Chapter 1

The Role of Financial

Management
© 2001 Prentice-Hall, Inc.
Fundamentals of Financial Management, 11/e
Created by: Gregory A. Kuhlemeyer, Ph.D.
Carroll College, Waukesha, WI
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 The Role of
Financial Management

 What is Financial
Management?
 The Goal of the Firm
 Organization of the Financial
Management Function

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 What Is Finance?
 Finance can be defined as the art and science of managing
money.
 Virtually all individuals and organizations earn or raise money
and spend or invest money.
 Finance is concerned with the process, institutions, markets,
and instruments involved in the transfer of money among
individuals, businesses, and governments.
 Most adults will benefit from an understanding of finance, which
will enable them to make better personal financial decisions.
 Those who work in financial jobs will benefit by being able to
interface effectively with the firm’s financial personnel,
processes, and procedures.

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 Role of Financial Manager
 Financial managers actively manage the financial
affairs of any type of businesses—financial and
nonfinancial, private and public, large and small,
profit-seeking and not-for-profit.
 They perform such varied financial tasks
 Planning
 extending credit to customers
 evaluating proposed large expenditures
 raising money to fund the firm’s operations.

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 Relationship to Accounting
Emphasis on Cash Flows:
 The accountant’s primary function is to develop and report data
for measuring the performance of the firm, assessing its
financial position, and paying taxes.
 Using certain standardized and generally accepted principles,
the accountant prepares financial statements that recognize
revenue at the time of sale (whether payment has been received
or not) and recognize expenses when they are incurred.
 This approach is referred to as the accrual basis.

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 Cont.…
Emphasis on Cash Flows:
 The financial manager, on the other hand, places primary
emphasis on cash flows, the intake and outgo of cash. He or
she maintains the firm’s solvency by planning the cash flows
necessary to satisfy its obligations and to acquire assets needed
to achieve the firm’s goals.
 The financial manager uses this cash basis to recognize the
revenues and expenses only with respect to actual inflows and
outflows of cash.
 Regardless of its profit or loss, a firm must have a sufficient flow
of cash to meet its obligations as they come due.

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 Example:

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 Decision Making
 The second major difference between finance and
accounting has to do with decision making.
Accountants devote most of their attention to the
collection and presentation of financial data.
 Financial managers evaluate the accounting
statements, develop additional data, and make
decisions on the basis of their assessment of the
associated returns and risks.

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 What is Financial
Management?
Concerns the acquisition, financing,
and management of assets with
some overall goal in mind.
 the decision function of financial management
can be broken down into three major areas:
 The investment,
 The financing,
 The asset management

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 Investment Decisions
Most important of the three
decisions.
 What is the optimal firm size?
 What specific assets should be
acquired? (the composition of the
assets)
 Disinvestment what assets (if any)
should be reduced or eliminated?
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 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?
 Howwill the funds be physically
acquired? short-term loan, long-term lease
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 Asset Management
Decisions
 How do we manage existing assets
efficiently?
 Financial Manager has varying degrees
of operating responsibility over assets.
i.e. Greater emphasis on current
asset management than fixed asset
management.
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 What is the Goal
of the Firm?
Maximization of Shareholder
Wealth!

Shareholder wealth is represented by the market

price per share of the firm’s common stock,
which, in turn, is a reflection of the firm’s
investment, financing, and asset management
decisions.

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 Value Creation

Value creation occurs when we

maximize the share price for
current shareholders.

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 Shortcomings of
Alternative Perspectives
Profit Maximization
 Maximizing a firm’s earnings after taxes.
To achieve this goal, the financial manager would take only those
actions that were expected to make a major contribution to the firm’s
overall profits.
For each alternative being considered, the financial manager would
select the one that is expected to result in the highest monetary return.

Problems
 Could increase current profits while harming firm (e.g., defer
maintenance, issue common stock to buy T-bills, etc.).
 Ignores changes in the risk level of the firm.

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 Shortcomings of
Alternative Perspectives
Earnings per Share Maximization
Maximizing earnings after taxes divided
by shares outstanding.
Problems
 Doesnot specify timing or duration of
expected returns.
 Ignores changes in the risk level of the firm.
 GreaterEPS does not necessarily means that
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 Example:

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 Strengths of Shareholder
Wealth Maximization
Takes account of: current and future
profits and EPS; the timing,
duration, and risk of profits and EPS;
dividend policy; and all other
relevant factors.
Thus, share price serves as a
barometer for business performance.
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 The Modern Corporation

Modern Corporation

Shareholders Management

There exists a SEPARATION

between owners and managers.
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 Role of Management
Management acts as an agent
for the owners (shareholders)
of the firm.
 An agent is an individual
authorized by another person,
called the principal, to act in
the latter’s behalf.
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 Agency Problems
 The objectives of management may
differ from those of the firm’s
shareholders.
 Thus this separation of ownership
from management creates a situation
in which management may act in its
own best interests rather than those
of the shareholders.
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 Agency Theory

Jensen and Meckling developed

a theory of the firm based on
agency theory.
Agency Theory is a branch of
economics relating to the
behavior of principals and their
agents.
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 Agency Theory

Principals must provide incentives

so that management acts in the
principals’ best interests and then
monitor results.
Incentives include stock options,
perquisites, and bonuses.

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 Governance and Agency:
Corporate Governance

• Corporate governance refers to the rules,

processes, and laws by which companies are
operated, controlled, and regulated.
• It defines the rights and responsibilities of the
corporate participants such as the
shareholders, board of directors, officers and
managers, and other stakeholders, as well as
the rules and procedures for making corporate
decisions.
© 2012 Pearson Prentice Hall. All rights reserved. 1-25
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 Governance and Agency:
Government Regulation

• Government regulation generally shapes the

corporate governance of all firms.
• During the recent decade, corporate
governance has received increased attention
due to several high-profile corporate scandals
involving abuse of corporate power and, in
some cases, alleged criminal activity by
corporate officers.

© 2012 Pearson Prentice Hall. All rights reserved. 1-26

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 Governance and Agency:
Government Regulation

 The Sarbanes-Oxley Act of 2002:

• established an oversight board to monitor the accounting industry;
• tightened audit regulations and controls;
• toughened penalties against executives who commit corporate
fraud;
• strengthened accounting disclosure requirements and ethical
guidelines for corporate officers;
• established corporate board structure and membership guidelines;
• established guidelines with regard to analyst conflicts of interest;
• mandated instant disclosure of stock sales by corporate executives;
• increased securities regulation authority and budgets for auditors
and investigators.
© 2012 Pearson Prentice Hall. All rights reserved. 1-27
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 Social Responsibility
 Wealth maximization does not
preclude the firm from being socially
responsible.
 Assume we view the firm as producing
both private and social goods.
 Then shareholder wealth maximization
remains the appropriate goal in
governing the firm.
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 Organization of the Financial
Management Function

Board of Directors

President
(Chief Executive Officer)

Vice President VP of Vice President

Operations Finance Marketing

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 Organization of the Financial
Management Function

VP of Finance
Treasurer Controller
Capital Budgeting Cost Accounting
Cash Management Cost Management
Credit Management Data Processing
Dividend Disbursement General Ledger
Fin Analysis/Planning Government Reporting
Pension Management Internal Control
Insurance/Risk Mngmt Preparing Fin Stmts
Tax Analysis/Planning Preparing Budgets
Preparing Forecasts
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