©2009 McGraw-Hill Ryerson Limited 1 of The Goals and Functions of Financial Management ©2009 McGraw-Hill Ryerson Limited Prepared by: Michel Paquet SAIT Polytechnic

©2009 McGraw-Hill Ryerson Limited 2 of 22 Chapter 1 - Outline What is Finance? Goals of Financial Management Functions of Financial Management Forms of Organization Role of Financial Markets Summary and Conclusions

©2009 McGraw-Hill Ryerson Limited 3 of 22 Learning Objectives 1.Illustrate how finance builds on the discipline of accounting and economics. (LO1) 2.Identify the analysis and decision-making nature of finance considering return and risk. (LO2) 3.Examine the primary goal of finance as the maximization of shareholder wealth as measured by share price. (LO3) 4.Debate alternative goals of the firm on the basis of social or management interest. (LO4)

©2009 McGraw-Hill Ryerson Limited 4 of 22 Learning Objectives 5.Identify financial manager functions connected to the raising and investing of funds. (LO5) 6.Outline the role of financial markets in allocating capital, determining value and establishing yields. (LO6)

©2009 McGraw-Hill Ryerson Limited 5 of 22 What is Finance? Finance is about making decisions that focus on creating value within the firm. Finance builds upon the disciplines of economics and accounting. -- economics provides theories about economic system and decision making, -- accounting supplies financial data and data analysis tools. Finance has evolved from a pure descriptive discipline through an analytical, decision- oriented discipline to now a discipline used by financial managers. LO1

©2009 McGraw-Hill Ryerson Limited 6 of 22 What is Finance? Finance tries to help financial managers to answer (i.e. make decisions about) the following questions: 1. What long-term investments or projects the firm should undertake? (capital budgeting decision) 2. How the firm should pay for these assets? By issuing equity or debt? (capital structure decision) 3. How much cash or inventory the firm should carry? How much trade credit the firm should provide or use? (working capital management decision) These decisions are made within a risk-return framework. LO2

©2009 McGraw-Hill Ryerson Limited 7 of 22 Goals of Financial Management The primary goal is shareholder wealth maximization because the firm is owned by the shareholders. This goal should be measured in terms of market share price, which is a value that investors collectively are prepared to pay. The closest alternative – profit – fails to consider risk and timing and more importantly, it is almost impossible to accurately measure profit. LO3

©2009 McGraw-Hill Ryerson Limited 8 of 22 Goals of Financial Management The goal of maximizing shareholder wealth may conflict with - interests of management (their compensation) - social/ethical goals Agency theory is about the potential conflict between shareholders and managers. Tradeoffs exist among the agency costs of monitoring management actions, allowing sufficient discretion for management and designing compensation packages to motivate management. LO3

©2009 McGraw-Hill Ryerson Limited 9 of 22 Goals of Financial Management The goal of shareholder wealth maximization can be consistent with a concern for social responsibility. Firms should take socially desirable actions even if certain actions like pollution control may at times conflict with this goal. Managers should strictly follow the rules of fairness and honesty. Insider trading and manipulation of financial results have been proven to serve the firm/shareholders as well as the management no good. LO4

©2009 McGraw-Hill Ryerson Limited 10 of 22 Functions of Financial Management The study of finance has a variety of functions -Corporate finance -Banking -Securities trading and underwriting -Money management -Financial planning -Risk management (insurance) Some of these functions are performed on a daily basis and others are less routine. All these functions are carried out with the intention to proper balance profitability against risk. LO5

©2009 McGraw-Hill Ryerson Limited 11 of 22 Trade-off Daily Cash management (receipt and disbursement of funds) Credit management Inventory control Short-term financing Exchange and interest rate hedging Bank relations Intermediate financing Bond issues Leasing Stock issues Capital budgeting Dividend decisions Forecasting Profitability Risk Goal: Maximize shareholder wealth Figure 1-1 Functions of the Financial Manager Occasional LO5

©2009 McGraw-Hill Ryerson Limited 12 of 22  Profitability   Risk  Profitability   Risk e.g. investing in stocks vs. savings accounts Stocks may be more profitable but are riskier Savings accounts are less profitable and less risky (or safer) Financial manager must choose appropriate combination of potential profit (return) and level of risk (safety) Risk-Return Tradeoff LO6

©2009 McGraw-Hill Ryerson Limited 13 of 22 Forms of Organization Sole Proprietorship (one owner) - largest in actual number but smallest in total sales revenue Partnership (two or more owners) Corporation (legal entity unto itself) - smallest in actual number but largest in total sales revenue LO5

©2009 McGraw-Hill Ryerson Limited 14 of 22 A business owned by one person Freedom Freedom Simplicity Low Start Up Costs Tax Benefits UnlimitedLiability Lack of Continuity Lack of Continuity Difficulty in Raising Money Reliance on One Person Reliance on One Person Advantages Disadvantages Forms of Organization: Sole Proprietorships LO5

©2009 McGraw-Hill Ryerson Limited 15 of 22 Greater Talent Pool Greater Talent Pool More Capital Ease of Formation Ease of Formation Tax Benefits Unlimited Liability Unlimited Liability Lack of Continuity OwnershipTransferDifficult Possibility of Conflict A business venture with two or more owners A business venture with two or more owners Advantages Disadvantages Disadvantages Forms of Organization: Partnerships LO5

©2009 McGraw-Hill Ryerson Limited 16 of 22 Limited Liability Limited Liability Continuity Continuity Greater Likelihood Greater Likelihood of Professional of Professional Management Management Easier Access to Easier Access to Money Money Potential Shareholder Revolts Revolts Higher Start-Up Costs Costs Regulation Double Taxation Double Taxation A corporation is a separate legal entity Advantages Disadvantages Forms of Organization: Corporations LO5

©2009 McGraw-Hill Ryerson Limited 17 of 22 Role of Financial Markets Financial markets are a vast global network of corporations, financial institutions, governments and individuals that either need money or have money to lend or invest Public financial markets are those markets for governments to borrow funds for public activities Corporate financial markets are those markets for corporations to raise funds The effect of managerial decisions on the value of the firm is realized in financial markets LO6

©2009 McGraw-Hill Ryerson Limited 18 of 22 Structure and Functions of Financial Markets Money markets deal in short-term securities (<1 year) –e.g. Treasury Bills, commercial paper Capital markets deal in long-term securities –e.g. common stock, preferred stock, corporate bonds, government bonds Primary market is where a firm issues new bonds or shares Secondary market is where investors buy and sell (trade) outstanding bonds or shares LO6

©2009 McGraw-Hill Ryerson Limited 19 of 22 Securities in Financial Markets Stock (Share) = ownership or equity Shareholders own the company Bond = debt or liability Bondholders are owed $ by company LO6

©2009 McGraw-Hill Ryerson Limited 20 of 22 Role of Financial Markets Financial markets determine value and allocate capital to the most productive use on a risk-return basis Trend in financial markets –reliance on debt, and low but volatile interest rates –internationalization LO6

©2009 McGraw-Hill Ryerson Limited 21 of 22 Figure 1-2 Prime rate versus percent change in the CPI LO6 Source: Bank of Canada

©2009 McGraw-Hill Ryerson Limited 22 of 22 Summary and Conclusions Finance links economics and accounting. It helps managers make decisions to maximize shareholder wealth. However, managers may pursue their own interests instead of those of shareholders. Agency theory studies the conflicts between shareholders and management. Financial managers make investment and financing decisions. Financial markets are where financial managers raise funds and are given feedback about the effect of their decisions.