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Finance 311 1

Chapter 1The Roles and Objectives

of Financial Management

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Finance 311 2

Introduction

This chapter introduces the financial

management process of the typicalfirm. It looks at the financial manager,the field of finance, financial decisionsand their implications, and the dailyquestions faced by the firms financialmanagement.

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A GENERAL LOOK ATFINANCE

Finance is the art and science of

managing money

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How is finance related to other fields ofstudy?

What are the goals and objectives offinancial managers?

How has the finance field evolved?

How is the finance field changingtoday?

Questions Faced in Finance

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Finance 311 5

THERE ARE THREE MAJOR AREAS OF

FINANCE Investments -- Concerned with analyzing

potential investments (including RealEstate) in order to achieve a certain rate ofreturn consistent with a desired level ofrisk. Return on Investment

Financial institutions and markets --Concerned with the management offinancial institutions like commercial banks,insurance companies, etc. Also concernedwith analyzing financial markets andpredicting interest rates.

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AREAS OF FINANCE --continued

Business finance or corporate finance ormanagerial finance which is concerned with

the management of the non-financialcorporation. Primarily concerned with thefor profit organization, but sameprinciples apply to the not for profitorganization.

This course is concerned with managerialfinance, but we will get into the other areas.That is, at times, we will assume the role of abanker or investor.

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What Activities are Involved inManagerial Finance

Investment of funds or capital budgeting Risk versus Return

Real Options

Working capital management Amount of cash to hold Amount of credit to grant

Amount of inventory to hold

Where to obtain short term capital

Acquisition of funds - Financing Debt versus equity

Long term debt versus short term debt

Lease versus own

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Activities in Finance -continued Distribution or Dividend Decision

Financial planning

Others Mergers and acquisitions

Bankruptcies

Spin-offs Leverage buy-outs (LBO)

Valuations

EVA and MVA

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In Making Financial Management

Decisions, What is Our Goal?

Some Possibilities

Maximize revenue Maximize profits

Maximize EPS

Minimize losses Others

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OwnersWealth

Maximization(OWM) orStockholders

WealthMaximization(SWM)

Objective of the

financial manager

NOT

profit maximization

Does not consider

time value of money or cash flows

or risk

Objective

of

Financial Management

( FM )

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Principal Forms of BusinessOrganizationsare:

Sole

proprietorshipPartnership

Corporation

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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

Check out small business info from the SBA

http://www.sba.gov/

http://www.sba.gov/http://www.sba.gov/

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PartnershipOwned by two or more personsClassified as general or limited

Partnership dissolves when a

general partner dies

General partner has unlimitedliability

Limited partners liability limitedby partnership agreement

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Finance 311 14

Corporation Limited liability

Permanency

Flexibility

Ability to raisecapital

Legal entity

Have a board of

directors Owners are

stockholders

Easy marketability ofshares of ownership

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Finance 311 15

Optimal Form of

Organization Influenced byCost

ComplexityLiability

Continuity

Raising capitalDecision making

Tax considerations

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Finance 311 16

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

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Major Advantage of Corporation isLimited Liability

We will assume in this course thatwe are working with corporations

Ownership is represented bycommon stock (CS)

Our objective is to maximize the

longterm value of the commonstock (this is the same as OWM orSWM)

MVA and EVA

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Three Basic FactorsDetermine

C/S Market Value1) Amount of

2) Timing of

3) Risk of

Expected cash flows

Also, interest rates and tenor of the market

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Finance 311 19

Risk-Return Tradeoff We will assume that

firms and investors

are risk averse There is no such

thing as a freelunch

Do you want tosleep well or eatwell?

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Finance 311 20

SWM

Considers the timing and risk of thebenefits from stock ownership

Determines that a good decisionincreases the price of the firm'scommon stock ( c/s )

Is an impersonal objective Is concerned for social responsibility

and ethics

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Finance 311 21

Social Responsibility Ethical issues will constantly confront

financial managers as they achieve thegoal of the firm ( SWM ).

Avoid personal conflicts

Maintain confidentiality

Be objective

Act fairly

(essentially, treat others as you would have

them treat you)

Managers Must

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Finance 311 22

Conditions Affecting Market

Value Economic environment factors

Managerial Decisions -- Which will determine

Expected cash flows Risk of expected cash flows

Timing of expected cash flows

Conditions in financial markets

Interest rates

Tenor of the market

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Finance 311 23

Stockholderselect a board

of directors

Board ofdirectors then

hiremanagement

( officers )

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Finance 311 24

Who Manages? Board of directors

deals with broad

policy

3 to 5 year strategicplan

Management makesmost of the decisions

Day-to-day decisions

following thestrategic plan

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Stockholder Rights Dividend

Voting

Asset

Preemptive

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Finance 311 26

Priority of Corporate SecuritiesBonds (highest)

Preferred stock

Common stock (C/S) (lowest)

Major corporate Web sites

http://www.bankofamerica.com/http://www.ge.com/

http://www.ibm.com/us/

http://www.wachovia.com

O A R l ti hi / P bl

http://wwwbankofamerica.com/http://www.ge.com/http://www.ibm.com/us/http://www.wachovia.com/http://www.wachovia.com/http://www.ibm.com/us/http://www.ge.com/http://wwwbankofamerica.com/

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Finance 311 27

Problem created

by separation of

Management maximizes

their own welfare instead

of the owners wealth

Owners (shareholders)

Management

and

Employees

Job Security

One Agency Relationships / Problems

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Finance 311 28

Job Security Management decisions based on retaining

management rather than SWM

ExampleA decision to retain suppliers ratherthan selecting new suppliers providing higherquality or lower cost

WhyIf the transition is mishandledmanagement will be scrutinized but if nochange is made the issue will be ignored

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Finance 311 29

Agency Costs

A. Management incentives (e.g. stock options)

B. Monitor performance (e.g. auditing)

C. Owners protection (e.g. bonding)

D. Complex Organizational Structures

Pervasive TrendsFlatten organization structures to cut costs

Incorporate Technology in Managing

Eliminate Back Office Operations

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Agency Problemcreated by

separation of

Owners

Management

A second and similar

Agency problem

Owners

Creditors

Protective covenants

in loan agreements

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Agency Problem between

Stockholders and Creditors

Creditors return is limited (fixed) by

interest rate on debt Stockholders have limited liability and

potential for unlimited returns. They

are willing and rewarded for takingrisks.

Examples of Protective

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Examples of ProtectiveCovenants

Limitations on

common stock dividends

the type of investments

divestitures

additional debts

poison puts

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Competitive Factors InfluencingC/S Market Value

New entrants

Substitute products

Bargaining power of buyers

Bargaining power of suppliers

Rivalry among current competitors

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Finance 311 34

Cash Flow Concept Used for

Financial analysis

Planning Resource allocation

External sourcesCash

Internal sources

CF does not equal accounting profit

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Shareholder Wealth

Maximizing Is a MarketConcept and Results in

Maximizing PV of E(R)

Measured by Market Value of C/S

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NPV of an Investment NPV = PV of future cash inflows minus

PV of cash outflows

The NPV of an investment representsthe contributions of that investment tothe value of the firm and affects the

Stockholders Wealth Maximization(SWM)

EVA and MVA

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Small BusinessVs.

Large Corporations

Fundamental concepts are the same

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Finance 311 38

Small Business

1) Not the dominant firm in the industry

2) Tend to grow more rapidly

3) Limited access to financial markets4) Lack management resources

5) Have a high failure rate

6) Stock is not publicly traded7) Poorly diversified

8) Owner/manager frequently the same

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Finance 311 39

Treasurers Activities Management of cash and marketable

securities

Capital Budgeting

Financial Planning

Credit Analysis Investor Relations

Pension Fund Management

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Finance 311 40

Controllers Activities Financial Accounting

Cost Accounting

Taxes

Data Processing

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Economics

Accounting

Marketing

Production

Human Resources

Quantitative Analysis

MIS

Finance

Disciplines Impacting Finance

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Finance 311 42

Professional Organizations Financial Executives International

Institute of Chartered Financial Analysts

Financial Management Association

Credit Management Association

Institute of Certified Financial Planners Institute of Management Accountants

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Exciting Career Opportunities

in Finance Certified Cash Manager Credit Manager

Vice President of Finance

(CFO) Director, Investor

Relations

Assistant Treasurer

Tax Manager Financial Planner

Banker

Financial Analyst

Mutual Fund Manager

Account Executive,Security Broker

Mortgage Analyst

Investment Banker Real Estate Analyst

Insurance Broker

Check outhttp://www.careerpath.com/

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