Contemporary Financial Management, 9th Edition Copyright ©2003 South-Western/Thomson Learning by Moyer, McGuigan, Kretlow Instructor: Wen-I Chuang

Copyright ©2003 South-Western/Thomson Learning Chapter 1 The Role and Objective of Financial Management

Introduction This chapter introduces the financial management process of the typical firm. It looks at the financial manager, the field of finance, financial decisions and their implications, and the daily questions faced by the firm’s financial management.

Questions Faced in Finance How is finance related to other fields of study? What are financial managers’ goals and objectives? How has the finance field evolved? How is the finance field changing today? More questions are listed in the text.

Principal Forms of Business Organizations Sole proprietorship Partnership Corporation

Sole Proprietorship Owned by one person Easy formation → advantage Unlimited liability → disadvantage Difficulty raising funds → disadvantage Represent 75 percent of all businesses Account for less than 6% of the dollar volume

Partnership Owned by two or more persons Classified as general or limited –General Partner: Has unlimited liability for all obligations of the business → disadvantage –Limited Partner: Liability limited to the partnership agreement → advantage Partnership dissolves when a general partner dies. → disadvantage

Corporation Limited liability Permanency Ability to raise capital Has a board of directors Owners are stockholders Flexibility Legal entity Easy marketability of shares of ownership All advantages

Board of Directors Stockholders elect a board of directors Board of directors then elect the officers –Chairman of the board –Chief executive officer (CEO) –Chief operating officer (COO) –President –Chief financial officer (CFO) –Vice presidents –Treasurer –Secretary Management

Who Manages? Board of directors deals with broad policy 3 to 5 year strategic plan Management makes most of the decisions Day-to-day decisions following the strategic plan

Stockholder Rights Dividend Voting Asset Preemptive

Priority of Corporate Securities Bonds (highest) Preferred stock Common stock (C/S) (lowest) Major corporate Web sites

Optimal Form of Organization Influenced by Cost Complexity Liability Continuity Raising capital Decision making Tax considerations

Shareholder Wealth Maximization (SWM) NOT Profit maximization, which does not consider the time value of money Objective of the financial manager Objective of financialmanagement Shareholder Wealth Maximization

Considers the timing and risk of the benefits from stock ownership Determines that a good decision increases the price of the firm’s common stock (C/S) Is an impersonal objective Is concerned for social responsibility

Social Responsibility Ethical issues will constantly confront financial managers as they achieve the goal of the firm (SWM). Avoid personal conflictsAvoid personal conflicts Maintain confidentialityMaintain confidentiality Be objectiveBe objective Act fairlyAct fairly Managers Must

Job security Job security Management may maximize its own welfare instead of the owners’ wealth. Owners (shareholders) Management and Employees Problem created by separation of Agency Relationships/Problems

Job Security Management decisions based on retaining management rather than SWM Example –A decision to retain suppliers rather than selecting new suppliers providing higher quality and/or lower cost –Why? If a change is made management will be scrutinized, but if no change is made, the issue will be ignored.

Agency Costs Management incentives Monitor performance Owners protection Complex organization structures Recent Trends Flatten organization structures to cut costs

Problems Problem created by separation of Owners Management A similar problem Owners Creditors Protective covenants in loan agreements

Problems Creditors have a fixed financial claim on the company’s resources in the form of long-term debt, bank loans, commercial papers, lease, accounts payable, taxes payable, and so on.

Examples of Protective Covenants Limitations on –common stock dividends –the type of investments –divestitures –additional debts –poison puts: A “poison puts” is an option contained in a bond indenture that permits the bondholder to sell the bond back to the issuing company at face value under certain circumstances, such as a leveraged buyout that raises the risk for existing debt holders.

Shareholder Wealth Maximizing Is a Market Concept and Results in Maximizing PV of E(R) Measured by Market Value of Common Stock (C/S)

Three Basic Factors Determine C/S Market Value 1) Amount of 2) Timing of 3) Risk of Expected cash flows

Conditions Affecting Market Value Economic environment factors Decisions under management control Conditions in financial markets Expected cash flows

Cash Flow Concept Used for Financial analysis Planning Resource allocation Please see Figure 1.2 CF does not equal accounting profit External sources Cash Internal sources

Competitive Forces Influencing C/S Market Value New entrants Substitute products Bargaining power of buyers Bargaining power of suppliers Rivalry among current competitors

NPV of an Investment NPV = present value of future cash flows minus initial cash outlays The NPV of an investment made by a firm represents the contribution of that investment to the value of the firm and, accordingly, passes on to SWM.

Different Size Businesses Small Business vs. Large Corporations Fundamental concepts are the same

Small Business Not the dominant firm in the industry Tend to grow more rapidly Limited access to financial market Lack management resources Have a high failure rate Stock is not publicly traded Poorly diversified Owner/manager frequently the same

Controller’s Activities Financial accounting Cost accounting Taxes Data processing

Treasurer’s Activities Management of cash and marketable securities Capital budgeting Financial planning Credit analysis Investors relations Pension fund management

Economics Accounting Marketing Production Human Resources Quantitative Analysis MIS Finance Disciplines Impacting Finance Please see Figure 1.4

Professional Organizations Financial Executive Institute Institute of Charted Financial Analysis Financial Management Association Institute of Management Accounting

Exciting Career Opportunities VP of Finance Director Investor Relations Assistant Treasurer Tax Manager Financial Analyst Account Executive Security Broker Mortgage Analyst Banking Check out