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FINANCIAL MANAGEMENT  Disinvestment – must not be ignored.

Assets
First Trimester 2016 that can no longer be economically justified
By Alfredo M. Ofrecio III may need to be reduced, eliminated, or
replaced.
Course Overview:
2. FINANCING DECISION - concerned with the makeup of
1. Introduction to Financial Management
the right-hand side of the balance sheet.
2. Valuation
 Dividend policy must be viewed as an integral
3. Financial Analysis and Planning
part of the firm’s financing decision.
4. Capital Management and Investment
“Dividend-Payout Ratio”
5. Cost of Capital, Capital Structure and Dividend
 Once the mix of financing has been decided,
Policy
the financial manager must still determine
6. Zero Base Budget Setup
how best to physically acquire the needed
funds. The mechanics of getting a short-term
loan, entering into a long-term lease
arrangement, or negotiating a sale of bonds or
stock must be understood.
PART 1. INTRODUCTION TO FINANCIAL MANAGEMENT
3. ASSET MANAGEMENT DECISION - assets must be
“THE ROLE OF FINANCIAL MANAGEMENT”
managed efficiently.
 The financial manager be more concerned
Chapter Overview: with the management of current assets than
A. Objectives and Introduction with that of fixed assets.
B. What is Financial Management?
C. The Goal of the Firm
D. Corporate Governance
C. THE GOAL OF THE FIRM
E. Organization of the Financial Management Function

The goal of the firm is to maximize the wealth of the firm’s present
owners.
A. INTRODUCTION
WEALTH MAXIMIZATION
(MARKET PRICE PER SHARE)
The financial manager plays a dynamic role in a modern company’s
development. This has not always been the case. Until around the first
Shares of common stock give evidence of ownership in a corporation.
half of the 1900s financial managers primarily raised funds and
Shareholder wealth is represented by the market price per share of the
managed their firms’ cash positions – and that was pretty much it. In
firm’s common stock, which, in turn, is a reflection of the firm’s
the 1950s, the increasing acceptance of present value concepts
investment, financing, and asset management decisions. The idea is
encouraged financial managers to expand their responsibilities and to
that the success of a business decision should be judged by the effect
become concerned with the selection of capital investment projects.
that it ultimately has on share price.
Today, external factors have an increasing impact on the financial
 VALUE CREATION
manager. Heightened corporate competition, technological change,
ü Profit Maximization – EPS would fall.
volatility in inflation and interest rates, worldwide economic
ü Earnings Per Share (EPS) – improved version of
uncertainty, fluctuating exchange rates, tax law changes,
Profit Maximization.
environmental issues, and ethical concerns over certain financial
 It doesn’t specify the timing and duration
dealings must be dealt with almost daily. AS A RESULT, FINANCE IS
of expected returns.
REQUIRED TO PLAY AN EVER MORE VITAL STRATEGIC ROLE WITHIN
 Risk is not considered.
THE CORPORATION.
 This objective does not allow for the
effect of dividend policy on the market
The financial manager has emerged as a team player in the overall
price of the stock.
effort of a company to create value.

The successful financial manager of tomorrow will need to supplement IMPORTANT POINT: The market price of a firm’s stock represents the
the traditional metrics of performance with new methods that focal judgment of all market participants as to the value of the
encourage a greater role for uncertainty and multiple assumptions. particular firm. It takes into account present and expected future
earnings per share; the timing, duration, and risk of these earnings;
the dividend policy of the firm; and other factors that bear on the
B. WHAT IS FINANCIAL MANAGEMENT? market price of the stock. The market price serves as a barometer for
business performance; it indicates how well management is doing on
behalf of its shareholders.
FINANCIAL MANAGEMENT is concerned with the acquisition,
financing, and management of assets with some overall goal in mind.  AGENCY PROBLEMS
Thus the decision function of financial management can be broken ü The objectives of management may differ from
down into three major areas: the investment, financing, and asset those of the firm’s shareholders.
management decisions. ü In a large corporation, stock may be so widely held
that shareholders cannot even make known their
THREE MAJOR AREAS OF DECISIONS objectives, much less control or influence
management. Thus this separation of ownership
1. INVESTMENT DECISION – most important when it from management creates a situation in which
comes to value creation. management may act in its own best interests
 This is the determination of the total amount rather than those of the shareholders.
of assets needed to be held by the firm. ü Management = Agents = Individual(s) authorized
 Even when this number is known, the by another person, called the principal, to act on
composition of the assets must still be the latter’s behalf.
decided.

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ü Agency Theory (Arrangement)= They showed that
the principals, in our case the shareholders, can
assure themselves that the agents (management)
will make optimal decisions only if appropriate E. ORGANIZATION OF THE FINANCIAL MANAGEMENT
incentives are given and only if the agents are
FUNCTION
monitored.

 CORPORATE SOCIAL RESPONSIBILITY (CSR)


ü A business outlook that acknowledges a firm’s
responsibilities to its stakeholders and the natural
environment.
ü Ex. 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.
ü Stakeholders = All constituencies with a stake in
the fortunes of the company. They include
shareholders, creditors, customers, employees,
suppliers, and local and international communities
in which the firm operates.
ü Sustainability = Meeting the needs of the present
without compromising the ability of future
generations to meet their own needs.

D. CORPORATE GOVERNANCE

The system by which corporations are managed and controlled. It


encompasses the relationships among a company’s shareholders,
board of directors, and senior management.

 Common Shareholders
 Board of Directors
 Senior Management

 THE ROLE OF THE BOARD OF DIRECTORS


The board of directors sets company-wide policy and advises
the CEO and other senior executives, who manage the QUESTIONS
company’s day-to-day activities.
Boards review and approve strategy, significant investments, 1. If all companies had an objective of maximizing shareholder
and acquisitions. The board also oversees operating plans, wealth, would people overall tend to be better or worse off?
capital budgets, and the company’s financial reports to
common shareholders. With an objective of maximizing shareholder wealth, capital will tend
to be allocated to the most productive investment opportunities on a
 SARBANES-OXLEY ACT OF 2002 (SOX) risk-adjusted return basis. Other decisions will also be made to
Sarbanes-Oxley mandates reforms to combat corporate and maximize efficiency. If all firms do this, productivity will be heightened
accounting fraud, and imposes new penalties for violations of and the economy will realize higher real growth. There will be a greater
securities laws. It also calls for a variety of higher standards level of overall economic want satisfaction. Presumably people overall
for corporate governance, and establishes the Public will benefit, but this depends in part on the redistribution of income
Company Accounting Oversight Board (PCAOB). and wealth via taxation and social programs. In other words, the
economic pie will grow larger and everybody should be better off if
there is no reslicing. With reslicing, it is possible some people will be
worse off, but that is the result of a governmental change in
redistribution. It is not due to the objective function of corporations.

2. Contrast the objective of maximizing earnings with that of


maximizing wealth.

Maximizing earnings is a nonfunctional objective for the following


reasons:
a. Earnings is a time vector. Unless one time vector of earnings
clearly dominates all other time vectors, it is impossible to
select the vector that will maximize earnings.
b. Each time vector of earning possesses a risk characteristic.
Maximizing expected earnings ignores the risk parameter.
c. Earnings can be increased by selling stock and buying
treasury bills. Earnings will continue to increase since stock
does not require out-of-pocket costs.
d. The impact of dividend policies is ignored. If all earnings are
retained, future earnings are increased. However, stock

Page 2 of 3- Part 1. Introduction to Financial Management – alfred.ofrecio@gmail.com


prices may decrease as a result of adverse reaction to the
absence of dividends. As in other things, there is a competitive market for good managers. A
Maximizing wealth takes into account earnings, the timing and risk of company must pay them their opportunity cost, and indeed this is in
these earnings, and the dividend policy of the firm. the interest of stockholders. To the extent managers are paid in excess
of their economic contribution, the returns available to investors will
3. What is financial management all about? be less. However, stockholders can sell their stock and invest
elsewhere. Therefore, there is a balancing factor that works in the
Financial management is concerned with the acquisition, financing, direction of equilibrating managers’ pay across business firms for a
and management of assets with some overall goal in mind. Thus, the given level of economic contribution.
function of financial management can be broken down into three
major decision areas: the investment, financing, and asset 10. How does the notion of risk and reward govern the behavior of
management decisions. financial managers?

4. Is the goal of zero profits for some finite period (three to five In competitive and efficient markets, greater rewards can be obtained
years, for example) ever consistent with the maximization-of- only with greater risk. The financial manager is constantly involved in
wealth objective? decisions involving a trade-off between the two. For the company, it is
important that it do well what it knows best. There is little reason to
Yes, zero accounting profit while the firm establishes market position is believe that if it gets into a new area in which it has no expertise that
consistent with the maximization of wealth objective. Other the rewards will be commensurate with the risk that is involved. The
investments where short-run profits are sacrificed for the long-run also risk-reward trade-off will become increasingly apparent to the student
are possible. as this book unfolds.

5. Explain why judging the efficiency of any financial decision 11. What is corporate governance? What role does a corporation’s
requires the existence of a goal. board of directors play in corporate governance?

The goal of the firm gives the financial manager an objective function Corporate governance refers to the system by which corporations are
to maximize. He/she can judge the value (efficiency) of any financial managed and controlled. It encompasses the relationships among a
decision by its impact on that goal. Without such a goal, the manager company’s shareholders, board of directors, and senior management.
would be "at sea" in that he/she would have no objective criterion to These relationships provide the framework within which corporate
guide his/her actions. objectives are set and performance is monitored.

6. What are the three major functions of the financial manager? The board of directors sets company-wide policy and advises the CEO
How are they related? and other senior executives, who manage the company’s day-to-day
activities. The Board reviews and approves strategy, significant
The financial manager is involved in the acquisition, financing, and investments, and acquisitions. The board also oversees operating
management of assets. These three functional areas are all plans, capital budgets, and the company’s financial reports to common
interrelated (e.g., a decision to acquire an asset necessitates the shareholders.
financing and management of that asset, whereas financing and
management costs affect the decision to invest). 12. Compare and contrast the roles that a firm’s treasurer and
controller have in the operation of the firm.
7. Should the managers of a company own sizable amounts of
common stock in the company? What are the pros and cons? The controller’s responsibilities are primarily accounting in nature. Cost
accounting, as well as budgets and forecasts, would be for internal
If managers have sizable stock positions in the company, they will have consumption. External financial reporting would be provided to the
a greater understanding for the valuation of the company. Moreover, IRS, the SEC, and the stockholders.
they may have a greater incentive to maximize shareholder wealth
than they would in the absence of stock holdings. However, to the The treasurer’s responsibilities fall into the decision areas most
extent persons have not only human capital but also most of their commonly associated with financial management: investment (capital
financial capital tied up in the company, they may be more risk averse budgeting, pension management), financing (commercial banking and
than is desirable. If the company deteriorates because a risky decision investment banking relationships, investor relations, dividend
proves bad, they stand to lose not only their jobs but have a drop in disbursement), and asset management (cash management, credit
the value of their assets. Excessive risk aversion can work to the management).
detriment of maximizing shareholder wealth as can excessive risk
seeking, if the manager is particularly risk prone.
Reference:
8. During the last few decades, a number of environmental, hiring,  Fundamentals of Financial Management 13th Edition, James C. Van
and other regulations have been imposed on businesses. In view Horne and John M. Wachowicz, Jr.
of these regulatory changes, is maximization of shareholder
wealth any longer a realistic objective?

Regulations imposed by the government constitute constraints against


which shareholder wealth can still be maximized. It is important that
wealth maximization remain the principal goal of firms if economic
efficiency is to be achieved in society and people are to have increasing
real standards of living. The benefits of regulations to society must be
evaluated relative to the costs imposed on economic efficiency. Where
benefits are small relative to the costs, businesses need to make this
known through the political process so that the regulations can be
modified. Presently there is considerable attention being given in
Washington to deregulation. Some things have been done to make
regulations less onerous and to allow competitive markets to work.

9. As an investor, do you think that some managers are paid too


much? Do their rewards come at your expense?

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