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1
THE GOALS AND
FUNCTIONS OF
FINANCIAL
MANAGEMENT
1-2
Learning Objectives
1. Illustrate how finance builds on the
disciplines of accounting and economics.
(LO1)
2. Identify the analysis and decision-making
nature of finance considering return and risk.
(LO2)
3. Examine the primary goal of finance as the
maximization of shareholder wealth as
measured by share price. (LO3)
1-3
Learning Objectives
4. Debate alternative goals of the firm on the
basis of social or management interests.
(LO4)
5. Identify financial manager functions
connected to the raising and investing of
funds. (LO5)
6. Outline the role of financial markets in
allocating capital, determining value and
establishing yields. (LO6)
1-4
What is Finance?
• Finance is about making decisions that focus on
creating value within the firm.
• Finance builds upon the disciplines of
economics and accounting.
• economics provides theories about economic system
and decision making,
• accounting supplies financial data and data analysis
tools.
• Finance has evolved from a pure descriptive
discipline through an analytical, decision-
oriented discipline to now a discipline used by
financial managers.
LO1 1-5
What is Finance?
• Finance tries to help financial managers to
answer (i.e. make decisions about) the following
questions:
1. What long-term investments or projects the firm
should undertake? (capital budgeting decision)
2. How the firm should pay for these assets? By issuing
equity or debt? (capital structure decision)
3. How much cash or inventory the firm should carry?
How much trade credit the firm should provide or
use? (working capital management decision)
• These decisions are made within a risk-return
framework.
LO2 1-6
Goals of Financial Management
• The primary goal is shareholder wealth
maximization because the firm is owned by the
shareholders.
• This goal should be measured in terms of
market share price, which is a value that
investors collectively are prepared to pay.
• The closest alternative – profit – fails to consider
risk and timing and more importantly, it is almost
impossible to accurately measure profit.
LO3 1-7
Goals of Financial Management
• The goal of maximizing shareholder wealth may
conflict with
- interests of management (their compensation)
- social/ethical goals
• Agency theory is about the potential conflict
between shareholders and managers.
• Tradeoffs exist among the agency costs of
monitoring management actions, allowing
sufficient discretion for management and
designing compensation packages to motivate
management.
LO3 1-8
Goals of Financial Management
• The goal of shareholder wealth maximization
can be consistent with a concern for social
responsibility.
• Firms should take socially desirable actions
even if certain actions like pollution control may
at times conflict with this goal.
• Managers should strictly follow the rules of
fairness and honesty.
• Insider trading and manipulation of financial
results have been proven to serve the
firm/shareholders as well as the management no
good.
LO4 1-9
Functions of Financial Management
LO5 1-11
Risk-Return Tradeoff
Profitability Risk
Profitability Risk
• e.g. investing in stocks vs. savings accounts
• Stocks may be more profitable but are riskier
• Savings accounts are less profitable and less
risky (or safer)
Financial manager must choose
appropriate combination of potential
profit (return) and level of risk (safety)
LO6 1-12
Forms of Organization
• Sole Proprietorship (one owner) -
largest in actual number but smallest in
total sales revenue
LO5 1-13
Forms of Organization:
Sole Proprietorships
A business owned by one person
Advantages Disadvantages
• Freedom • Unlimited Liability
LO6 1-17
Structure and Functions of
Financial Markets
• Money markets deal in short-term securities
(<1 year)
– e.g. Treasury Bills, commercial paper
• Capital markets deal in long-term securities
(>1 year)
– e.g. common stock, preferred stock, corporate bonds,
government bonds
• Primary market is where a firm issues new
bonds or shares to raise new funds
• Secondary market is where investors buy and
LO6 sell (trade) outstanding bonds or shares 1-18
Securities in Financial Market
LO6 1-19
Role of Financial Markets
• Financial markets determine value and allocate
capital to the most productive use on a risk-
return basis
• Debt is an important component of a firm’s
capital structure
– Too much debt can erode the firm’s cash flow and
increases the firm’s risk
– Interest rates or yields help establish the allocation of
capital
– Greater risk increases the spread between inflation
and yield
LO6 1-20
Figure 1-2
Prime rate versus per cent change in the CPI
20.00
14.00
Percent
12.00
10.00
8.00
6.00
4.00
2.00
0.00
Source: www.bankofcanada.ca
LO6 1-21
Summary and Conclusions
• Finance links economics and accounting.
• It helps managers make decisions to maximize
shareholder wealth.
• However, managers may pursue their own interests
instead of those of shareholders.
• Agency theory studies the conflicts between
shareholders and management.
• Financial managers make investment and financing
decisions.
• Financial markets are where financial managers raise
funds and are given feedback about the effect of their
decisions.
1-22