Chap001

The Goals and Functions of Financial Management : 

The Goals and Functions of Financial Management 1

Chapter Outline : 

1-2 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

Financial Management : 

1-3 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.

Relationship between Finance, Economics and Accounting : 

1-4 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.

Evolution in the Field of Finance : 

1-5 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.

Evolution in the Field of Finance (cont’d) : 

1-6 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

Recent Issues in Finance : 

1-7 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.

Recent Issues in Finance (cont’d) : 

1-8 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.

Advances in Internet and Finance : 

1-9 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

Advances in Internet and Finance (cont’d) : 

1-10 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.

Functions of the Financial Manager : 

1-11 Functions of the Financial Manager

Risk-Return Trade-Off : 

1-12 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

Sole Proprietorship : 

1-13 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.

Partnership : 

1-14 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.

Corporation : 

1-15 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.

Corporation (cont’d) : 

1-16 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.

Corporate Governance : 

1-17 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)

Sarbanes-Oxley Act of 2002 : 

1-18 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 publicly-traded corporations accurately present their assets, liabilities, and equity and income on their financial statements.

Goals of Financial Management : 

1-19 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.

Social Responsibility : 

1-20 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.

Ethical Behavior : 

1-21 Ethical Behavior Ethical behavior creates invaluable reputation. Insider trading Protected against by the Securities and Exchange Commission (SEC).

The Role of Financial Markets : 

1-22 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

Structure and Functions of the Financial Markets : 

1-23 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.

Stocks versus Bonds : 

1-24 Stocks versus Bonds Stock = ownership or equity Stockholders own the company Bond = debt or IOU Bondholders are owed $ by company

Allocation of Capital : 

1-25 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.

Return Maximization and Risk Minimization : 

1-26 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 high-priced 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.

Restructuring : 

1-27 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.

Internationalization of Financial Markets : 

1-28 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.

Technological Impact on Capital Market : 

1-29 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.