Chapter 1

The
The Role
Role of
of Financial
Financial
Management
Management
COURSE DESCRIPTION/OBJECTIVES:
• Every decision that a business makes has financial implications, and
any decision which affects the finances of a business is a corporate
finance decision. The objectives of the course is
• To provide the students basic concepts of corporate finance
• To provide students with an in-depth knowledge of business
finance concepts, principles and methods and
• To develop the ability and skills to develop finance concepts to be
applied in different organizations.
• to help the students to understand the financial problems faced
by the business today, as well as the best way to solve these problems
2
RECOMMENDED TEXTBOOKS:
• Fundamentals of Financial Management by James C Van Horne (13th/
Latest Edition)
• Fundamentals of Financial Management by Eugene F. Brigham (12th/
Latest Edition)
• Fundamentals of Corporate Finance By Ross Wester field and Jordon
(9th/Latest Edition)

3
Why should I care about Financial
Management ?
• Prepare for the workplace of tomorrow.
• Broadening expectations of financial knowledge and skills.
• Use and understand financial terminology and concepts in
team communication.
• Developing cross-functional capabilities.
• Critical thinking.

4
The Role of
Financial Management
• What is Financial Management?
• The Goal of the Firm
• Corporate Governance
• Organization of the Financial Management
Function

5
What is Financial Management?
Financial Management concerns with the
1. acquisition,
2. financing, and
3. management
of organization’s assets with some overall goal in mind.

6
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?

7
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 (e.g.,
dividend-payout ratio)?
• How will the funds be physically acquired?

8
Asset Management Decisions
• How do we manage existing assets efficiently?
• Financial Manager has varying degrees of
operating responsibility over assets.
• Greater emphasis on current asset
management than fixed asset management.

9
What is the Goal of the
Firm?

Maximization of
Shareholder Wealth!
Value creation occurs when we maximize
the share price for current shareholders.

10
Corporate Social Responsibility
Discussion
Class Discussion: What role should CSR and/or
sustainability have on living the “goal of the firm”?

Corporate Social Responsibility (CSR): A business

outlook that acknowledges a firm’s responsibilities to
its stakeholders and the natural environment.
Sustainability: Meeting the needs of the present without
compromising the ability of future generations to meet
their own needs.
11
What Goals do some Firms have?
• “Creating superior shareholder value is our top priority.”
Associated Banc-Corp 2006 Annual Report.
• “The desire to increase shareholder value is what drives our
actions.” Phillips 2006 Annual Report.
• “FedEx’s main responsibility is to create shareholder value.” FedEx
Corporation, SEC Form Def 14A for the period ending 9/25/2006.
• “… the Board of Directors plays a central role in the Company’s
corporate governance system; it has the power (and the duty) to
direct Company business, pursuing and fulfilling its primary and
ultimate objective of creating shareholder value.” Pirelli & C.
S.p.A. Milan Annual Report 2006.
12
Shortcomings of Alternative
Perspectives
Profit Maximization
• Maximizing a firm’s earnings after taxes.
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.

13
Shortcomings of Alternative Perspectives

Earnings per Share Maximization

• Maximizing earnings after taxes divided by
shares outstanding.
Problems
• Does not specify timing or duration of expected
returns.
• Ignores changes in the risk level of the firm.
• Calls for a zero payout dividend policy.
14
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.

15
The Modern Corporation

Modern Corporation

Shareholders Management

There exists a SEPARATION between owners and

managers.

16
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.

17
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.

18
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.

19
Corporate Social Responsibility

• Wealth maximization does not preclude the

firm from being socially responsible at the
corporate level.
• Assume we view the firm as producing both
private and social goods.
• Then shareholder wealth maximization
remains the appropriate goal in governing the
firm.

20
Corporate Governance
• Corporate governance: represents the system
by which corporations are managed and
controlled.
• Includes shareholders, board of directors,
and senior management.
• Then shareholder wealth maximization
remains the appropriate goal in governing the
firm.

21
Organizational Structure
Business Legal Entities
• Sole Proprietorship :
• It is an unincorporated business owned by one individual.
• Going into a business as a sole proprietor is simple – one merely has
to begin business operations.
• Proprietorship consists of 80% of the total number of businesses
worldwide.
Sole Proprietorship
Advantages:
• It is easily & inexpensively formed.
• It is subject to few government regulations.
• The business pays no corporate income tax; only personal income tax is
paid by the proprietor.
Limitations:
• It is difficult for a proprietorship to obtain large sums of capital.
• The proprietor has unlimited personal liability for the business debts, which
can result in losses hat exceed the money invested by him in the business.
• The life of the business organized as proprietorship is limited to the life of
the individual who created it.
Partnership
• A partnership exists whenever two or more persons associate to conduct a non-
corporate business. It could be registered or unregistered.
• A Partnership Firm has no separate legal entity distinct from its partners. A
Company, on the other hand, is a separate legal entity different from its members.
Advantages:
• Low cost involved
• Ease of formation.
Limitations:
• Unlimited Liability.
• Limited life of the organization.
• Difficulty of transferring ownership.
• Difficulty of raising large amounts of capital.
Corporation
• A corporation is a limited company and a separate legal entity
registered by the government.
• It is separate & distinct from its owners & managers.
• It Can be Private Limited (Pvt. Ltd.) or Public Limited (which may be
listed on Stock Exchange).
• The businesses in the form of corporations control 80% of global sales
of products and services.
Corporation
Advantages:
Unlimited life:
• A corporation can continue even after the death of its original owners.
Easy transferability of ownership interest:
• Ownership interests can be divided into shares of stock, which in turn can be
transferred far more easily than can proprietorship & partnership interests.
Limited Liability:
• The liability of the shareholders is limited up to the extent of nominal value
of shares held by them. Creditors and banks cannot confiscate personal
properties of director & shareholders in case of its bankruptcy.
Corporation
Limitations:

• Double Taxation:
Corporate earnings may be subject to double taxation – the earnings of
the corporation are taxed at corporate level, and then any earnings paid
out as dividends are taxed again as income to the stockholders.
• Legal Formalities:
Setting up a corporation, and filing many official documents, is more
complex and time consuming than for a proprietor ship or a
partnership.
Corporation
Advantages:
Unlimited life:
• A corporation can continue even after the death of its original owners.
Easy transferability of ownership interest:
• Ownership interests can be divided into shares of stock, which in turn can
be transferred far more easily than can proprietorship & partnership
interests.
Limited Liability:
• The liability of the shareholders is limited up to the extent of nominal
value of shares held by them. Creditors and banks cannot confiscate
personal properties of director & shareholders in case of its bankruptcy.
Corporation
Limitations:

• Double Taxation:
Corporate earnings may be subject to double taxation – the earnings
of the corporation are taxed at corporate level, and then any earnings
paid out as dividends are taxed again as income to the stockholders.
• Legal Formalities:
Setting up a corporation, and filing many official documents, is more
complex and time consuming than for a proprietor ship or a
partnership.
Internal Business Environment:
• Internal environment of business normally consists of the following.
• Finance
• Marketing
• Human Resources
• Operations (Production, Manufacturing)
• Technology
• Other Functions (Logistics, Communications)
External Business Environment
The following business environment factors outside an organization
have a profound effect on the functions and operations of an
organization.
• Customers
• Suppliers
• Competitors
• Government/Legal Agencies & Regulations
• Macro Economy/Markets:
• Technological Revolution
SWOT ANALYSIS
An analysis which is used in a business is called SWOT Analysis. SWOT is
an acronym where
• S stands for Strengths
• W stands for Weaknesses
• O stands for Opportunities
• T stands for Threats
• Strengths and weaknesses are within an organization, i.e., they pertain
to the internal environment of the organization.
• Opportunities and threats, on the other hand, pertain to the external
environment, i.e., outside the organization.