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The Goals and

1
Functions of
Financial
Management

Chapter

McGraw-Hill/Irwin
Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
What is finance?
• Finance is the study of how people and businesses
evaluate investments and raise capital to fund
them.
• Finance is study best deals with the sources
funding (best mix of capital structure) of
corporations with best uses of momey
(investments)
• Finance is a field that deals with the study of
investments. It includes the dynamics of assets and
liabilities over time under conditions of different
degrees of uncertainty and risk. .
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 Finance is the art and science of
managing wealth.
It is about making decisions regarding
what assets to buy/sell and when to
buy/sell these assets.
Its main objective is to make individuals
and their businesses better off.

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Copyright © 2006 Pearson Addison-
Wesley. All rights reserved.
Three Questions Addressed
by the Study of Finance:
1. What long-term investments should the firm
undertake? (capital budgeting decisions)
2. How should the firm fund these
investments? (capital structure decisions)
3. How can the firm best manage its cash
flows as they arise in its day-to-day
operations? (working capital management
decisions)
Why Study Finance?

• Knowledge of financial tools is critical


to making good decisions in both
professional world and personal lives.

• Many personal decisions require


financial knowledge (for example: buying a
house, planning for retirement, leasing a car)


Top 3 Types of Financial Management
Decisions :help to achieve the financ
-ial goals
Type # 1. Investment Decisions:
(i)Long-term investment decision : The long-term investment decision
is referred to as the capital budgeting
(ii)Short-term investment decision: the short-term investment decision
as working capital management.
Type # 2. Financing Decisions:
financing decision is not only concerned with how best to finance new
assets, but also concerned with the best overall mix of financing
for the firm
Type # 3. Dividend Decision:
The third major financial decision relates to the disbursement of
profits back to investors who supplied capital to the firm. The term
dividend refers to that part of profits of a company which is distributed
by it among its shareholders

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Working capital:
•The cash available for day-to-day operations of
an organization.
•The amount of money a company has on hand,.
• Working capital is frequently used to measure a
firm's ability to meet current obligations.

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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?
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?
• The balance sheet displays the company's total
assets, and how these assets are financed,
through either debt or equity
• On the right side, the balance sheet outlines the
companies liabilities and shareholders' equity
Dividend Decision:

• What is the best dividend policy (e.g.,


dividend-payout ratio)?
• Calculating dividend payout ratio as a
percentage of earnings
• How will the funds be physically
acquired(obtained)?
• If the price of a stock rises: ,it is mean
(maximize the wealth of shareholders (owners) )
• How will the Dividend Decision help to
achieve its financial goals?

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Value of the Stock
market value (price)

• Primary goal is to maximize the wealth


of the company’s shareholders (owners)
by increasing the market value (price)
of their shares

E(Dt)
P0  
t  0 (1  r)
t
Value of a Stock Rises When:
• Expected Dividends Increase E(D) 
• Risk of the Bank Falls  Risk (r)
• Combination of Expected Dividend
Increase  and Risk Decline 
What is Financial Management? The role of the financial manager

Financial managers typically do the


following:
 Prepare (and the adjustment) the financial
statements., business activity reports, and
forecasts
 Monitor financial details to ensure that legal
requirements are met
 Supervise employees who do financial reporting
and budgeting
 Review company financial reports and seek ways
to reduce costs
 Analyze market trends to find opportunities for
expansion or for acquiring other companies
 Help management make financial decisions
to maximize the wealth of the company’s shareholders
(owners) 1-13
PPT 1-3

What is Financial
Management?
The business function involving:
– Managing daily financial
activities-cash inflows and
outflows
– Choosing long-term
investments of value and
obtaining the funds to pay for
them
– Managing the risks taken
by the firm
Relationship between Finance,
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
– Statement of cash flows
• Finance links economic theory with the numbers of
accounting
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• Social: Knowledge of the composition(structure) of the
society and knowledge of customs and traditions.
• Study Cultural Differences :For example :Fitness may be big
business in the United States, but it’s unlikely to have the same draw in
certain Middle Eastern countries. You need to understand cultural
differences that could affect your business’s viability. Research the
culture surrounding the product or service you’ll be selling to ensure
that there’s a market and a need for it
• Politics: the activities associated with the governance of a
country or area, especially the debate between parties
having power.
Security and political stability

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PPT 1-5
If you want to read the financial statements you need to understand many
economic factors, such as:

The Economic Environment


The financial manager • domestic and international
considers many competition: The level
of competition you will experience in
economic factors, such foreign markets is likely to be more
as dynamic and complex than you
experience in domestic markets
• inflation:is the rate at which the
general level of prices for goods and
• foreign trade statistics:is the
services is rising official source for Countries. export
and import statistics
• unemployment rate:Is the number •international capital flows : the
of workless people as a percentage of the movement of money for the purpose
labour force of investment, trade or business
• industrial production: is a production Across international
measure of output of the industrial sector borders
of the economy •
The Economic Environment
• exchange rates:is the rate at • the state of financial
which one currency will be exchanged
for another.
markets:is a market in which
people trade financial securities,
• changes in technology: commodities, and value at low
technological development: transaction costs and at prices that
• Technological changes are very reflect supply and demand.(type)
rapid
• changes in government
• consumer and investor
policy: For example, a rise in
attitudes:Understanding corporation tax (on business profits)
consumer attitudes can help a has the same effect as an increase
business understand customers in costs.
better and perhaps even change
their attitudes. • etc. etc.

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What is th Financial Management? What are the Functions and Activities
of Financial Management?

Financial Management
 Financial management or business finance
is concerned with managing an entity’s
money
 Functions:
– Allocate funds to current and fixed assets
– Obtain the best mix of financing alternatives
– Develop an appropriate dividend policy within
the context of the firm’s objectives

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Functions and Activities PPT 1-9

of Financial Management
Functions involve:
– raising funds for the firm at minimal cost and acceptable risk
– investing those funds in company assets so as to earn an
attractive return given acceptable risks
Activities include:
– Working Capital Management
• short-term (S/T) financial decisions (<1 year)
• ex., managing cash and other current assets
– Capital Budgeting
• long-term (L/T) financial decisions (>1 year)
• ex., purchasing a new machine in the future
– Financing decisions (capital structure)
structure
• how to raise money: loans? leases? shares? bonds?
Financial Management Decisions

• Capital budgeting
– What long-term investments or projects should
the business take on?
• Capital structure
– How should we pay for our assets?
– Should we use debt or equity?
• Working capital management
– How do we manage the day-to-day finances of
the firm?

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What is Corporate Finance?
Corporate Finance addresses the
following three questions:

1. What long-term investments should the firm


engage in?
2. How can the firm raise the money for the
required investments?
3. How much short-term cash flow does a
company need to pay its bills?
The Balance-Sheet Model of the
Total Value of Assets:
Firm Total Firm Value to Investors:

Current
Liabilities
Current Assets

Long-Term Debt

Fixed Assets
1 Tangible
Shareholders’
2 Intangible Equity
Functions of the Financial Manager

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Corporate Finance

• Some important questions that are


answered using finance:
– What long-term investments should the firm
take on?
– Where will we get the long-term financing to
pay for the investment?
– How will we manage the everyday financial
activities of the firm?

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Financial Manager

• Financial managers try to answer some or all


of these questions
• The top financial manager within a firm is
usually the Chief Financial Officer (CFO)
– Treasurer –Treasurer a person appointed to administer or
manage the financial assets and liabilities of a society, company,
local authority, or other body> oversees
cash
management, credit management, capital
expenditures, and financial planning
– Controller – oversees taxes, cost accounting,
financial accounting and data processing

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1-27

Hypothetical Organization Chart


Board of Directors

Chairman of the Board and


Chief Executive Officer (CEO)

President and Chief


Operating Officer (COO)

Vice President Finance

Treasurer Controller

Cash Manager Credit Manager Tax Manager Cost Accounting

Capital Expenditures Financial Planning Financial Accounting Data Processing

McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited


Managing Managers

• Managerial compensation
– Incentives can be used to align management and
stockholder interests
– The incentives need to be structured carefully to make
sure that they achieve their goal
• Corporate control
– The threat of a takeover may result in better
management :
Carl Icahn – buys a major stake in company that is poorly run.
Improves operations by firing bad managers. Some managers are
motivated to do better and everybody benefits. Company value
goes up which in return maxes profits of shareholders .

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1.2 The Corporate Firm
• The corporate form of business is the
standard method for solving the problems
encountered in raising large amounts of
cash.
• However, businesses can take other
forms.
PPT 1-14

Public and Private Corporations

• Public corporations’
shares are available
for purchase on the
market for the general
public
• The shares in a
private corporation are
held by a small group
of individuals and are
not sold to the public
Forms of Business Organization

• The Sole Proprietorship


• The Partnership
– General Partnership:is an arrangement by which partners
conducting a business jointly have unlimited liability ,
– Limited Partnership
– A limited partnership (LP) is a form of partnership similar to a
general partnership, except that where a general partnership must
have at least two general partners (GPs),
a limited partnership must have at least one GP and at least one
limited partner
• The Corporation
Subchapter S corporation

Owner has limited liability of a corporate shareholder but


pays income tax like a sole proprietor or partner
Subchapter S corporation
•limited liability company (LLC)
•nonprofit corporation
•With a Subchapter S corporation
. Income is taxed as direct income to stockholders.
. Has all the organizational benefits of a corporation
and its income is only taxed once.

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Sole Proprietorship
• Advantages • Disadvantages
– Easiest to start: is – Limited to life of
the easiest business structure to
form (you only need to get a owner
license or permit and register
your business with your local – Equity capital
government) (hence its
popularity) limited to owner’s
– Least regulated personal wealth
– Single owner – Unlimited liability:
Commitment goes
keeps all the profits beyond his shares to his
– Taxed once as own money

personal income – Difficult to sell


A business owned by ownership interest
one person
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Partnership

• Advantages • Disadvantages
– Two or more – Unlimited liability
owners • General
partnership
– More capital
• Limited partnership:
available
– Partnership
– Relatively easy to
dissolves when
start
one partner dies or
– Income taxed once wishes to sell
as personal – Difficult to transfer
income
ownership
A business venture with two or more owners
1-34
Corporation

• Advantages • Disadvantages
– Limited liability – Separation of
– Unlimited life ownership and
– Separation of management
ownership and – Double taxation
management (income taxed at
– Transfer of the corporate rate
and then dividends
ownership is easy
taxed at the
– Easier to raise
personal rate)
capital
A corporation
is a separate legal entity
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What The Goals of Financial Management ? How to increase market share price?

Goal of Financial Management


• What should be the goal of a corporation?
– Maximize profit?
– Minimize costs?
– Maximize market share?
– Maximize the current value of the company’s stock?
• Does this mean we should do anything and
everything to maximize owner wealth?

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The Goals of Financial Management PPT 1-7

• Primary goal is to maximize the wealth of the company’s


shareholders (owners) by increasing the market value
(price) of their shares
• May conflict with
– social / ethical goals (for example, pollution control)
– interests of management (for example, short-term
compensation)
• Management can encourage an increase in share price
by earning an attractive return (Dividents)(E(D)) at an
acceptable level of risk ( r )
Social Responsibility
• Adopting policies that:
– Maximize values in the market :A goal of financial
management can be to maximize shareholder wealth by paying dividends
and/or causing the market value to increase.

– Attracts capital
– Provides employment
– Offers benefits to the society

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The Agency Problem

• Agency relationship
– Principal hires an agent to represent his/her
interests
– Stockholders (principals) hire managers (agents)
to run the company
• Agency problem
– Conflict of interest between principal and
agent

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For Example:
• Shareholders of a company appoint managers to
look after the proceedings of the company and earn
profits on their behalf.
• The shareholders expect the managers to
distribute all the profits to the shareholders. But the
managers sensing their own growth and salary
expectation try to retain the profits for future as a
safe side. This can lead to principle agent
problem. It is one of the most noticed problems in
the current situation when most companies are not
being managed by the owners themselves
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Corporate Governance
• Agency theory
– Examines the relationship between the owners
and managers of the firm
– Conflict of interest between principal and
agent
• Institutional investors
– Have more to say about the way publicly
owned companies are managed

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Financial Markets
• A financial market is a market in which
people trade financial securities,
commodities, and other fungible items of
value at low transaction costs and at prices
that reflect supply and demand.
• Securities: include stocks and bonds, and
commodities include precious metals or
agricultural products

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Financial Markets
• Cash flows to the firm :Suppose we start with the firm
selling shares of stock and borrowing money to raise cash.
Cash flows to the firm from the financial markets (A).
The firm invests the cash in current and fixed assets (B).
These assets generate cash (C), some of which goes to pay
corporate taxes (D). After taxes are paid, some of this cash
flow is reinvested in the firm (E). The rest goes back to the
financial markets as cash paid to creditors and shareholders
• Primary vs. secondary markets
– Dealer vs. auction markets
– Listed vs. over-the-counter securities
• NYSE
• NASDAQ
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Types of financial markets
• Capital markets : which consist of:
• Stock markets, which provide financing through the issuance of shares
or common stock, and enable the subsequent trading thereof.
• Bond markets, which provide financing through the issuance of bonds, and
enable the subsequent trading thereof.
• Commodity markets, which facilitate the trading of commodities.
• Money markets, which provide short term debt financing and investment.
• Derivatives markets, which provide instruments for the management
of financial risk.[1]
• Futures markets, which provide standardized forward contracts for trading
products at some future date;
• Insurance markets, which facilitate the redistribution of various risks.

• .
Foreign exchange markets, which facilitate the trading of foreign exchange

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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
− Deals with short-term securities that have a
life of one year or less
− Securities in these markets 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

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Structure and Functions
of the Financial Markets (cont’d)
• Capital markets
– Defined as those where securities have a life of
more than one year
– Long-term markets
– Securities include:
• Common stock
• Preferred stock
• Corporate and government bonds

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Allocation of Capital Market
1 - Primary market
•The primary market is the part of the capital market that deals with
issuing of new security finance securities.
• Companies, governments or public sector institutions can obtain
funds through the sale of a new stock or bond issues through primary
market. through the sale of new stock through an initial public offering
(IPO).
– When a corporation uses the financial markets
to raise new funds, the sale of securities is
made by way of a new issue

1-48
2 - Secondary market
A secondary market is a market where investors purchase
securities or assets from other investors, rather than from
issuing companies themselves
•When the securities are sold to the public
(institutions and individuals)
•Financial managers are given feedback about
their firms’ performance

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'Risk-Return Tradeoff'

• The risk-return tradeoff :is the principle that


potential return rises with an increase in risk. Low
levels of uncertainty (low-risk) are associated
with low potential returns, whereas high levels
of uncertainty (high-risk) are associated with high
potential returns. According to the risk-return
tradeoff, invested money can render higher profits
only if it is subject to the possibility of being lost

1-50
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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PPT 1-8

 Profitability   Risk
 Profitability   Risk

• ex., 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)

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