Lecture 1 - Introduction of Financial Management 1

Chapter 1
The
The Role
Role of
of Financial
Financial
Management
Management
1
After studying Chapter 1,
you should be able to:
1. Explain why the role of the financial manager today is so
important.
2. Describe "financial management" in terms of the three major
decision areas that confront the financial manager.
3. Identify the goal of the firm and understand why
shareholders' wealth maximization is preferred over other
goals.
4. Understand the potential problems arising when
management of the corporation and ownership are separated
(i.e., agency problems).
5. Understand the basic responsibilities of financial managers
and the differences between a "treasurer" and a "controller."
2
Historical Perspective
 In early 1900, financial managers had the responsibility to raise funds and
manage cash position of the firm
 In 1950’s, they were also involved in capital budgeting techniques.
 Now, they are more dynamic in responding to changing economic conditions,

managing volatilities in inflation, interest changes, world wide economic
uncertainty, fluctuating exchange rates.
3
What is Financial
Management?
Concerns the acquisition, financing, and management of assets with
some overall goal in mind. Thus the decision function of financial
management can be broken down into three major areas.
Investment
Financing
&
Asset management
4
Investment Decisions
Most important of the three decisions
when it comes to value creation.
 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
6
acquired?
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
What is the Goal
of the Firm?
Maximization of
Shareholder Wealth!
Value creation occurs when

we maximize the share price
for current shareholders.
8
Shortcomings of
Alternative Perspectives
Profit Maximization
 Maximizing a firm’s earnings after taxes.
Problems
 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.
9
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.
10
Strengths of Shareholder
Wealth Maximization
 Takes account of: current and future
profits and EPS;
EPS the timing,
duration, and risk of profits and EPS;
EPS
dividend policy;
policy and all other
relevant factors.
 Thus, share price serves as a
barometer for business performance.
11
The Modern Corporation
Modern Corporation
Shareholders Management
There exists a SEPARATION

between owners and managers.
12
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.
13
Agency Theory
 Jensen and Meckling developed

a theory of the firm based on
agency theory.
theory
 Agency Theory is a branch of
economics relating to the
behavior of principals and their
agents.
14
Agency Theory
 Principals must provide incentives

so that management acts in the
principals’ best interests and then
monitor results.
 Incentives include stock options,
perquisites, and bonuses.
bonuses
15
Social Responsibility
 Wealth maximization does not
preclude the firm from being socially
responsible.
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.
16
Organization of the Financial
Management Function
Board of Directors
President
(Chief Executive Officer)
Vice President VP of Vice President

Operations Finance Marketing
17
Organization of the Financial
Management Function
VP of Finance
Treasurer Controller
Capital Budgeting Cost Accounting
Cash Management Cost Management
Credit Management Data Processing
Dividend Disbursement General Ledger
Fin Analysis/Planning Government Reporting
Pension Management Internal Control
Insurance/Risk Mngmt Preparing Fin Stmts
Tax Analysis/Planning Preparing Budgets
Preparing Forecasts
18

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Chapter 1

 In 1950’s, they were also involved in capital budgeting techniques.

 Now, they are more dynamic in responding to changing economic conditions,

 What is the best financing mix?

Value creation occurs when

There exists a SEPARATION

 Jensen and Meckling developed

 Principals must provide incentives

Vice President VP of Vice President

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