CHAPTER 1

Goals & Governance of the Firm

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 The Role of Financial Management

 What is Financial Management?

 The Goal of the Firm

 Organization of the Financial Management Function

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 What is Financial Management?
Financial management is concerned with
the duties of the financial manager in the
business firm. Its important to comprehend
the financial decision-making process
since most business decisions ultimately
involve financial considerations.

Concerns the acquisition, financing, and

management of assets with some overall
goal in mind.
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What is Financial Management

Acquisition
 
Management To achieve goal

 Assets
Financing


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 What is Financial Management?

 Investment Decisions: involves spending money (tangible &

intangible assets)
 Financing Decisions: raising money (equity financing or debt
investors)
 Choice between debt and equity financing is called capital
structure decision. (long term financing)
 Asset Management Decisions
Finance Managers add value when ever the
corporation can invest to earn a higher return
than its shareholders can earn for themselves.

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 Investment Decisions

Most important of the three

decisions.
 What is the optimal firm size?
 What specific assets should be acquired?
 What assets (if any) should be reduced or eliminated?

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 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 acquired?

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 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.

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Real Assets & Financial Assets
 When the firm invests, it acquires real assets , which are then used
to produce the firm’s products and services
 The firm finances its investment in real assets by issuing financial
assets to investors. A share of stock is a financial asset, which has
value as a claim on the firm’s real assets and on the income that
those assets will produce. A bank loan is a financial asset also. It
gives the bank the right to get its money back plus interest. If the
firm’s operations can’t generate enough income to pay what the
bank is owed, the bank can force the firm into bankruptcy and
stake a claim on its real assets. Shares of stock and other financial
assets that can be purchased and traded by investors are called
securities.

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 The Goal of the Firm?

 Profit Maximization? (short term vs long term approach /

divident payout vs reinvestment approach)

 Earnings per Share Maximization?

 Sales Maximization?

 Maximization of Shareholder Wealth (opportunity cost of

capital)
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What is the Goal of the Firm?

Maximization of Shareholder
Wealth!
Value creation occurs when we maximize the share price for
current shareholders.

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Relationship between FM &
supportive disciplines
Financial Decision areas

Primary Discipline
•Accounting

•Macroeconomics
Support

Investment analysis •Microeconomics
Working capital management

Source & cost of funds

Determine capital structure

Dividend policy

Analysis of risks & returns

Support
 Other related disciplines
•Marketing

•Production

•Quantitative methods
Resulting in


Shareholder wealth maximization

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Financial Managers
 Chief Financial Officer: Sets overall financial strategy he is
deeply involved in financial policy and financial planning and
is in constant contact with the chief executive officer (CEO)
and other top management. The CFO is the most important
financial voice of the corporation and explains earnings
results and forecasts to investors and the media.
 Treasurer: Looks after the firm’s cash, raises new capital, and
maintains relationships with banks and other investors that
hold the firm’s securities.
 Controller: prepares the financial statements, manages the
firm’s internal budgets and accounting, and looks after its tax
affairs
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 Strengths of Shareholder Wealth
Maximization
 Takes account of: current and future profits and EPS; the timing, duration, and risk of profits and EPS; dividend policy; and all other relevant factors.

 Thus, share price serves as a barometer for business performance and any activity that is expected to increase a firm’s share price should be pursued.

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An overview of Financial
Management
 Financial Management

Maximization of share value



Financial Decision

Investment Financing
 Assets
Decision decision Management

Trade-off


Return Risk


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 What About Other Stakeholders
Stakeholders include all groups of individuals who have a
vested/financial interest in the firm including:
 Employees
 Customers
 Suppliers
 Creditors
 Owners
 Government
 The "Stakeholder View" prescribes that the firm make a conscious
effort to avoid actions that could be detrimental to the wealth
position of its stakeholders.
 Such a view is considered to be "socially responsible."

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 Social Responsibility

 Wealth maximization does not preclude the firm

from being socially 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.

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Corporate Social responsibility

CSR is about how companies manage

the business processes to produce an

overall positive impact on society.

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Responsibility of the Financial Staff
 Maximize stock value by:
 Forecasting and planning

 Investment and financing decisions

 Coordination and control

 Transactions in the financial markets

 Managing risk

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Role of Finance in a Typical Business
Organization

Board of Directors

President

VP: Sales VP: Finance VP: Operations

Treasurer Controller

Credit Manager Cost Accounting

Inventory Manager Financial Accounting

Capital Budgeting Director Tax Department

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Alternative Forms of Business
Organization
 Sole proprietorship
 Partnership
 Corporation

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Sole Proprietorship
 Unincorporated business owned by one individual (1
owner)
 Advantages:
 Easily and inexpensively formed
 Subject to few regulations
 Its income is not subject to corporate taxation but
 it is taxed only as a part of the proprietor’s income

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Sole Proprietorship
 Disadvantages:
 Difficult to raise capital
 It is difficult for a single owner to obtain the capital needed for
growth
 Unlimited liability
 The proprietor has unlimited personal liability for the business’s
debts
 Limited life
 The life of a proprietorship is limited to the life of its founder
 Used primarily for small businesses

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Partnership
 More than 1 owner
 Exists whenever two or more persons associate to conduct a
business for profit
 Partnership agreements
 Formal or informal
 Define the ways any profits and losses are shared between
partners

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Partnership
 Major advantage
 Its low cost and ease of formation
 Partnership’s income is not subject to corporate taxation but is
taxed only as a part of the partner’s personal income

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Partnership
 Disadvantages
 Unlimited liability
 Limited life of the organization
 Difficulty transferring ownership
 Difficulty raising large amounts of capital
 Regarding liability
 The partners can potentially lose all of their personal assets,
even assets not invested in the business
 Under partnership law, each partner is liable for the business’s
debts

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Partnership
 Disadvantages
 Unlimited liability
 Limited life of the organization
 Difficulty transferring ownership
 Difficulty raising large amounts of capital
 Regarding liability
 The partners can potentially lose all of their personal assets,
even assets not invested in the business
 Under partnership law, each partner is liable for the business’s
debts

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Partnership
 It is possible to limit the liabilities of some of the partners by
establishing a limited partnership
 Certain partners are designated general partners and others
limited partners
 Limited partners are liable only for the amount of their investment in the
partnership
 Limited partners typically have no control
 General partners have unlimited liability

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Partnership
 In both regular and limited partnership, at least one
partner is liable for the debts of the partnership
 In a limited liability partnership (LLP), or
 limited liability company (LLC)
 All partners enjoy limited liability with regard to the business’s
liabilities
 Their potential losses are limited to their investment
 This increase the risk faced by an LLP’s lender, customers, and
suppliers

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Corporation
 Is a distinct permanent legal entity
 Many owners (shareholder or stockholders)
 Legal entity created by a state, and it is separate and distinct
from its owners and managers
 Management & control through board of Directors

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Corporation
 Advantages:
 Unlimited life
 A corporation can continue after its original owners and
managers are deceased
 Easy transfer of ownership
 Ownership interests can be divided into shares of stock, which
can be transferred easily
 Limited liability
 Losses are limited to the actual funds invested
 Ease of raising capital

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Corporation
 Disadvantages:
 Corporate earnings may be subject to double taxation
 The earnings of the corporation are taxed at the corporate level,
and then
 earnings paid out as dividends are taxed again as income to the
stock holders
 Cost of set-up and report filing
 Setting up a corporation involves preparing a charter, writing a
set of bylaws and filling the many required reports

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Corporation
 Charter: Establishing Separate Legal Entity
 Name
 Activities
 Amount of Capital Stock
 Number of Directors
 Names & Addresses of Directors
 Bylaws: Rules for conduct of Activities
 How Directors will be elected
 Preemptive Right to new stock issues
 Procedures for changing Bylaws, if required

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Financial Goals of the Corporation

 The primary financial goal is shareholder wealth

maximization, which translates to maximizing stock price.
 Do firms have any responsibilities to society at large?
 Is stock price maximization good or bad for society?
 Should firms behave ethically?

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Is stock price maximization the same
as profit maximization?

 No, despite a generally high correlation amongst stock price,

EPS, and cash flow.
 Current stock price relies upon current earnings, as well as
future earnings and cash flow.
 Some actions may cause an increase in earnings, yet cause the
stock price to decrease (and vice versa).

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Agency relationships
 An agency relationship exists whenever a principal hires an
agent to act on their behalf.
 Within a corporation, agency relationships exist between:
 Shareholders and managers

 Shareholders and creditors

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Shareholders versus Managers
 Managers are naturally inclined to act in their own best
interests.
 But the following factors affect managerial behavior:
 Managerial compensation plans
 Direct intervention by shareholders
 The threat of firing
 The threat of takeover

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Shareholders versus Creditors
 Shareholders (through managers) could take actions to
maximize stock price that are detrimental to creditors.
 In the long run, such actions will raise the cost of debt and
ultimately lower stock price.

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Factors that affect stock price
 Projected cash flows to
shareholders
 Timing of the cash flow
stream
 Riskiness of the cash
flows

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 Factors that Affect the Level and
Riskiness of Cash Flows

 Decisions made by financial managers:

 Investment decisions
 Financing decisions (the relative use of debt financing)
 Asset Management decisions
 Dividend policy decisions
 The external environment

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END

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