-profitable. her or she must decide when. the market value per share will be maximised and the firm’s capital structure would be considered optimum.

Periodically. The optimum dividend policy is one that maximises the market value of the firm’s shares. Current assets should be managed efficiently for safeguarding the firm against the dangers of illiquidity and insolvency. Dividend Decision Dividend decision is the third major financial decision. But it would lose profitability. or retain them. Like the debt policy. a proper trade-off must be achieved between profitability and liquidity. it may become illiquid. a firm considers many other factors such as control. Liquidity Decision Current assets management that affects a firm’s liquidity is yet another important finances function. bonus shares and cash dividends in practice. called bonus share (or stock dividend).financial manager is able to determine the best combination of debt and equity. or distribute a portion and retain the balance. Thus if shareholders are not indifferent to the firm’s dividend policy. the financial manager should develop sound techniques of managing current assets. flexibility loan convenience. . additional shares. The financial manager must decide whether the firm should distribute all profits. In practice. are also issued to the existing shareholders in addition to the cash dividend. in deciding its capital structure. Most profitable companies pay cash dividends regularly. Investment in current assets affects the firm’s profitability. In order to ensure that neither insufficient nor unnecessary funds are invested in current assets. Liquidity and risk. the financial manager must determine the optimum dividend – payout ratio. legal aspects etc. in addition to the management of long-term assets. The financial manager should also consider the questions of dividend stability. The payout ratio is equal to the percentage of dividends to earnings available to shareholders. If the firm does not invest sufficient funds in current assets. the dividend policy should be determined in terms of its impact on the shareholders’ value. A conflict exists between profitability and liquidity while managing current assets. Thus. as idle current assets would not earn anything. he or she must raise the appropriate amount through the best available sources.

Financial management is looked on as cutting across functional even disciplinary boundaries. growth. the value of the firm. finance manager is expected to call upon the expertise of other functional managers of the firm particularly in regard to investment of funds. financial management is directly concerned with production. However. The determination of dividend policies is almost exclusively a finance function. decision pertaining to the proportion in which fixed assets and current assets are mixed determines the risk complexion of the firm. Costs of various methods of financing are affected by this risk. terms of credit should be made after consulting production and marketing executives.He or she should estimate firm’s needs for current assets and make sure that funds would be made available when needed. Thus. dividend decisions influence financing decisions and are themselves influenced by investment decisions. in addition to raising funds. This. and ultimately. marketing and other functions. Various financial functions are intimately connected with each other. profitability and risk of the firm. type of customers to be granted credit facilities. A finance manager has a final say in decisions on dividends than in asset management decisions. in the management of income finance manager has to act on his own. Likewise. marketing and other functions of the firm. within an enterprise whenever decisions are about the acquisition or distribution of assets. It would thus be clear that financial decisions directly concern the firm’s decision to acquire or dispose off assets and require commitment or recommitment of funds on a continuous basis. To quote Ezra Solomon The function of financial management is to review and control decisions to commit or recommit funds to new or ongoing uses. finance functions may affect the size. For instance. level of inventories to be kept in hand. It is in this context that finance functions are said to influence production. It is in such an environment that finance manager works as a part of total . In view of this. Decisions pertaining to kinds of fixed assets to be acquired for the firm. in consequence.

In principle. Of course. the managers are their agents. It allows the firm to hire professional managers. there are no costs when the shareholders are also the managers. It allows share ownership to change without interfering with the operation of the business. managers may seek a more leisurely or luxurious working lifestyle. just as . Separation of Ownership and Management In large businesses separation of ownership and management is a practical necessity. You can see the danger: Rather than attending to the wishes of shareholders. That is one of the advantages of a sole proprietorship. as noted above. a finance manager is held responsible to handle all such problem: that involve money matters. You have studied separate legal entity concept in financial accounting the following paragraph is extension of the same. The separation of ownership and management has clear advantages. Ownermanagers have no conflicts of interest. Major corporations may have hundreds of thousands of shareholders. But in actual practice. Shareholders want management to increase the value of the firm. Conflicts between shareholders and managers are not the only principal-agent problems that the financial manager is likely to encounter. But it also brings problems if the managers' and owners' objectives differ. they may shun unpopular decisions. There is no way for all of them to be actively involved in management: Authority has to be delegated to managers. For example. The shareholders are the principals. Such conflicts between shareholders and managers' objectives create principal agent problems.management. Agency costs are incurred when (1) managers do not attempt to maximize firm value and (2) shareholders incur costs to monitor the managers and influence their actions. he has to call on the expertise of those in other functional areas to discharge his responsibilities effectively. but managers may have their own axes to grind or nests to feather. or they may attempt to build an empire with their shareholders' money.

shareholders need to encourage managers to work for the shareholders' interests. when banks lend money to the firm. For example. they insist on a formal contract stating the rate of interest and repayment dates. perhaps placing restrictions on dividends or additional borrowing. We have seen that the goal of the financial manager should be to maximize the wealth of the owners of the firm and given them decision-making authority to manage the firm. and lenders may all have different information about the value of a real or financial asset. Technically. since it gets to tax corporate profits. All these claimants are bound together in a complex web of contracts and understandings. Think of the company's overall value as a pie that is divided among a number of claimants. shareholders. But you can't devise written rules to cover every possible future event. In this case senior management are the principals and junior management and other employees are their agents. any manager who owns less than 100 percent of the firm is to some degree an agent of the other owners. That is rarely the case in finance. Financial managers need to recognize these information asymmetries and find ways to reassure investors that there are no nasty surprises on the way. Principal-agent problems would be easier to resolve if everyone had the same information. The government is a claimant too. and it may be many years before all the information is revealed. as well as the company's workforce and the banks and investors who have bought the company's debt. The Agency Issue The control of the modern corporation is frequently placed in the hands of professional non-owner managers. So written contracts are incomplete and need to be supplemented by understandings and by arrangements that help to align the interests of the various parties. . These include the management and the shareholders. so senior management needs to think about how to motivate everyone else in the company. Managers.

These holders of large block of a firm's stock have begun in recent years to exert pressure on management to perform. managers are also concerned with their personal wealth. limousines. and fringe benefits. Such concerns may make managers reluctant or unwilling to take more that. job security. however. such as mutual funds. The result is a less-than-maximum return and a potential loss of wealth for the owners. Agency Costs To minimize agency problems and contribute to the maximization of owners' wealth. operations.In theory. moderate risk if they perceive that too much risk might result in a loss of job and damage to personal wealth. In practice. ensuring against dishonest acts of management. all provided at company expense. most financial managers would agree with the goal of owner wealth maximization. These are the costs of monitoring management behavior. particularly large institutional investors. and posh offices. such as country club memberships. Another market force is the threat of takeover by another firm that believes that it can enhance the firm's value by restructuring its management. and giving managers the financial incentive to maximize share . Market Forces One market force is major shareholders. When necessary they exercise their voting rights as stockholders to replace under performing management. and pension funds. Two factors-market forces and agency costs-act to prevent or minimize agency problems. life insurance companies. and financing. How do we resolve the agency problem? From this conflict of owners and managers arises what has been called the agency problem-the likelihood that managers may place personal goals ahead of corporate goals. The constant threat of takeover tends to motivate management to act in the best interest of the firm's owners by attempting to maximize share price. stockholders incur agency costs.

supporting education. well-structured compensation packages allow firms to hire the best managers available. In addition. suppliers. and becoming involved in such environmental issues as clean air and water . maintaining fair hiring practices and safe working conditions. Social Responsibility Maximizing shareholder wealth does not mean that management should ignore social responsibility. These options allow managers to purchase stock at a set market price. powerful. such as protecting the consumer. These stakeholders include creditors. The most popular. Today more firms are tying management compensation to the firm's performance. Only through attention to the legitimate concerns of the firm’s various stakeholders can the firm attain its ultimate goal of maximizing shareholder wealth. The objective is to compensate managers for acting in the best interests of the owners. Let us discuss.price. customers. This is frequently accomplished by granting stock options to management. employees. and expensive approach is to structure management compensation to correspond with share price maximization. paying fair wages to employees. the higher future stock price would result in greater management compensation. if the market price rises.It is appropriate for management to consider the interests of stakeholders other than shareholders. Another point demanding attention is social responsibility. communities in which a company operates. This incentive appears to motivate managers to operate in a manner reasonably consistent with stock price maximization. and others. .

It cannot sustain jobs. Lloyds TSB. p. As businessmen and businesswomen. a leading Untied Kingdom based financial services group. a leader in the community and a leader in sponsorship of education. Reproduced with permission of Lloyds TSB Group plc. Here is what Lloyds TSB chairman. our business partners and our communities—than by creating value over time for those who employ us. . employees. Putting value creation in the forefront does not mean. but our fellow employees. much less widen the opportunities available to its employees. Source: Lloyds TSB Group Annual Report & Accounts 1998. however. has to say about” putting value creation first”. that its customers. not only to the company. It cannot give to philanthropic causes. the arts and sport. enterprise. Putting value creation first can bring huge benefits. The Lloyds TSB foundations will receive some ₤27 million in 1999 for distribution to charities. No company can service for long unless it creates wealth. is one such firm that views maximizing shareholder value as its governing objective.3. but to society as a whole. with a particular focus on disabled and disadvantaged people. we believe that there is no better way for us to serve all our stakeholders not just our shareholders and customers. or society in general will take a back seat.Lloyds TSB speaks out on value creation and Society Lloyds TSB Companies everywhere that want to attract capital have to ensure that they are response to shareholders interests. A sick company is a drag on society. It cannot adequately serve customers. sir Brain Pitman. It is our success in value creation that has also enabled the Lloyds TSB group to become leader in charitable giving.

In spite of his efforts and those of his departmental co-workers. During their lunch break one day. The only way we benefit is for the stock price to rise. Shouldn't management do what's best for stockholders? Something's wrong!" Loren responded." Dale chimed in. they began talking about the company. they decided to meet the next day to continue their discussion. Loren said that she had seen documents describing the firm's profit-sharing plan under which all managers were partially compensated on the basis of the firm's profits. the only profits stockholders receive are in the form or cash dividends.CASE STUDY Assessing the Goal of Sports Products Ltd. Neither could understand why the firm's stock price was falling as profits rose. Why spend money for pollution controls? It increases costs. .25 per share over the past 9 months. maybe that explains why the company hasn't concerned itself with the stock price. Dale said. the firm's stock price had declined nearly Rs. "That doesn't make sense. because the stockholders own the firm. "Well. "That probably explains why the firm is being sued by state and central environmental officials for dumping pollutants in the adjacent stream. and this firm has never paid dividends during its 20-year history. Before leaving. lowers profits.. because it directly affected their pay. trying not to waste packing materials and to perform his job efficiently and cost-effectively. We as stockholders therefore don't directly benefit from profits. Loren indicated that she shared Dale's frustration. She suggested that maybe it was profit that was important to management. Dale complained that he had always worked hard. particularly because the firm's profits had been rising. Look. and therefore lowers management's earnings!" Loren and Dale realized that the lunch break had ended and they must quickly return to work. Loren and Dale work in the Shipping Department of Sports Products Ltd.

Inc. what specific recommendations would you offer the firm? . What should the management of Sports Products. Does it seem to be ethical? Why might incurring the expense to control pollution be in the best interests of the firm's owners in spite of its negative impact on profits? d. pursue as its overriding goal? Why? b.. On the basis of the information provided. Does the firm appear to have an agency problem? Explain. c.Required a. Evaluate the firm's approach to pollution control.

Which of the following statements is correct regarding profit maximization as the primary goal of the firm? a) Profit maximization considers the firm's risk level.Questions for lesson 1 & 2 1. ownership and management are separated. __________ is concerned with the maximization of a firm's earnings after taxes. __________ is concerned with the acquisition. What is financial management all about? 3. In large corporations. financing. What is the most appropriate goal of the firm? a) b) c) d) Shareholder wealth maximization Profit maximization Stakeholder maximization EPS maximization. . What are the main implications of this separation? 4. c) Profit maximization does consider the impact on individual shareholder's EPS. a) b) c) d) Shareholder wealth maximization Profit maximization Stakeholder maximization EPS maximization 3. What are agency costs & what causes them? Multiple Choice Questions 1. 2. Contrast the objective of maximizing earnings with that of maximizing wealth. a) b) c) d) Financial management Profit maximization Agency theory Social responsibility 2. 4. and management of assets with some overall goal in mind. b) Profit maximization will not lead to increasing short-term profits at the expense of lowering expected future profits.

b) Financing . a) Asset management. a) b) c) d) Financial management Profit maximization Agency theory Social responsibility 6.d) Profit maximization is concerned more with maximizing net income than the stock price. You need to understand financial management even if you have no intention of becoming a financial manager. specialties Generalist. cross-functional capabilities 9. quantitative skills Team player. __________ is concerned with the branch of economics relating the behavior of principals and their agents. and whether any assets need to be reduced. a) b) c) d) Asset management Financing Investment Capital budgeting 8. the composition of the assets. eliminated. One reason is that the successful manager of the not-toodistant future will need to be much more of a __________ who has the knowledge and ability to move not just vertically within an organization but horizontally as well. A concept that implies that the firm should consider issues such as protecting the consumer. not the exception. The __________ decision involves a determination of the total amount of assets needed. paying fair wages. 5. The __________ decision involves determining the appropriate make-up of the righthand side of the balance sheet. supporting education. a) b) c) d) Financial management Profit maximization Agency theory Social responsibility 7. and considering environmental issues. a) b) c) d) Specialist. maintaining fair hiring practices. general business skills Technician. Developing __________ will be the rule. or replaced.

c) Use the income statement to determine earnings after taxes (net income) and divide by the number of common and preferred shares outstanding. What is the most important of the three financial management decisions? a) b) c) d) Asset management decision Financing decision Investment decision Accounting decision 12. The __________ decision involves efficiently managing the assets on the balance sheet on a day-to-day basis. a) b) c) d) Asset management Financing Investment Accounting 13. d) Use the income statement to determine earnings after taxes (net income) and divide by the forecasted period's earnings after taxes. Then subtract 1 from the previously calculated value. Which of the following is not a perquisite (perk)? a) b) c) d) Company-provided automobile Expensive office Salary Country club membership 14.How are earnings per share calculated? a) Use the income statement to determine earnings after taxes (net income) and divide by the previous period's earnings after taxes. b) Use the income statement to determine earnings after taxes (net income) and divide by the number of common shares outstanding. Then subtract 1 from the previously calculated value.c) Investment d) Accounting 10. 11. All constituencies with a stake in the fortunes of the company are known as __________. especially current assets. a) b) c) d) Shareholders Stakeholders Creditors Customers .

Financing 8. Investment decision 12. Use the income statement to determine earnings after taxes (net income) and divide by the number of common shares outstanding. 11. Shareholder wealth maximization . 5. 2. 3. __________ is concerned with the maximization of a firm's stock price. 16. Investment 10. Asset management 13. cross-functional capabilities 9. EPS maximization does not specify the timing or duration of expected EPS. 16. Asset management 14. Financial management Profit maximization Shareholder wealth maximization Profit maximization is concerned more with maximizing net income than the stock price. EPS maximization is concerned with maximizing net income. Stakeholders 15. Which of the following statements is not correct regarding earnings per share (EPS) maximization as the primary goal of the firm? a) b) c) d) EPS maximization ignores the firm's risk level. Social responsibility 7. EPS maximization is concerned with maximizing net income. EPS maximization naturally requires all earnings to be retained. 4. a) b) c) d) Shareholder wealth maximization Profit maximization Stakeholder welfare maximization EPS maximization Answers to above 1. Agency theory 6. Team player.15.

IMPORTANT Slide 1 Chapter 1 The Role of Financial The Role of Financial Management Management 1-1 ________________________________________________________________________ ________________________________________________________________________ ________________________________________________________________________ ________________________________________________________________________ ________________________________________________________________________ ________________________________________________________________________ ________________________________________________________________________ ________________________________________________________________________ ________________________________________________________________________ ________________________________________________________________________ ________________________________________________________________________ ____________________________________________________________________ .

Slide 2 The Role of Financial Management What is Financial Management? The Goal of the Firm Organization of the Financial Management Function 1-2 ________________________________________________________________________ ________________________________________________________________________ ________________________________________________________________________ ________________________________________________________________________ ________________________________________________________________________ ________________________________________________________________________ ________________________________________________________________________ ________________________________________________________________________ ________________________________________________________________________ ________________________________________________________________________ ________________________________________________________________________ ____________________________________________________________________ .

financing. and management of assets with some overall goal in mind. 1-3 ________________________________________________________________________ ________________________________________________________________________ ________________________________________________________________________ ________________________________________________________________________ ________________________________________________________________________ ________________________________________________________________________ ________________________________________________________________________ ________________________________________________________________________ ________________________________________________________________________ ________________________________________________________________________ ________________________________________________________________________ ____________________________________________________________________ .Slide 3 What is Financial Management? Concerns the acquisition.

Slide 4 Investment Decisions Most important of the three decisions. What is the optimal firm size? What specific assets should be acquired? What assets (if any) should be reduced or eliminated? 1-4 ________________________________________________________________________ ________________________________________________________________________ ________________________________________________________________________ ________________________________________________________________________ ________________________________________________________________________ ________________________________________________________________________ ________________________________________________________________________ ________________________________________________________________________ ________________________________________________________________________ ________________________________________________________________________ ________________________________________________________________________ ____________________________________________________________________ .

Slide 5 Financing Decisions Determine how the assets (LHS of balance sheet) will be financed (RHS of balance sheet). What is the best type of financing? What is the best financing mix? What is the best dividend policy? How will the funds be physically acquired? 1-5 ________________________________________________________________________ ________________________________________________________________________ ________________________________________________________________________ ________________________________________________________________________ ________________________________________________________________________ ________________________________________________________________________ ________________________________________________________________________ ________________________________________________________________________ ________________________________________________________________________ ________________________________________________________________________ ________________________________________________________________________ ____________________________________________________________________ .

Greater emphasis on current asset management than fixed asset management.Slide 6 Asset Management Decisions How do we manage existing assets efficiently? Financial Manager has varying degrees of operating responsibility over assets. 1-6 ________________________________________________________________________ ________________________________________________________________________ ________________________________________________________________________ ________________________________________________________________________ ________________________________________________________________________ ________________________________________________________________________ ________________________________________________________________________ ________________________________________________________________________ ________________________________________________________________________ ________________________________________________________________________ ________________________________________________________________________ ____________________________________________________________________ .

Slide 7 What is the Goal of the Firm? Maximization of Shareholder Wealth! Value creation occurs when we maximize the share price for current shareholders. 1-7 ________________________________________________________________________ ________________________________________________________________________ ________________________________________________________________________ ________________________________________________________________________ ________________________________________________________________________ ________________________________________________________________________ ________________________________________________________________________ ________________________________________________________________________ ________________________________________________________________________ ________________________________________________________________________ ________________________________________________________________________ ____________________________________________________________________ .

etc. defer maintenance. issue common stock to buy T-bills. 1-8 ________________________________________________________________________ ________________________________________________________________________ ________________________________________________________________________ ________________________________________________________________________ ________________________________________________________________________ ________________________________________________________________________ ________________________________________________________________________ ________________________________________________________________________ ________________________________________________________________________ ________________________________________________________________________ ________________________________________________________________________ ____________________________________________________________________ ..Slide 8 Shortcomings of Alternative Perspectives Profit Maximization Maximizing a firm’s earnings after taxes. Ignores changes in the risk level of the firm.).g. Problems Could increase current profits while harming firm (e.

Problems Does not specify timing or duration of expected returns.Slide 9 Shortcomings of Alternative Perspectives Earnings per Share Maximization Maximizing earnings after taxes divided by shares outstanding. Calls for a zero payout dividend policy. 1-9 ________________________________________________________________________ ________________________________________________________________________ ________________________________________________________________________ ________________________________________________________________________ ________________________________________________________________________ ________________________________________________________________________ ________________________________________________________________________ ________________________________________________________________________ ________________________________________________________________________ ________________________________________________________________________ ________________________________________________________________________ ____________________________________________________________________ . Ignores changes in the risk level of the firm.

EPS duration. and risk of profits and EPS. and all other policy relevant factors. the timing. Thus. 1-10 ________________________________________________________________________ ________________________________________________________________________ ________________________________________________________________________ ________________________________________________________________________ ________________________________________________________________________ ________________________________________________________________________ ________________________________________________________________________ ________________________________________________________________________ ________________________________________________________________________ ________________________________________________________________________ ________________________________________________________________________ ____________________________________________________________________ . EPS dividend policy. share price serves as a barometer for business performance.Slide 10 Strengths of Shareholder Wealth Maximization Takes account of: current and future profits and EPS.

Slide 11 The Modern Corporation Modern Corporation Shareholders Management There exists a SEPARATION between owners and managers. 1-11 ________________________________________________________________________ ________________________________________________________________________ ________________________________________________________________________ ________________________________________________________________________ ________________________________________________________________________ ________________________________________________________________________ ________________________________________________________________________ ________________________________________________________________________ ________________________________________________________________________ ________________________________________________________________________ ________________________________________________________________________ ____________________________________________________________________ .

called the principal. An agent is an individual authorized by another person. to act in the latter’s behalf. 1-12 ________________________________________________________________________ ________________________________________________________________________ ________________________________________________________________________ ________________________________________________________________________ ________________________________________________________________________ ________________________________________________________________________ ________________________________________________________________________ ________________________________________________________________________ ________________________________________________________________________ ________________________________________________________________________ ________________________________________________________________________ ____________________________________________________________________ .Slide 12 Role of Management Management acts as an agent for the owners (shareholders) of the firm.

Slide 13 Agency Theory Jensen and Meckling developed a theory of the firm based on agency theory. theory Agency Theory is a branch of economics relating to the behavior of principals and their agents. 1-13 ________________________________________________________________________ ________________________________________________________________________ ________________________________________________________________________ ________________________________________________________________________ ________________________________________________________________________ ________________________________________________________________________ ________________________________________________________________________ ________________________________________________________________________ ________________________________________________________________________ ________________________________________________________________________ ________________________________________________________________________ ____________________________________________________________________ .

and bonuses.Slide 14 Agency Theory Principals must provide incentives so that management acts in the principals’ best interests and then monitor results. bonuses 1-14 ________________________________________________________________________ ________________________________________________________________________ ________________________________________________________________________ ________________________________________________________________________ ________________________________________________________________________ ________________________________________________________________________ ________________________________________________________________________ ________________________________________________________________________ ________________________________________________________________________ ________________________________________________________________________ ________________________________________________________________________ ____________________________________________________________________ . perquisites. Incentives include stock options.

responsible Assume we view the firm as producing both private and social goods.Slide 15 Social Responsibility Wealth maximization does not preclude the firm from being socially responsible. 1-15 ________________________________________________________________________ ________________________________________________________________________ ________________________________________________________________________ ________________________________________________________________________ ________________________________________________________________________ ________________________________________________________________________ ________________________________________________________________________ ________________________________________________________________________ ________________________________________________________________________ ________________________________________________________________________ ________________________________________________________________________ ____________________________________________________________________ . Then shareholder wealth maximization remains the appropriate goal in governing the firm.

Slide 16 Organization of the Financial Management Function Board of Directors President (Chief Executive Officer) Vice President Operations 1-16 VP of Finance Vice President Marketing ________________________________________________________________________ ________________________________________________________________________ ________________________________________________________________________ ________________________________________________________________________ ________________________________________________________________________ ________________________________________________________________________ ________________________________________________________________________ ________________________________________________________________________ ________________________________________________________________________ ________________________________________________________________________ ________________________________________________________________________ ____________________________________________________________________ .

Slide 17 Organization of the Financial Management Function VP of Finance Treasurer Capital Budgeting Cash Management Credit Management Dividend Disbursement Fin Analysis/Planning Pension Management Insurance/Risk Mngmt Tax Analysis/Planning 1-17 Controller Cost Accounting Cost Management Data Processing General Ledger Government Reporting Internal Control Preparing Fin Stmts Preparing Budgets Preparing Forecasts ________________________________________________________________________ ________________________________________________________________________ ________________________________________________________________________ ________________________________________________________________________ ________________________________________________________________________ ________________________________________________________________________ ________________________________________________________________________ ________________________________________________________________________ ________________________________________________________________________ ________________________________________________________________________ ________________________________________________________________________ ____________________________________________________________________ .

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