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Chapter 1The Roles and Objectives
of Financial Management
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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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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/7/29/2019 ch01 (7)
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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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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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Optimal Form of
Organization Influenced byCost
ComplexityLiability
Continuity
Raising capitalDecision making
Tax considerations
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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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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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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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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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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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Stockholderselect a board
of directors
Board ofdirectors then
hiremanagement
( officers )
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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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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/7/29/2019 ch01 (7)
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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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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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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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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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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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Treasurers Activities Management of cash and marketable
securities
Capital Budgeting
Financial Planning
Credit Analysis Investor Relations
Pension Fund Management
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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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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
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Vice President of Finance
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