Chapter 1

The
The Role
Role of
of Financial
Financial
Management
Management
© Pearson Education Limited 2004
Fundamentals of Financial Management, 12/e
Created by: Gregory A. Kuhlemeyer, Ph.D.
Carroll College, Waukesha, WI
1
 1. An overview of Financial Management
2. Introduction and significance of financial markets
3. Differentiation between real assets and financial
assets
4. Types of Financial Markets
5. Role of capital and money markets in economic
development
6. Organizational goals and shareholder wealth
maximizationperspective

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 What is Financial
Management?

Concerns the acquisition,

financing, and
management of assets
with some overall goal in
mind.
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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 (e.g.,
dividend-payout ratio)?
 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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 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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 Shortcomings of
Alternative Perspectives
Profit Maximization
 Maximizing a firm’s earnings after taxes.
Problems
 Could increase current profits while
harming firm (e.g., defer maintenance)
 Ignores changes in the risk level of the
firm.
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 Shortcomings of
Alternative Perspectives
Earnings per Share Maximization
 Maximizing earnings after taxes divided
by shares outstanding.
Problems
 Does not specify timing or duration of
expected returns.
 Ignores changes in the risk level of the firm.

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 Strengths of Shareholder
Wealth Maximization
 Takes account of: current and future
profits and EPS;
EPS the timing,
duration, and risk of profits and EPS;
EPS
dividend policy;
policy and all other
relevant factors.
 Thus, share price serves as a
barometer for business performance.
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 The Modern Corporation

Modern Corporation

Shareholders Management

There exists a SEPARATION

between owners and managers.
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 Role of Management
Management acts as an agent
for the owners (shareholders)
of the firm.
 An agent is an individual
authorized by another person,
called the principal, to act in the
latter’s behalf.
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 Agency Theory

 Jensen and Meckling developed

a theory of the firm based on
agency theory.
theory
 Agency Theory is a branch of
economics relating to the
behavior of principals and their
agents.
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 Agency Theory

 Principals must provide incentives

so that management acts in the
principals’ best interests and then
monitor results.
 Incentives include, stock options,
perquisites, and bonuses.
bonuses

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 Separation of Ownership
and Management
 Large size of firms requires separation of ownership and management
o In 2008 GE had over $800 billion in assets and over 650,000
stockholders
o Owners (principals) ≠ Managers (agents)
o Agency costs: Owners’ interests may not align with managers’
interests
o Mitigating factors:
 Performance based compensation
 Boards of Directors may fire managers
 Threat of takeovers

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 Financial Markets
 A system comprised of
individuals and institutions,
instruments, and procedures
that bring together borrowers
and savers.

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 Flow of Funds
 Provides the ability to transfer income through
time
 Borrowing sacrifices
future income to increase
current income.
 Saving, or investing, sacrifices
current income in exchange
for greater expected income
in the future.

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 Flow of Funds
 1. Direct Transfer
 business sells its stock
directly to investors

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 Flow of Funds
 2. Indirect Transfer through Investment Bankers
 investment banker acts as middleman and
facilitates issuance of securities by reselling
the securities to savers
 (A security is a financial instrument that
represents an ownership position in a publicly-
traded corporation (stock), a creditor relationship
with governmental body or a corporation (bond)

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 Flow of Funds
 3. Indirect Transfer through
financial intermediary
 bank or mutual fund obtains
funds
from savers and uses
the money to lend
or purchase securities
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 Types of Financial
Markets
 Money Markets
 instruments traded mature in
one year or less
 Capital Markets
 includesinstruments with
maturities greater than one year
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 Types of Financial
Markets
 Debt Markets
 treasury,
corporate, mortgage-
backed, money market,
municipal, etc...
 Equity Markets
 stock markets
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 Equity Markets
 Primary
 corporationsraise funds by issuing
new securities
 Secondary
 securities
are traded among
investors after they have been
issued
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 Real Versus Financial Assets
 Essential nature of investment
• Reduce current consumption in hopes of greater
future consumption

 Real Assets
• Used to produce goods and services: Property,
plant & equipment, human capital, etc.

 Financial Assets
• Claims on real assets or claims on asset income

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 Real versus Financial
Assets
 All financial assets (owner of the claim) are offset
by a financial liability (issuer of the claim).
 When we aggregate over all balance sheets, only
real assets remain.
 Hence the net wealth of an economy is the sum of
its real assets.

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 Financial Markets and the
Economy

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 Financial Markets
 Informational Role of Financial Markets
o Do market prices equal the fair value estimate of a
security’s expected future risky cash flows?
o Can we rely on markets to allocate capital to the best uses?
 What other mechanism could we use to
allocate capital?
 Whatwould be the advantages and
disadvantages of another system?

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 Consumption Timing
o People tend to smooth consumption over time.

o If one has more than enough cash to meet

their basic needs in the current time period
one might shift consumption through time by
investing the surplus.

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 Allocation of Risk
o Investors can choose a desired risk level

 Bonds versus stock of a given company

 Tradeoff between risk and return?

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 Efficient Markets

o Market efficiency:
o Securities should be neither underpriced
nor overpriced on average

o Security prices should reflect all

information available to investors

o Whether we believe markets are efficient

affects our choice of appropriate
investment management style.

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