You are on page 1of 43

Chapter 1

The Roles and Objectives of Financial Management

Finance 311

1

Introduction

This chapter introduces the financial management process of the typical firm. It looks at the financial manager, the field of finance, financial decisions and their implications, and the daily questions faced by the firm’s financial management.
Finance 311 2

A GENERAL LOOK AT FINANCE

Finance is the art and science of managing money

Finance 311

3

Questions Faced in Finance

 

How is finance related to other fields of study? What are the goals and objectives of financial managers? How has the finance field evolved? How is the finance field changing today?
Finance 311 4

insurance companies.THERE ARE THREE MAJOR AREAS OF FINANCE   Investments -. Also concerned with analyzing financial markets and predicting interest rates.Concerned with analyzing potential investments (including Real Estate) in order to achieve a certain rate of return consistent with a desired level of risk. Finance 311 5 . etc. Return on Investment Financial institutions and markets -Concerned with the management of financial institutions like commercial banks.

at times. but we will get into the other areas. That is. This course is concerned with managerial finance. we will assume the role of a banker or investor.  Finance 311 6  . Primarily concerned with the “for profit” organization.AREAS OF FINANCE --continued Business finance or corporate finance or managerial finance which is concerned with the management of the “non-financial” corporation. but same principles apply to the “not for profit” organization.

Financing    .What Activities are Involved in Managerial Finance   Investment of funds or capital budgeting  Risk versus Return Real Options Amount of cash to hold Amount of credit to grant Amount of inventory to hold Where to obtain short term capital Debt versus equity Long term debt versus short term debt Lease versus own Finance 311 7  Working capital management      Acquisition of funds .

Activities in Finance -continued    Distribution or Dividend Decision Financial planning Others      Mergers and acquisitions Bankruptcies Spin-offs Leverage buy-outs (LBO) Valuations  EVA and MVA Finance 311 8 .

What is Our Goal?  Some Possibilities      Maximize revenue Maximize profits Maximize EPS Minimize losses Others Finance 311 9 .In Making Financial Management Decisions.

Objective of Financial Management ( FM ) Objective of the financial manager Owner’s Wealth Maximization (OWM) or Stockholders’ Wealth Maximization (SWM) NOT profit maximization Does not consider time value of money or cash flows or risk Finance 311 10 .

Principal Forms of Business Organizations are: Sole proprietorship Partnership Corporation Finance 311 11 .

sba.Sole Proprietorship        Owned by one person Easy formation advantage Unlimited liability disadvantage Difficulty raising funds disadvantage Represent 75 percent of all businesses Account for less than 6% of the dollar volume Check out small business info from the SBA http://www.gov/ Finance 311 12 .

Partnership  Owned by two or more persons  Classified as general or limited  Partnership dissolves when a general partner dies  General partner has unlimited liability  Limited partner’s liability limited by partnership agreement Finance 311 13 .

Corporation     Limited liability Permanency Flexibility Ability to raise capital     Legal entity Have a board of directors Owners are stockholders Easy marketability of shares of ownership Finance 311 14 .

Optimal Form of Organization Influenced by  Cost  Complexity  Liability  Continuity  Raising capital  Decision making  Tax considerations Finance 311 15 .

Board of Directors   Stockholders elect a board of directors Board of directors then elect the officers         Chairman of the board Chief executive officer (CEO) Chief operating officer (COO) President Chief financial officer (CFO) Vice presidents Treasurer Secretary Finance 311 Management 16 .

Major Advantage of Corporation is Limited Liability    We will assume in this course that we are working with corporations Ownership is represented by common stock (CS) Our objective is to maximize the long term value of the common stock (this is the same as OWM or SWM)  MVA and EVA Finance 311 17 .

Three Basic Factors Determine C/S Market Value 1) Amount of 2) Timing of 3) Risk of Also. interest rates and tenor of the market Finance 311 18 Expected cash flows .

Risk-Return Tradeoff    We will assume that firms and investors are risk averse “There is no such thing as a free lunch” “Do you want to sleep well or eat well?” Finance 311 19 .

SWM  Considers the timing and risk of the benefits from stock ownership  Determines that a good decision increases the price of the firm's common stock ( c/s )  Is an impersonal objective  Is concerned for social responsibility and ethics Finance 311 20 .

Managers Must Avoid personal conflicts Maintain confidentiality Be objective Act fairly (essentially.Social Responsibility  Ethical issues will constantly confront financial managers as they achieve the goal of the firm ( SWM ). treat others as you would have them treat you) Finance 311 21 .

Which will determine  Expected cash flows  Risk of expected cash flows  Timing of expected cash flows  Conditions in financial markets  Interest rates  Tenor of the market Finance 311 22 .Conditions Affecting Market Value  Economic environment factors  Managerial Decisions -.

Stockholders elect a board of directors Board of directors then hire management ( officers ) Finance 311 23 .

Who Manages?  Board of directors deals with broad policy  Management makes most of the decisions  3 to 5 year strategic plan  Day-to-day decisions following the strategic plan Finance 311 24 .

Stockholder Rights  Dividend Voting Asset Preemptive Finance 311 25    .

wachovia.com/ http://www.com/us/ http://www.com Finance 311 26 (highest) .ibm.Priority of Corporate Securities Bonds Preferred stock Common stock (C/S) (lowest) Major corporate Web sites http://www.ge.bankofamerica.com/ http://www.

One Agency Relationships / Problems Owners (shareholders)  Problem created by separation of Management and Employees  Management maximizes their own welfare instead of the owners wealth Job Security Finance 311 27 .

Job Security    Management decisions based on retaining management rather than SWM Example–A decision to retain suppliers rather than selecting new suppliers providing higher quality or lower cost Why–If the transition is mishandled management will be scrutinized but if no change is made the issue will be ignored Finance 311 28 .

g. Management incentives (e. stock options) B. bonding) D.g. auditing) C. Monitor performance (e.g.Agency Costs A. Complex Organizational Structures Pervasive Trends Flatten organization structures to cut costs Incorporate Technology in Managing Eliminate “Back Office” Operations Finance 311 29 . Owners protection (e.

Agency Problem created by separation of Owners Management Owners A second and similar Agency problem Creditors Protective covenants in loan agreements Finance 311 30 .

Agency Problem between Stockholders and Creditors   Creditor’s return is limited (fixed) by interest rate on debt Stockholders have limited liability and potential for unlimited returns. They are willing and rewarded for taking risks. Finance 311 31 .

Examples of Protective Covenants  Limitations on  common stock dividends  the type of investments divestitures additional debts    poison puts Finance 311 32 .

Competitive Factors Influencing C/S Market Value      New entrants Substitute products Bargaining power of buyers Bargaining power of suppliers Rivalry among current competitors Finance 311 33 .

Cash Flow Concept Used for    Financial analysis Planning Resource allocation CF does not equal accounting profit Internal sources Cash Finance 311 External sources 34 .

Shareholder Wealth Maximizing Is a Market Concept and Results in   Maximizing PV of E(R) Measured by Market Value of C/S Finance 311 35 .

NPV of an Investment   NPV = PV of future cash inflows minus PV of cash outflows The NPV of an investment represents the contributions of that investment to the value of the firm and affects the Stockholders’ Wealth Maximization (SWM)  EVA and MVA Finance 311 36 .

Large Corporations Fundamental concepts are the same .Small Business Vs.

Small Business 1) 2) 3) 4) 5) 6) 7) 8) Not the dominant firm in the industry Tend to grow more rapidly Limited access to financial markets Lack management resources Have a high failure rate Stock is not publicly traded Poorly diversified Owner/manager frequently the same Finance 311 38 .

Treasurer’s Activities       Management of cash and marketable securities Capital Budgeting Financial Planning Credit Analysis Investor Relations Pension Fund Management Finance 311 39 .

Controller’s Activities     Financial Accounting Cost Accounting Taxes Data Processing Finance 311 40 .

Disciplines Impacting Finance Economics Accounting Marketing Production Human Resources Quantitative Analysis MIS Finance Finance 311 41 .

Professional Organizations       Financial Executives International Institute of Chartered Financial Analysts Financial Management Association Credit Management Association Institute of Certified Financial Planners Institute of Management Accountants Finance 311 42 .

Investor Relations Assistant Treasurer Tax Manager Financial Planner         Banker Financial Analyst Mutual Fund Manager Account Executive.careerpath.com/ Finance 311 .Exciting Career Opportunities in Finance        Certified Cash Manager Credit Manager Vice President of Finance (CFO) Director. Security Broker Mortgage Analyst Investment Banker Real Estate Analyst Insurance Broker 43 Check out http://www.