Chapter 1

1. Chapter 1 The Role of Financial Management The Role of Financial Management

2. After studying Chapter 1, you should be able to: • Explain why the role of the financial manager today is so important. • Describe "financial management" in terms of the three major decision areas that confront the financial manager. • Identify the goal of the firm and understand why shareholders' wealth maximisation is preferred over other goals. • Understand the potential problems arising when management of the corporation and ownership are separated (i.e., agency problems). • Demonstrate an understanding of corporate governance. • Discuss the issues underlying social responsibility of the firm. • Understand the basic responsibilities of financial managers and the differences between a "treasurer" and a "controller."

3. Finance vs Accounting • In Finance, we are concerned with transactions that are cash, or affect cash flows, only. • Accounting deals with transactions that affect both cash and non-cash activities.

4. Key Points • Financial management is concerned with achieving the goal of the firm – maximising the wealth of its owners (the shareholders). • This is achieved through careful and wise control of the acquisition, financing and management of its assets and involves three decision functions: • Investment decisions • Financing decisions • Asset management decisions

5. Course Map • Introduction - Chapters 1, 2, 6, 7 • Subject Investment Financing Asset Mgt • Time Value Ch3 Ch3 • Valuation Ch 4 • Risk Ch 5 Ch 5 • Mgt Work Cap. Ch 11 Chs 8-11 • Capital Invest. Chs 12-13 Ch 12 • Cost of Capital Ch 15 • Lev. & Cap. Struct. Chs 16-17

6. Definition of Finance • Finance: • is about making decisions regarding what assets to buy/sell and when to buy/sell these assets. • its main objective is to make individuals and their businesses better off. • Thus, it concerns the buying/selling of, the financingof, and the managment of assets with some overall goalin mind.

7. Three Decisions • Investment decision • Financing decision • Asset management decision

8. Investment Decision This is the 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 sold?

9. Financing Decision 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 obtained?

10. Asset Management Decision • 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.

11. What is the Goal of the Firm? Maximisation of Shareholder Wealth! Value creation occurs when we maximise the share price for current shareholders.

12. What is the Goal of the Firm? • Maximising shareholder wealth: • The goal of the firm, its managers and employees • Measured by share price

13. Shortcomings of Alternative Goals • Profit Maximisation • Maximising 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 (treasury bills), etc.). • Ignores changes in the risk level of the firm. • Can manipulate profits by changing accounting policies

14. Shortcomings of Alternative Goals • Earnings per Share Maximisation • Maximising earnings after taxes divided by number of shares on issue. • 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.

15. Strengths of Shareholder Wealth Maximisation • 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 priceserves as the best indicator of business performance.

16. The Modern Corporation There exists a SEPARATION between owners and managers. Modern Corporation Shareholders Management

17. The Agency Model • Agency relationship (between the owners (shareholders) and managers of the business) • Agency conflict • Why does it arise? • How can it be minimised? • Principal-agent problem • Agency theory • Agency costs

18. Role of Management Management acts as an agentfor the owners (shareholders) of the firm. • An agent is an individual authorised by another person, called the principal, to act in the principal’s behalf.

19. Agency Theory • Agency Theory is a branch of economics relating to the behavior of principals and their agents.

20. Agency Theory • Incentives include,stock options,perquisites (company car, expense account),andbonuses. • Principals must provide incentivesso that management acts in the principals’ best interests and then monitorresults.

21. Corporate Social Responsibility • Wealth maximization does not stop the firm from being socially responsible at the corporate level. • Assume we view the firm as producing both private and social goods. • Thenshareholder wealth maximisationremains the appropriate goal in governing the firm.

22. Corporate Governance • Corporate governance: represents the system by which corporations are managed and controlled. • Includes shareholders, board of directors, and senior management. • Thenshareholder wealth maximisationremains the appropriate goal in governing the firm.

23. Board of Directors • Typical responsibilities: • Set company-wide policy; • Advise the CEO and other senior executives; • Hire, fire, and set the compensation of the CEO; • Review and approve strategy, significant investments, and acquisitions; and • Oversee operating plans, capital budgets, and financial reports to common shareholders. • CEO/Chairman roles commonly same person in US, but separate in Britain (US moving in this direction).

24. Sarbanes-Oxley Act of 2002 • Sarbanes-Oxley Act of 2002 (SOX): addresses corporate governance, auditing and accounting, executive compensation, and enhanced and timely disclosure of corporate information. • Arose as a result of major US corporate scandals and accounting fraud in the late 1990s and early 2000s (e.g Enron, WorldCom, and other corporations) • Imposes new penalties for violations of securities laws. • Established the Public Company Accounting Oversight Board (PCAOB) to adopt auditing, quality control, ethics, disclosure standards for public companies and their auditors, and policing authority. • Generally increasing the standards for corporate governance.

25. Organisation of the Financial Management Function Board of Directors President (Chief Executive Officer) Executive Vice President (Operations) Executive Vice President (Finance - CFO) Executive Vice President (Marketing)

26. Organisation of the Financial Management Function EVP of Finance • Vice President (Treasurer) • Capital Investment • Cash Management • Commercial/investment banking relationships • Credit Management • Dividend Disbursement • Financial Analysis/Planning • Investor Relations • Mergers and Acquisitions • Pension Management • Insurance/Risk Management • Tax Analysis/Planning • Controller • Cost Accounting • Cost Management • Data Processing • General Ledger • Government Reporting • Internal Control • Preparing Financial Statements • Preparing Budgets • Preparing Forecasts