The Goals and

1
Functions of
Financial
Management

Chapter

McGraw-Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
 Chapter Outline
• Introduction to Finance
• Risk-Return Tradeoff
• Forms of Organizations
• Corporate Governance
• Goals of Financial Management
• Social Responsibility and Finance
• Role of Financial Markets

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 Financial Management
 Financial Management or business finance
is concerned with managing an entity’s
money.
 For example, a company must decide:
− where to invest its money.
− whether or not to replace an old asset.
− when to issue new stocks and bonds.
− whether or not to pay dividends.

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 Relationship between Finance,
Economics and Accounting
• Economics provides structure for decision
making in many important areas.
− Provides a broad picture of economic
environment.
• Accounting provides financial data in various
forms.
– Income statements, balance sheets, and
statement of cashflows.
• Finance links economic theory with the
numbers of accounting.
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 Evolution in the Field of Finance
• At the turn of the century: Emerged as a field
separate from economics.
• By 1930s: Financial practices revolved
around such topics as:
– Preservation of capital.
– Maintenance of liquidity.
– Reorganization of financially troubled
corporation.
– Bankruptcy.
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 Evolution in the Field of Finance
(cont’d)
• By mid-1950s: Finance becomes more
analytical.
– Financial Capital (accounting capital/ money)
was used to purchase Real Capital (economic
capital/ long-term plant and equipment).
– Cash and inventory management
– Capital structure theory
– Dividend policy

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 Recent Issues in Finance
• Recent focus has been on:
– Risk-return relationships.
– Maximization of returns for a given level of risk.
– Portfolio management.
– Capital structure theory.
• New financial products with a focus on
hedging are being widely used.

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 Recent Issues in Finance (cont’d)
• The following are significant to financial
managers during decision making:
– Effects of inflation and disinflation on financial
forecasting.
– Required rates of return for capital budgeting
decisions.
– Cost of capital.

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 Advances in Internet and Finance
• Internet and its acceptance has enabled
acceleration of e-commerce solutions for “old
economy” companies.
• E-commerce solutions for existing companies
− B2C
− B2B
• Spurt in new business models and companies
− Amazon.com
− eBay

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 Advances in Internet and Finance
(cont’d)
• For a financial manager e-commerce
impacts financial management because it
affects the pattern and field through which
cash flows through the firm.
– B2C Model: Products are bought with credit
cards, credit card checks are performed, and
selling firms get the cash flow faster.
– B2B: Orders can be placed, inventory managed,
and bids to supply products can be accepted –
all online.
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Functions of the Financial Manager

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 Risk-Return Trade-Off
• Influences operational side (capital versus
labor/ Product A versus Product B)
• Influences financial mix (stocks versus
bonds versus retained earnings)
− Stocks are more profitable but riskier.
− Savings accounts are less profitable and less
risky (or safer)
• Financial manager must choose appropriate
combinations
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 Sole Proprietorship
• Represents single-person ownership
• Advantages:
– Simplicity of decision-making.
– Low organizational and operational costs.
• Drawback
– Unlimited liability to the owner.
– Profits and losses are taxed as though they
belong to the individual owner.

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 Partnership
• Similar to sole proprietorship except there
are two or more owners.
– Articles of partnership: Specifies ownership
interest, the methods for distributing profits, and
the means of withdrawing from the partnership.
– Limited partnership: One or more partners are
designated as general partners and have
unlimited liability of the debts of the firm; other
partners designated limited partners and are
liable only for their initial contribution.
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 Corporation
• Corporation
− Articles of incorporation: Specify the rights and
limitations of the entity.
− Its owned by shareholders who enjoy the
privilege of limited liability.
− Has a continual life.
− Key feature is the easy divisibility of
ownership interest by issuing shares of
stock.
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 Corporation (cont’d)
• Disadvantage:
– The potential of double taxation of earnings.
• Subchapter S corporation: Income is taxed as a direct
income to stockholders and thus is taxed only once
as normal income.

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 Corporate Governance
• Agency theory
– Examines the relationship between the owners
and managers of the firm.
• Institutional investors
– Have more to say about the way publicly owned
companies are managed.
− Public Company Accounting Oversight Board
(PCAOB)

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 Sarbanes-Oxley Act of 2002
• Set up a five member Public Company
Accounting Oversight Board (PCAOB) with
responsibility for:
– Auditing standards within companies
– Controlling the quality of audits
– Setting rules and standards for the
independence of the auditors.
• Major focus is to make sure that publicly-
traded corporations accurately present their
assets, liabilities, and equity and income on
their financial statements.
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 Goals of Financial Management
• Valuation Approach
• Maximizing shareholder wealth (shareholder
wealth maximization)
• Management and stockholder wealth
− Retention of position of power in long run is by
becoming sensitized to shareholder concerns.
− Sufficient stock option incentives to motivate
achievement of market value maximization.
− Powerful institutional investors are increasing
management more responsive to shareholders.
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 Social Responsibility
• Adoption of policies that maximize values in
the market attracts capital, provides
employment and offers benefits to the
society.
• Certain cost-increasing activities may have
to be mandatory rather than voluntary
initially, to ensure burden falls equally over
all business firms.

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 Ethical Behavior
• Ethical behavior creates invaluable
reputation.
• Insider trading
• Protected against by the Securities and
Exchange Commission (SEC).

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 The Role of Financial Markets
• Financial markets are indicators of
maximization of shareholder value and the
ethical or the unethical behavior that may
influence the value of the company.
• Participants in the financial market range
over the public, private and government
institutions.
– Public financial markets
– Corporate financial markets
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Structure and Functions of the Financial
Markets
• Money markets
− Securities in this market include commercial
paper sold by corporations to finance their daily
operations or certificates of deposit with
maturities of less than 12 months sold by banks.
• Capital markets
− Long-term markets
− Securities include common stock, preferred
stock and corporate and government bonds.

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 Stocks versus Bonds
• Stock = ownership or equity
− Stockholders own the company

• Bond = debt or IOU

− Bondholders are owed $ by company

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 Allocation of Capital
• Primary market
– When a corporation uses the financial markets
to raise new funds, the sale of securities is made
by way of a new issue.
• Secondary market
– When the securities are sold to the public
(institutions and individuals).
– Financial managers are given a feedback about
their firms’ performance.

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 Return Maximization and Risk
Minimization
• Investors can choose risk level that meets
their objective and maximizes return for that
given level of risk.
• Companies that are rewarded with high-
priced securities can raise new funds in the
money and capital markets at a lower cost
compared to competitors.
• Firms pay a penalty for failing to perform
competitively.
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 Restructuring
• Restructuring can result in:
– Changes in the capital structure (liabilities and
equity on the balance sheet).
– Selling of low-profit-margin divisions with the
proceeds of the sale reinvested in better
investment opportunities.
– Removal or large reductions in the of current
management team.
• It has resulted in acquisitions and mergers.

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Internationalization of Financial Markets

• Allocation of capital and the search for low

cost sources of financing on the rise in
global market.
• The impact of international affairs and
technology has resulted in the need for
future financial managers to understand
− International capital flows.
− Computerized electronic funds transfer systems.
− Foreign currency hedging strategies.
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Technological Impact on Capital Market

• Consolidation among major stock markets

and mergers of brokerage firms with
domestic and international partners.
• Electronic markets have gained popularity as
against traditional organized exchanges and
NASDAQ.
• Resulted in the merger of NYSE with
Archipelago and NASDAQ bought out
Insinet from Reuters.
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