The Goals and Functions of Financial Management Chapter 1

Chapter 1 - Outline Introduction to Finance Short-Term vs. Long-Term Financing Decisions Risk-Return Trade-Off Financial vs. Real Capital Stocks vs. Bonds Forms of Organization Goals of Financial Management Corporate Governance

Finance Is a Combination of Accounting and Economics Financial Management (or Business Finance) is concerned with managing a corporation’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 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 Statement of cash flows Finance links economic theory with the numbers of accounting

Financial Management 1-5  Financial management or business finance is concerned with managing an entity’s money  Functions: Allocate funds to current and fixed assets Obtain the best mix of financing alternatives Develop an appropriate dividend policy within the context of the firm’s objectives

FIGURE 1-1 Functions of the financial manager

Short-Term vs. Long-Term Financing Working Capital is concerned with short-term (S/T) financing decisions <1 year ex., managing cash and other current assets Capital Budgeting is concerned with long-term (L/T) financing decisions >1 year ex., purchasing a new machine in the future

The Risk-Return Tradeoff  Profitability   Risk  Profitability   Risk ex., investing in stocks vs.savings accounts Stocks are more profitable but riskier Savings accounts are less profitable and less risky (or safer) Financial manager must choose appropriate combinations

Financial capital vs. Real capital Financial Capital (or Accounting Capital) = money Real Capital (or Economic Capital) = plant and equipment

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

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

Sole Proprietorship 1-12 Represents single-person ownership Advantages: Simplicity of decision-making Low organizational and operational costs Drawbacks Unlimited liability to the owner Profits and losses are taxed as though they belong to the individual owner

Partnership 1-13 Similar to sole proprietorship except there are two or more owners Articles of partnership specifies: The ownership interest The methods for distributing profits The means of withdrawing from the partnership Carries unlimited liability for the owners

Partnership (cont’d) 1-14 Limited partnership One or more partners are designated general partners and have unlimited liability for the debts of the firm Other partners designated limited partners and are liable only for their initial contribution Not all financial institutions will extend funds to a limited partnership

Corporation 1-15 Corporation Is unique—it is a legal entity unto itself − Articles of incorporation − Specify the rights and limitations of the entity − Owned by shareholders who enjoy the privilege of limited liability − Has a continual life − Key feature − Easy divisibility of ownership interest by issuing shares of stock

Corporation (cont’d) 1-16 Disadvantage: The potential of double taxation of earnings Subchapter S corporation Income is taxed as direct income to stockholders and thus is taxed only once as normal income

Goals of Financial Management Maximizing Shareholder Wealth Corporate Social Responsibility Ethical Behavior

Social Responsibility 1-18 Adopting policies that: Maximize values in the market Attracts capital Provides employment 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

Corporate Governance 1-19 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

Sarbanes-Oxley Act 1-20 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 Equity and income on their financial statements