Chap 001

1

The Goals and Functions of Financial Management

Chapter McGraw-Hill/Irwin

Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

Chapter Outline • • • • • • •

Introduction to Finance Risk-Return Tradeoff Forms of Organizations Corporate Governance Goals of Financial Management Social Responsibility and Finance Role of Financial Markets 1-2

Financial Management  Financial Management or business finance is concerned with managing an entity’s money.  For example, a company must decide: − where to invest its money. − whether or not to replace an old asset. − when to issue new stocks and bonds. − whether or not to pay dividends. 1-3

Relationship between Finance, Economics and Accounting • Economics provides structure for decision making in many important areas. − Provides a broad picture of economic environment.

• Accounting provides financial data in various forms. – Income statements, balance sheets, and statement of cashflows.

• Finance links economic theory with the numbers of accounting. 1-4

Evolution in the Field of Finance • At the turn of the century: Emerged as a field separate from economics. • By 1930s: Financial practices revolved around such topics as: – Preservation of capital. – Maintenance of liquidity. – Reorganization of financially troubled corporation. – Bankruptcy. 1-5

Evolution in the Field of Finance (cont’d) • By mid-1950s: Finance becomes more analytical. – Financial Capital (accounting capital/ money) was used to purchase Real Capital (economic capital/ long-term plant and equipment). – Cash and inventory management – Capital structure theory – Dividend policy

1-6

Recent Issues in Finance • Recent focus has been on: – Risk-return relationships. – Maximization of returns for a given level of risk. – Portfolio management. – Capital structure theory.

• New financial products with a focus on hedging are being widely used.

1-7

Recent Issues in Finance (cont’d) • The following are significant to financial managers during decision making: – Effects of inflation and disinflation on financial forecasting. – Required rates of return for capital budgeting decisions. – Cost of capital.

1-8

Advances in Internet and Finance • Internet and its acceptance has enabled acceleration of e-commerce solutions for “old economy” companies. • E-commerce solutions for existing companies − B2C − B2B

• Spurt in new business models and companies − Amazon.com − eBay

1-9

Advances in Internet and Finance (cont’d) • For a financial manager e-commerce impacts financial management because it affects the pattern and field through which cash flows through the firm. – B2C Model: Products are bought with credit cards, credit card checks are performed, and selling firms get the cash flow faster. – B2B: Orders can be placed, inventory managed, and bids to supply products can be accepted – all online. 1-10

Functions of the Financial Manager

1-11

Risk-Return Trade-Off • Influences operational side (capital versus labor/ Product A versus Product B) • Influences financial mix (stocks versus bonds versus retained earnings) − Stocks are more profitable but riskier. − Savings accounts are less profitable and less risky (or safer)

• Financial manager must choose appropriate combinations 1-12

Sole Proprietorship • Represents single-person ownership • Advantages: – Simplicity of decision-making. – Low organizational and operational costs.

• Drawback – Unlimited liability to the owner. – Profits and losses are taxed as though they belong to the individual owner. 1-13

Partnership • Similar to sole proprietorship except there are two or more owners. – Articles of partnership: Specifies ownership interest, the methods for distributing profits, and the means of withdrawing from the partnership. – Limited partnership: One or more partners are designated as general partners and have unlimited liability of the debts of the firm; other partners designated limited partners and are liable only for their initial contribution. 1-14

Corporation • Corporation − Articles of incorporation: Specify the rights and limitations of the entity. − Its owned by shareholders who enjoy the privilege of limited liability. − Has a continual life.

− Key feature is the easy divisibility of ownership interest by issuing shares of stock. 1-15

Corporation (cont’d) • Disadvantage: – The potential of double taxation of earnings. • Subchapter S corporation: Income is taxed as a direct income to stockholders and thus is taxed only once as normal income.

1-16

Corporate Governance • Agency theory – Examines the relationship between the owners and managers of the firm.

• Institutional investors – Have more to say about the way publicly owned companies are managed. − Public Company Accounting Oversight Board (PCAOB)

1-17

Sarbanes-Oxley Act of 2002 • Set up a five member Public Company Accounting Oversight Board (PCAOB) with responsibility for: – Auditing standards within companies – Controlling the quality of audits – Setting rules and standards for the independence of the auditors.

• Major focus is to make sure that publiclytraded corporations accurately present their assets, liabilities, and equity and income on their financial statements. 1-18

Goals of Financial Management • Valuation Approach • Maximizing shareholder wealth (shareholder wealth maximization) • Management and stockholder wealth − Retention of position of power in long run is by becoming sensitized to shareholder concerns. − Sufficient stock option incentives to motivate achievement of market value maximization. − Powerful institutional investors are increasing management more responsive to shareholders. 1-19

Social Responsibility • Adoption of policies that maximize values in the market attracts capital, provides employment and offers benefits to the society. • Certain cost-increasing activities may have to be mandatory rather than voluntary initially, to ensure burden falls equally over all business firms. 1-20

Ethical Behavior • Ethical behavior creates invaluable reputation. • Insider trading • Protected against by the Securities and Exchange Commission (SEC).

1-21

The Role of Financial Markets • Financial markets are indicators of maximization of shareholder value and the ethical or the unethical behavior that may influence the value of the company. • Participants in the financial market range over the public, private and government institutions. – Public financial markets – Corporate financial markets 1-22

Structure and Functions of the Financial Markets • Money markets − Securities in this market include commercial paper sold by corporations to finance their daily operations or certificates of deposit with maturities of less than 12 months sold by banks.

• Capital markets − Long-term markets − Securities include common stock, preferred stock and corporate and government bonds. 1-23

Stocks versus Bonds • Stock = ownership or equity − Stockholders own the company

• Bond = debt or IOU − Bondholders are owed $ by company

1-24

Allocation of Capital • Primary market – When a corporation uses the financial markets to raise new funds, the sale of securities is made by way of a new issue.

• Secondary market – When the securities are sold to the public (institutions and individuals). – Financial managers are given a feedback about their firms’ performance. 1-25

Return Maximization and Risk Minimization • Investors can choose risk level that meets their objective and maximizes return for that given level of risk. • Companies that are rewarded with highpriced securities can raise new funds in the money and capital markets at a lower cost compared to competitors. • Firms pay a penalty for failing to perform competitively. 1-26

Restructuring • Restructuring can result in: – Changes in the capital structure (liabilities and equity on the balance sheet). – Selling of low-profit-margin divisions with the proceeds of the sale reinvested in better investment opportunities. – Removal or large reductions in the of current management team.

• It has resulted in acquisitions and mergers. 1-27

Internationalization of Financial Markets • Allocation of capital and the search for low cost sources of financing on the rise in global market. • The impact of international affairs and technology has resulted in the need for future financial managers to understand − International capital flows. − Computerized electronic funds transfer systems. − Foreign currency hedging strategies. 1-28

Technological Impact on Capital Market • Consolidation among major stock markets and mergers of brokerage firms with domestic and international partners. • Electronic markets have gained popularity as against traditional organized exchanges and NASDAQ. • Resulted in the merger of NYSE with Archipelago and NASDAQ bought out Insinet from Reuters. 1-29