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

2. The Role of Financial Management
What is Financial Management?
The Goal of the Firm
Organization of the Financial Management Function

3. What is Financial Management?
Concerns the acquisition, financing, and management of assets with some overall goal in mind.

4. Most important of the three decisions.
Investment Decisions
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 eliminated?

5. Financing Decisions
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?
How will the funds be physically acquired?

6. Asset Management Decisions
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.

7. Organization of the Financial Management Function
Board of Directors
President
(Chief Executive Officer)
VP of
Finance
Vice President
Operations
Vice President
Marketing

8. Organization of the Financial Management Function
VP of Finance
Treasurer
Capital Budgeting
Cash Management
Credit Management
Dividend Disbursement
Fin Analysis/Planning
Pension Management
Insurance/Risk Mngmt
Tax Analysis/Planning
Controller
Cost Accounting
Cost Management
Data Processing
General Ledger
Government Reporting
Internal Control
Preparing Fin Stmts
Preparing Budgets
Preparing Forecasts

9. Financial Manager
Financial managers try to answer some or all of these questions
The top financial manager within a firm is usually the Chief Financial Officer (CFO)
Treasurer –cash management, credit management, capital expenditures and financial planning
Controller –taxes, cost accounting, financial accounting and data processing
Video Note: This video looks at the changing role of the Chief Financial Officer (CFO) at the Fortune 500 company, Abbot Laboratories.

10. Financial Management Decisions
Capital budgeting
What long-term investments or projects should the business take on?
Capital structure
How should we pay for our assets?
Should we use debt or equity?
Working capital management
How do we manage the day-to-day finances of the firm?
Provide some examples of capital budgeting decisions, such as what product or service will the firm sell, should we replace old equipment with newer, more advanced equipment, etc.
Be sure and define debt and equity.
Provide some examples of working capital management, such as who should we sell to on credit, how much inventory should we carry, when should we pay our suppliers, etc.

11. Main tasks of Financial Management
Capital budgeting: the process of planning and managing a firm’s long-term investments  fixed assets.
Capital structure: the mixture of debt and equity maintained by the firm  S-T and L-T debt and equity.
Working capital management: a firm’s short-term assets and liabilities  current assets and current liabilities.

12. The Capital Budgeting Decision
Current Assets
Current Liabilities
Long-Term Debt
What long-term investments should the firm choose?
Fixed Assets
1 Tangible
2 Intangible
Shareholders’ Equity

13. What is the Goal of the Firm?
Maximization of Shareholder Wealth!
Value creation occurs when we maximize the share price for current shareholders.

14. Shortcomings of Alternative Perspectives
Profit Maximization
Maximizing a firm’s earnings after taxes.
Problems
Ignores changes in the risk level of the firm.

15. Shortcomings of Alternative Perspectives
Earnings per Share Maximization
Maximizing earnings after taxes divided by shares outstanding.
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.

16. Strengths of Shareholder Wealth Maximization
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 price serves as an indicator for business performance.

17. Forms of Business Organization
Three major forms of the business
Sole proprietorship
Partnership
Corporation
www: Clicking on the “web surfer” will take you to a web site that will provide a discussion about which form of business may be appropriate for an entrepreneur. The following pages will provide links to specific pages on the web site that provide additional information about the legal aspects of each form of business, as well as a discussion of the advantages and disadvantages. The address is:

18. Sole Proprietorship Disadvantages Advantages Limited to life of owner
Equity capital limited to owner’s personal wealth
Unlimited liability
Difficult to sell ownership interest
Advantages
Easiest to start
Least regulated
Single owner keeps all the profits
Taxed once as personal income
www: Click on the “web surfer” for more information about sole proprietorships. If you click on the “--Sole Proprietorship” link, you will be taken to an index that will provide a link to information about husband and wife sole proprietorships.

19. Partnership Advantages Disadvantages Two or more owners
More capital available
Relatively easy to start
Income taxed once as personal income
Disadvantages
Unlimited liability
Partnership dissolves when one partner dies or wishes to sell
Difficult to transfer ownership
www: Click on the “web surfer” for more information about partnerships. If you click on the “—Partnerships” link, you will go to an index that provides links to additional information about limited partnerships, partnership agreements and buy-sell agreements.
Note that unlimited liability applies to all partners in a general partnership and only the general partners in a limited partnership
Written agreements are essential due to the unlimited liability.
Limited partners cannot be involved in the business or else they may be deemed as general partners.

20. Corporation Advantages Disadvantages Limited liability Unlimited life
Separation of ownership and management
Transfer of ownership is easy
Easier to raise capital
Disadvantages
Separation of ownership and management
Double taxation (income taxed at the corporate rate and then dividends taxed at the personal rate)
www: Click on the “web surfer” to go to a page that discusses corporations. If you click on the “—Corporations” link it will take you back to an index that provides links to additional information on corporations as well as limited liability corporations.
Discuss how separation of ownership and management can be both an advantage and a disadvantage:
Advantages
You can benefit from ownership in several different businesses (diversification)
You can take advantage of the expertise of others (comparative advantage)
Easier to transfer ownership
Disadvantage
Agency problems if management goals and owner goals are not aligned
The instructors manual provides additional discussion of limited liability companies and S-corporations

21. Possible goals of financial management
Survive
Beat the competition
Maximize sales
Maximize net income
Maximize market share
Minimize costs
Maximize the value of (stock) shares

22. The “appropriate” goal of financial management
Maximize the (fundamental or economic) value of (stock) shares is the right goal.
Why? Shareholders own shares. Managers, as agents, should act in a way to benefit shareholders; i.e., to enhance the value of the shares.
A limitation of this goal is that value is not directly observable.

23. Value vs. price
The value of shares are not observable. In contrast, the price of shares can be observable.
If one believes that share price is an accurate/good estimate of share value, the appropriate goal would be to maximize the price of shares.

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

25. Management acts as an agent for the owners (shareholders) of the firm.
Role of Management
Management acts as an agent for the owners (shareholders) of the firm.
An agent is an individual authorized by another person, called the principal, to act in the latter’s behalf.

26. Agency Theory
Jensen and Meckling (1976) developed a theory of the firm based on agency theory.
Agency Theory is a branch of economics relating to the behavior of principals and their agents.

27. Agency Theory
Principals must provide incentives so that management acts in the principals’ best interests and then monitor results.
Incentives include stock options, and bonuses.

28. The agency problem Agency relationship: Agency problem:
Principles (stockholders) hire agents (managers) to run the company.
Agency problem:
Conflict of interest between principals and agents.
This occurs in a corporate setting whenever the agents do not hold 100% of the firm’s shares.
The source of agency problems is the separation of (owners’) control and management.

29. Agency costs
Direct costs: (1) unnecessary expenses, such as a monitoring costs.
Indirect costs. For example, a manager may choose not to take on the optimal investment. She/he may prefer a less risky project so that she/he has a higher probability keeping her/his tenure.

30. Managing Managers/Corporate Governance
Managerial compensation
Incentives can be used to align management and stockholder interests
The incentives need to be structured carefully to make sure that they achieve their goal
Corporate control
The threat of a takeover may result in better management
Incentives – discuss how incentives must be carefully structured. For example, tying bonuses to profits might encourage management to pursue short-run profits and forego projects that require a large initial outlay. Stock options may work, but there may be an optimal level of insider ownership. Beyond that level, management may be in too much control and may not act in the best interest of all stockholders. The type of stock can also affect the effectiveness of the incentive.
Corporate control – ask the students why the threat of a takeover might make managers work towards the goals of stockholders.
Other groups also have a financial stake in the firm. They can provide a valuable monitoring tool, but they can also try to force the firm to do things that are not in the owners’ best interest.

31. Ethics
Managers are expected to behave in an ethical manner. He/she must ensure to sort out what is good and bad.

32. Social Responsibility
Wealth maximization does not rule out the firm from being socially responsible.
Assume we view the firm as producing both private and social goods.
Then shareholder wealth maximization remains the appropriate goal in governing the firm.