The Goals and Functions of Financial Management

1. The Goals and Functions of Financial Management 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

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.

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.

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.

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

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.

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.

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

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.

11. Functions of the Financial Manager

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

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.

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.

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.

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.

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)

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.

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.

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.

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

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

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.

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

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.

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.

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.

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.

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.