Lecture 02

Lesson 2

Chapter 1

Introduction

Unit 1

Core concepts in financial management

After reading this lesson you will be able to understand the following: -

Objective of financial management.

Separation of ownership & management

Major decisions in financial management

In first semester you have read financial accounting and by now you have a little idea

about financial management also so tell me what is the objective of financial

management?

What is the objective of financial management?

“If you don’t know where you are going, it does not matter how you get there”

What do you think should be the objective?

What do a finance manager do? Suppose he makes available the required funds at an

acceptable cost and those funds are suitably invested and that every thing goes according

to plan because of the effective control measures he uses. If the firm is a commercial or

profit seeking then the results of good performance are reflected in the profits the firm

makes. How are profits utilized? They are partly distributed among the owners as

dividends and partly reinvested in to the business. As this process continues over a period

of time the value of the firm increases. If the share of the organization is traded on stock

exchange the good performance is reflected through the market price of the share, which

shows an upward movement. When the market price is more a shareholder gets more

value then what he has originally invested thus his wealth increases. Therefore we can

say that the objective of financial management is to increase the value of the firm or

wealth maximization.

Objective: Maximize the Value of the Firm

Brealey & Myers: "Success is usually judged by value: Shareholders are made better off

by any decision which increases the value of their stake in the firm... The secret of

success in financial management is to increase value."

Copeland & Weston: The most important theme is that the objective of the firm is to

maximize the wealth of its stockholders."

Brigham and Gapenski: Management's primary goal is stockholder wealth

maximization, which translates into maximizing the price of the common stock.

The Objective in Decision Making

In traditional corporate finance, the objective in decision-making is to maximize the

value of the firm.

A narrower objective is to maximize stockholder wealth. When the stock is traded and

markets are viewed to be efficient, the objective is to maximize the stock price.

All other goals of the firm are intermediate ones leading to firm value maximization, or

operate as constraints on firm value maximization.

The Criticism of Firm Value Maximization

Maximizing stock price is not incompatible with meeting employee needs/objectives. In

particular:

• - Employees are often stockholders in many firms

• - Firms that maximize stock price generally are firms that have treated employees well.

Maximizing stock price does not mean that customers are not critical to success. In most

businesses, keeping customers happy is the route to stock price maximization.

Maximizing stock price does not imply that a company has to be a social outlaw.

Why traditional corporate financial theory focuses on maximizing stockholder

wealth?

Stock prices are easily observable and constantly updated (unlike other measures of

performance, which may not be as easily observable, and certainly not updated as

frequently).

If investors are rational, stock prices reflect the wisdom of decisions, short term and long

term, instantaneously. As it is, it is believed that market discounts all the information in

the form of market price of the share.

Why not profit maximization?

Profitability objective may be stated in terms of profits, return on investment, or

profit to-sales ratios. According to this objective, all actions such as increase income and

cut down costs should be undertaken and those that are likely to have adverse impact on

profitability of the enterprise should be avoided. Advocates of the profit maximisation

objective are of the view that this objective is simple and has the in-built advantage of

judging economic performance of the enterprise. Further, it will direct the resources in

those channels that promise maximum return. This, in turn, would help in optimal

utilisation of society's economic resources. Since the finance manager is responsible for

the efficient utilisation of capital, it is plausible to pursue profitability maximisation as

the operational standard to test the effectiveness of financial decisions.

However, profit maximisation objective suffers from several drawbacks rendering it

an ineffective decisional criterion. These drawbacks are:

(a) It is Vague

It is not clear in what sense the term profit has been used. It may be total profit before tax or after

tax or profitability rate. Rate of profitability may again be in relation to Share capital; owner's

funds, total capital employed or sales. Which of these variants of profit should the management

pursue to maximise so as to attain the profit maximisation objective remains vague? Furthermore,

the word profit does not speak anything about the short-term and long-term profits. Profits in the

short-run may not be the same as those in the long run. A firm can maximise its short-term profit

by avoiding current expenditures on maintenance of a machine. But owing to this neglect, the

machine being put to use may no longer be capable of operation after sometime with the result

that the firm will have to defray huge investment outlay to replace the machine. Thus, profit

maximisation suffers in the long run for the sake of maximizing short-term profit. Obviously,

long-term consideration of profit cannot be neglected in favor of short-term profit.

(b) It Ignores Time Value factor

Profit maximisation objective fails to provide any idea regarding timing of expected cash

earnings. For instance, if there are two investment projects and suppose one is likely to

produce streams of earnings of Rs. 90,000 in sixth year from now and the other is likely

to produce annual benefits of Rs. 15,000 in each of the ensuing six years, both the

projects cannot be treated as equally useful ones although total benefits of both the

projects are identical because of differences in value of benefits received today and those received

a year two years after. Choice of more worthy projects lies in the study of time value of future

flows of cash earnings. The interest of the firm and its owners is affected by the time value or.

Profit maximisation objective does not take cognizance of this vital factor and treats all benefits,

irrespective of the timing, as equally valuable.

(c) It Ignores Risk Factor

Another serious shortcoming of the profit maximisation objective is that it overlooks risk factor.

Future earnings of different projects are related with risks of varying degrees. Hence,

different projects may have different values even though their earning capacity is the

same. A project with fluctuating earnings is considered more risky than the one with

certainty of earnings. Naturally, an investor would provide less value to the former than

to the latter. Risk element of a project is also dependent on the financing mix of the

project. Project largely financed by way of debt is generally more risky than the one

predominantly financed by means of share capital.

In view of the above, the profit maximisation objective is inappropriate and unsuitable an

operational objective of the firm. Suitable and operationally feasible objective of the firm

should be precise and clear cut and should give weightage to time value and risk factors.

All these factors are well taken care of by wealth maximisation objective.

That is why we have Wealth Maximisation as an Objective

Wealth maximisation objective is a widely recognised criterion with which the

performance a business enterprise is evaluated. The word wealth refers to the net present

worth of the firm. Therefore, wealth maximisation is also stated as net present worth. Net

present worth is difference between gross present worth and the amount of capital

investment required to achieve the benefits. Gross present worth represents the present

value of expected cash benefits discounted at a rate, which reflects their certainty or

uncertainty. Thus, wealth maximisation objective as decisional criterion suggests that any

financial action, which creates wealth or which, has a net present value above zero is

desirable one and should be accepted and that which does not satisfy this test should be

rejected.

The wealth maximisation objective when used as decisional criterion serves as a very

useful guideline in taking investment decisions. This is because the concept of, wealth is

very clear. It represents present value of the benefits minus the cost of the investment.

The concept of cash flow is more precise in connotation than that of accounting profit.

Thus, measuring benefit in terms of cash flows generated avoids ambiguity.

The wealth maximisation objective considers time value of money. It recognises that

cash benefits emerging from a project in different years are not identical in value. This is

why annual cash benefits of a project are discounted at a discount rate to calculate total

value of these cash benefits. At the same time, it also gives due weightage to risk factor

by making necessary adjustments in the discount rate. Thus, cash benefits of a project

with higher risk exposure is discounted at a higher discount rate (cost of capital), while

lower discount rate applied to discount expected cash benefits of a less risky project. In

this way, discount rate used to determine present value of future streams of cash earning

reflects both the time and risk. .

In view of the above reasons, wealth maximisation objective is considered superior

profit maximisation objective. It may be noted here that value maximisation objective is

simply the extension of profit maximisation to real life situations. Where the time period

is short and magnitude of uncertainty is not great, value maximisation and profit

maximisation amount almost the same thing.

Objective redefined

Although shareholder wealth maximization is the primary goal, in recent years

many firms have broadened their focus to include the interests of stakeholders as

well as shareholders. Stakeholders are groups such as employees, customers,

suppliers, creditors, and owners who have a direct economic link to the firm.

Employees are paid for their labor, customers purchase the firm's products or

services, suppliers are paid for the materials and services they provide, creditors

provide debt financing, and owners provide equity financing. A firm with a

stakeholder focus consciously avoids actions that would prove detrimental to

stakeholders by damaging their wealth positions through the transfer of

stakeholder wealth to the firm. The goal is not to maximize stakeholder well

being, but to preserve it.

The stakeholder view tends to limit the firm's actions in order to preserve the wealth

of stakeholders. Such a view is often considered part of the firm's "social responsibility."

It is expected to provide long-run benefit to shareholders by maintaining positive

stakeholder relationships. Such relationships should minimize stakeholder turnover,

conflicts, and litigation. Clearly, the firm can better achieve its goal of shareholder wealth

maximization with the cooperation of- rather than conflict with-its other stakeholders.

To achieve the objective of financial management there are four major decisions that

a manager takes.

The Four Major Decisions in Corporate Finance/Financial management

The Allocation (Investment) decision

Where do you invest the scarce resources of your business?

What makes for a good investment?

The Financing decision

Where do you raise the funds for these investments?

Generically, what mix of owner’s money (equity) or borrowed money

(debt) do you use?

The Dividend Decision

How much of a firm’s funds should be reinvested in the business and how

much should be returned to the owners?

The Liquidity decision

How much should a firm invest in current assets and what should be the

components with their respective proportions? How to manage the

working capital?

A firm performs finance functions simultaneously and continuously in the normal course

of the business. They do not necessarily occur in a sequence. Finance functions call for

skilful planning, control and execution of a firm’s activities.

Let us note at the outset hat shareholders are made better off by a financial decision that

increases the value of their shares, Thus while performing the finance function, the

financial manager should strive to maximize the market value of shares. Whatever

decision does a manger takes need to result in wealth maximisation of a shareholder.

Investment Decision

Investment decision or capital budgeting involves the decision of allocation of capital or

commitment of funds to long-term assets that would yield benefits in the future. Two

important aspects of the investment decision are:

(a) the evaluation of the prospective profitability of new investments, and

(b) the measurement of a cut-off rate against that the prospective return of new

investments could be compared. Future benefits of investments are difficult to measure

and cannot be predicted with certainty. Because of the uncertain future, investment

decisions involve risk. Investment proposals should, therefore, be evaluated in terms of

both expected return and risk. Besides the decision for investment managers do see where

to commit funds when an asset becomes less productive or non-profitable.

There is a broad agreement that the correct cut-off rate is the required rate of

return or the opportunity cost of capital. However, there are problems in computing the

opportunity cost of capital in practice from the available data and information. A decision

maker should be aware of capital in practice from the available data and information. A

decision maker should be aware of these problems.

Financing Decision

Financing decision is the second important function to be performed by the financial

manager. Broadly, her or she must decide when, where and how to acquire funds to meet

the firm’s investment needs. The central issue before him or her is to determine the

proportion of equity and debt. The mix of debt and equity is known as the firm’s capital

structure. The financial manager must strive to obtain the best financing mix or the

optimum capital structure for his or her firm. The firm’s capital structure is considered to

be optimum when the market value of shares is maximised. The use of debt affects the

return and risk of shareholders; it may increase the return on equity funds but it always

increases risk. A proper balance will have to be struck between return and risk. When the

shareholders’ return is maximised with minimum risk, the market value per share will be

maximised and the firm’s capital structure would be considered optimum. Once the

financial manager is able to determine the best combination of debt and equity, he or she

must raise the appropriate amount through the best available sources. In practice, a firm

considers many other factors such as control, flexibility loan convenience, legal aspects

etc. in deciding its capital structure.

Dividend Decision

Dividend decision is the third major financial decision. The financial manager must

decide whether the firm should distribute all profits, or retain them, or distribute a portion

and retain the balance. Like the debt policy, the dividend policy should be determined in

terms of its impact on the shareholders’ value. The optimum dividend policy is one that

maximises the market value of the firm’s shares. Thus if shareholders are not indifferent

to the firm’s dividend policy, the financial manager must determine the optimum dividend

– payout ratio. The payout ratio is equal to the percentage of dividends to earnings

available to shareholders. The financial manager should also consider the questions of

dividend stability, bonus shares and cash dividends in practice. Most profitable

companies pay cash dividends regularly. Periodically, additional shares, called bonus

share (or stock dividend), are also issued to the existing shareholders in addition to the

cash dividend.

Liquidity Decision

Current assets management that affects a firm’s liquidity is yet another important finances

function, in addition to the management of long-term assets. Current assets should be managed

efficiently for safeguarding the firm against the dangers of illiquidity and insolvency. Investment

in current assets affects the firm’s profitability. Liquidity and risk. A conflict exists between

profitability and liquidity while managing current assets. If the firm does not invest sufficient

funds in current assets, it may become illiquid. But it would lose profitability, as idle current

assets would not earn anything. Thus, a proper trade-off must be achieved between profitability

and liquidity. In order to ensure that neither insufficient nor unnecessary funds are invested in

current assets, the financial manager should develop sound techniques of managing current assets.

He or she should estimate firm’s needs for current assets and make sure that funds would be made

available when needed.

It would thus be clear that financial decisions directly concern the firm’s decision to

acquire or dispose off assets and require commitment or recommitment of funds on a continuous

basis. It is in this context that finance functions are said to influence production, marketing and

other functions of the firm. This, in consequence, finance functions may affect the size, growth,

profitability and risk of the firm, and ultimately, the value of the firm. To quote Ezra Solomon

The function of financial management is to review and control decisions to commit or

recommit funds to new or ongoing uses. Thus, in addition to raising funds, financial management

is directly concerned with production, marketing and other functions, within an enterprise

whenever decisions are about the acquisition or distribution of assets.

Various financial functions are intimately connected with each other. For

instance, decision pertaining to the proportion in which fixed assets and current assets are

mixed determines the risk complexion of the firm. Costs of various methods of financing

are affected by this risk. Likewise, dividend decisions influence financing decisions and

are themselves influenced by investment decisions.

In view of this, finance manager is expected to call upon the expertise of other

functional managers of the firm particularly in regard to investment of funds. Decisions

pertaining to kinds of fixed assets to be acquired for the firm, level of inventories to be

kept in hand, type of customers to be granted credit facilities, terms of credit should be

made after consulting production and marketing executives.

However, in the management of income finance manager has to act on his own. The

determination of dividend policies is almost exclusively a finance function. A finance

manager has a final say in decisions on dividends than in asset management decisions.

Financial management is looked on as cutting across functional even disciplinary

boundaries. It is in such an environment that finance manager works as a part of total

management. In principle, a finance manager is held responsible to handle all such

problem: that involve money matters. But in actual practice, as noted above, he has to call

on the expertise of those in other functional areas to discharge his responsibilities

effectively.

You have studied separate legal entity concept in financial accounting the

following paragraph is extension of the same.

Separation of Ownership and Management

In large businesses separation of ownership and management is a practical necessity.

Major corporations may have hundreds of thousands of shareholders. There is no way for

all of them to be actively involved in management: Authority has to be delegated to

managers.

The separation of ownership and management has clear advantages. It allows

share ownership to change without interfering with the operation of the business. It

allows the firm to hire professional managers. But it also brings problems if the man-

agers' and owners' objectives differ. You can see the danger: Rather than attending to the

wishes of shareholders, managers may seek a more leisurely or luxurious working

lifestyle; they may shun unpopular decisions, or they may attempt to build an empire with

their shareholders' money.

Such conflicts between shareholders and managers' objectives create principal

agent problems. The shareholders are the principals; the managers are their agents.

Shareholders want management to increase the value of the firm, but managers may have

their own axes to grind or nests to feather. Agency costs are incurred when (1) managers

do not attempt to maximize firm value and (2) shareholders incur costs to monitor the

managers and influence their actions. Of course, there are no costs when the shareholders

are also the managers. That is one of the advantages of a sole proprietorship. Owner-

managers have no conflicts of interest.

Conflicts between shareholders and managers are not the only principal-agent

problems that the financial manager is likely to encounter. For example, just as

shareholders need to encourage managers to work for the shareholders' interests, so

senior management needs to think about how to motivate everyone else in the company.

In this case senior management are the principals and junior management and other

employees are their agents.

Think of the company's overall value as a pie that is divided among a number of

claimants. These include the management and the shareholders, as well as the company's

workforce and the banks and investors who have bought the company's debt. The

government is a claimant too, since it gets to tax corporate profits.

All these claimants are bound together in a complex web of contracts and un-

derstandings. For example, when banks lend money to the firm, they insist on a formal

contract stating the rate of interest and repayment dates, perhaps placing restrictions on

dividends or additional borrowing. But you can't devise written rules to cover every

possible future event. So written contracts are incomplete and need to be supplemented

by understandings and by arrangements that help to align the interests of the various

parties.

Principal-agent problems would be easier to resolve if everyone had the same

information. That is rarely the case in finance. Managers, shareholders, and lenders may

all have different information about the value of a real or financial asset, and it may be

many years before all the information is revealed. Financial managers need to recognize

these information asymmetries and find ways to reassure investors that there are no nasty

surprises on the way.

The Agency Issue

The control of the modern corporation is frequently placed in the hands of

professional non-owner managers. We have seen that the goal of the financial

manager should be to maximize the wealth of the owners of the firm and given

them decision-making authority to manage the firm. Technically, any manager

who owns less than 100 percent of the firm is to some degree an agent of the other

owners.

In theory, most financial managers would agree with the goal of owner wealth

maximization. In practice, however, managers are also concerned with their

personal wealth, job security, and fringe benefits, such as country club

memberships, limousines, and posh offices, all provided at company expense.

Such concerns may make managers reluctant or unwilling to take more that,

moderate risk if they perceive that too much risk might result in a loss of job and

damage to personal wealth. The result is a less-than-maximum return and a

potential loss of wealth for the owners.

How do we resolve the agency problem?

From this conflict of owners and managers arises what has been called the agency

problem-the likelihood that managers may place personal goals ahead of

corporate goals. Two factors-market forces and agency costs-act to prevent or

minimize agency problems.

Market Forces One market force is major shareholders, particularly large

institutional investors, such as mutual funds, life insurance companies, and

pension funds. These holders of large block of a firm's stock have begun in recent

years to exert pressure on management to perform. When necessary they exercise

their voting rights as stockholders to replace under performing management.

Another market force is the threat of takeover by another firm that believes that it

can enhance the firm's value by restructuring its management, operations, and

financing. The constant threat of takeover tends to motivate management to act in

the best interest of the firm's owners by attempting to maximize share price.

Agency Costs To minimize agency problems and contribute to the maximization

of owners' wealth, stockholders incur agency costs. These are the costs of

monitoring management behavior, ensuring against dishonest acts of

management, and giving managers the financial incentive to maximize share

price. The most popular, powerful, and expensive approach is to structure

management compensation to correspond with share price maximization. The

objective is to compensate managers for acting in the best interests of the owners.

This is frequently accomplished by granting stock options to management. These

options allow managers to purchase stock at a set market price; if the market price

rises, the higher future stock price would result in greater management

compensation. In addition, well-structured compensation packages allow firms to

hire the best managers available. Today more firms are tying management

compensation to the firm's performance. This incentive appears to motivate

managers to operate in a manner reasonably consistent with stock price

maximization.

Another point demanding attention is social responsibility. Let us discuss.

Social Responsibility

Maximizing shareholder wealth does not mean that management should ignore

social responsibility, such as protecting the consumer, paying fair wages to

employees, maintaining fair hiring practices and safe working conditions,

supporting education, and becoming involved in such environmental issues as

clean air and water .It is appropriate for management to consider the interests of

stakeholders other than shareholders. These stakeholders include creditors,

employees, customers, suppliers, communities in which a company operates, and

others. Only through attention to the legitimate concerns of the firm’s various

stakeholders can the firm attain its ultimate goal of maximizing shareholder

wealth.

Lloyds TSB speaks out on value creation and Society

Lloyds TSB

Companies everywhere that want to attract capital have to ensure that they are response to

shareholders interests. Lloyds TSB, a leading Untied Kingdom based financial services

group, is one such firm that views maximizing shareholder value as its governing objective.

Putting value creation in the forefront does not mean, however, that its customers,

employees, or society in general will take a back seat. Here is what Lloyds TSB chairman,

sir Brain Pitman, has to say about” putting value creation first”.

Putting value creation first can bring huge benefits, not only to the company, but to society

as a whole. No company can service for long unless it creates wealth. A sick company is a

drag on society. It cannot sustain jobs; much less widen the opportunities available to its

employees. It cannot adequately serve customers. It cannot give to philanthropic causes.

As businessmen and businesswomen, we believe that there is no better way for us to

serve all our stakeholders not just our shareholders and customers, but our fellow

employees, our business partners and our communities—than by creating value over time

for those who employ us. It is our success in value creation that has also enabled the Lloyds

TSB group to become leader in charitable giving, a leader in the community and a leader

in sponsorship of education, enterprise, the arts and sport. The Lloyds TSB foundations

will receive some ₤27 million in 1999 for distribution to charities, with a particular focus

on disabled and disadvantaged people.

Source: Lloyds TSB Group Annual Report & Accounts 1998, p.3. Reproduced with permission of Lloyds TSB Group plc.

CASE STUDY

Assessing the Goal of Sports Products Ltd.

Loren and Dale work in the Shipping Department of Sports Products Ltd.. During

their lunch break one day, they began talking about the company. Dale

complained that he had always worked hard, trying not to waste packing materials

and to perform his job efficiently and cost-effectively. In spite of his efforts and

those of his departmental co-workers, the firm's stock price had declined nearly

Rs.25 per share over the past 9 months. Loren indicated that she shared Dale's

frustration, particularly because the firm's profits had been rising. Neither could

understand why the firm's stock price was falling as profits rose.

Loren said that she had seen documents describing the firm's profit-sharing plan

under which all managers were partially compensated on the basis of the firm's

profits. She suggested that maybe it was profit that was important to management,

because it directly affected their pay. Dale said, "That doesn't make sense,

because the stockholders own the firm. Shouldn't management do what's best for

stockholders? Something's wrong!" Loren responded, "Well, maybe that explains

why the company hasn't concerned itself with the stock price. Look, the only

profits stockholders receive are in the form or cash dividends, and this firm has

never paid dividends during its 20-year history. We as stockholders therefore

don't directly benefit from profits. The only way we benefit is for the stock price

to rise." Dale chimed in, "That probably explains why the firm is being sued by

state and central environmental officials for dumping pollutants in the adjacent

stream. Why spend money for pollution controls? It increases costs, lowers

profits, and therefore lowers management's earnings!"

Loren and Dale realized that the lunch break had ended and they must quickly

return to work. Before leaving, they decided to meet the next day to continue their

discussion.

Required

a. What should the management of Sports Products, Inc., pursue as its overriding

goal? Why?

b. Does the firm appear to have an agency problem? Explain.

c. Evaluate the firm's approach to pollution control. Does it seem to be ethical?

Why might incurring the expense to control pollution be in the best interests of

the firm's owners in spite of its negative impact on profits?

d. On the basis of the information provided, what specific recommendations would you

offer the firm?

Questions for lesson 1 & 2

1. Contrast the objective of maximizing earnings with that of

maximizing wealth.

2. What is financial management all about?

3. In large corporations, ownership and management are separated.

What are the main implications of this separation?

4. What are agency costs & what causes them?

Multiple Choice Questions 1. __________ is concerned with the acquisition, financing, and management of assets with some overall goal in mind.

a) Financial management b) Profit maximization c) Agency theory d) Social responsibility

2. __________ is concerned with the maximization of a firm's earnings after taxes.

a) Shareholder wealth maximization b) Profit maximization c) Stakeholder maximization d) EPS maximization

3. What is the most appropriate goal of the firm?

a) Shareholder wealth maximization b) Profit maximization c) Stakeholder maximization d) EPS maximization.

4. Which of the following statements is correct regarding profit maximization as the primary goal of the firm?

a) Profit maximization considers the firm's risk level. b) Profit maximization will not lead to increasing short-term profits at the expense of

lowering expected future profits. c) Profit maximization does consider the impact on individual shareholder's EPS.

d) Profit maximization is concerned more with maximizing net income than the stock price.

5. __________ is concerned with the branch of economics relating the behavior of principals and their agents.


6. A concept that implies that the firm should consider issues such as protecting the consumer, paying fair wages, maintaining fair hiring practices, supporting education, and considering environmental issues.


7. The __________ decision involves determining the appropriate make-up of the right-hand side of the balance sheet.

a) Asset management b) Financing c) Investment d) Capital budgeting

8. You need to understand financial management even if you have no intention of becoming a financial manager. One reason is that the successful manager of the not-too-distant future will need to be much more of a __________ who has the knowledge and ability to move not just vertically within an organization but horizontally as well. Developing __________ will be the rule, not the exception.

a) Specialist; specialties b) Generalist; general business skills c) Technician; quantitative skills d) Team player; cross-functional capabilities

9. The __________ decision involves a determination of the total amount of assets needed, the composition of the assets, and whether any assets need to be reduced, eliminated, or replaced.

a) Asset management. b) Financing

c) Investment d) Accounting

10.How are earnings per share calculated?

a) Use the income statement to determine earnings after taxes (net income) and divide by the previous period's earnings after taxes. Then subtract 1 from the previously calculated value.

b) Use the income statement to determine earnings after taxes (net income) and divide by the number of common shares outstanding.

c) Use the income statement to determine earnings after taxes (net income) and divide by the number of common and preferred shares outstanding.

d) Use the income statement to determine earnings after taxes (net income) and divide by the forecasted period's earnings after taxes. Then subtract 1 from the previously calculated value.

11. What is the most important of the three financial management decisions?

a) Asset management decision b) Financing decision c) Investment decision d) Accounting decision

12. The __________ decision involves efficiently managing the assets on the balance sheet on a day-to-day basis, especially current assets.

a) Asset management b) Financing c) Investment d) Accounting

13. Which of the following is not a perquisite (perk)?

a) Company-provided automobile b) Expensive office c) Salary d) Country club membership

14. All constituencies with a stake in the fortunes of the company are known as __________.

a) Shareholders b) Stakeholders c) Creditors d) Customers

15. Which of the following statements is not correct regarding earnings per share (EPS) maximization as the primary goal of the firm?

a) EPS maximization ignores the firm's risk level. b) EPS maximization does not specify the timing or duration of expected EPS. c) EPS maximization naturally requires all earnings to be retained. d) EPS maximization is concerned with maximizing net income.

16. __________ is concerned with the maximization of a firm's stock price.

a) Shareholder wealth maximization b) Profit maximization c) Stakeholder welfare maximization d) EPS maximization

Answers to above

1. Financial management 2. Profit maximization 3. Shareholder wealth maximization 4. Profit maximization is concerned more with maximizing net income than the

stock price. 5. Agency theory 6. Social responsibility 7. Financing 8. Team player; cross-functional capabilities 9. Investment 10. Use the income statement to determine earnings after taxes (net income) and

divide by the number of common shares outstanding. 11. Investment decision 12. Asset management 13. Asset management 14. Stakeholders 15. EPS maximization is concerned with maximizing net income. 16. Shareholder wealth maximization

IMPORTANT Slide 1

1-1

Chapter 1Chapter 1

The Role of Financial Management

The Role of Financial The Role of Financial ManagementManagement

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1-2

The Role of The Role of Financial ManagementFinancial Management

What is Financial Management?The Goal of the FirmOrganization of the Financial Management Function

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1-3

What is Financial What is Financial Management?Management?

Concerns the acquisition, financing, and

management of assets with some overall goaloverall goal in

mind.

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1-4

Investment DecisionsInvestment Decisions

What is the optimal firm size?What specific assets should be acquired?What assets (if any) should be reduced or eliminated?

Most important of the three Most important of the three decisions.decisions.

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1-5

Financing DecisionsFinancing Decisions

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?

Determine how the assets (LHS of Determine how the assets (LHS of balance sheet) will be financed (RHS balance sheet) will be financed (RHS

of balance sheet).of balance sheet).

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1-6

Asset Management Asset Management DecisionsDecisions

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.

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1-7

What is the Goal What is the Goal of the Firm?of the Firm?

Maximization of Maximization of Shareholder Wealth!Shareholder Wealth!

Value creation occurs when we maximize the share price

for current shareholders.

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1-8

Shortcomings of Shortcomings of Alternative PerspectivesAlternative Perspectives

Could increase current profits while harming firm (e.g., defer maintenance, issue common stock to buy T-bills, etc.).Ignores changes in the risk level of the firm.

Profit MaximizationProfit MaximizationMaximizing a firm’s earnings after taxes.

ProblemsProblems

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1-9

Shortcomings of Shortcomings of Alternative PerspectivesAlternative Perspectives

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.

Earnings per Share MaximizationEarnings per Share MaximizationMaximizing earnings after taxes divided by shares outstanding.

ProblemsProblems

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1-10

Strengths of Shareholder Strengths of Shareholder Wealth MaximizationWealth Maximization

Takes account of: current and future current and future profits and EPSprofits and EPS; the timing, the timing, duration, and risk of profits and EPSduration, and risk of profits and EPS; dividend policydividend policy; and all other relevant factors.Thus, share priceshare price serves as a barometer for business performance.

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1-11

The Modern CorporationThe Modern Corporation

There exists a SEPARATION between owners and managers.

Modern Corporation

Shareholders Management

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1-12

Role of ManagementRole of Management

An agentagent is an individual authorized by another person, called the principal, to act in the latter’s behalf.

Management acts as an agentagentfor the owners (shareholders)

of the firm.

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1-13

Agency TheoryAgency Theory

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

Jensen and Meckling developed a theory of the firm based on agency theoryagency theory.

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1-14

Agency TheoryAgency Theory

Incentives include stock optionsstock options,,perquisitesperquisites,, and bonusesbonuses.

Principals must provide incentivesincentivesso that management acts in the principals’ best interests and then monitormonitor results.

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1-15

Social ResponsibilitySocial Responsibility

Wealth maximization does notpreclude the firm from being socially socially responsibleresponsible.Assume we view the firm as producing both private and social goods. Then shareholdershareholder wealthwealth maximizationmaximizationremains the appropriate goal in governing the firm.

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1-16

Organization of the Financial Organization of the Financial Management Function Management Function

Board of Directors

President(Chief Executive Officer)

Vice PresidentOperations

Vice PresidentMarketing

VP ofFinance

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1-17

TreasurerCapital BudgetingCash ManagementCredit Management

Dividend DisbursementFin Analysis/PlanningPension ManagementInsurance/Risk MngmtTax Analysis/Planning

Organization of the Financial Organization of the Financial Management Function Management Function

VP of FinanceController

Cost AccountingCost ManagementData ProcessingGeneral Ledger

Government ReportingInternal Control

Preparing Fin StmtsPreparing Budgets

Preparing Forecasts

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Lecture 02

Documents

Transcript of Lecture 02