An Overview of Finance and

Financial Management

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Finance
Finance is the study of how people and businesses
evaluate investments and raise capital to fund them.
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?
How can we manage financial and market risk?
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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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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 oversees cash management, capital
expenditures and financial planning
Controller oversees taxes, cost accounting,
financial accounting and data processing

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An Overview of Financial
Management
Career opportunities
Issues of the new millennium
Forms of business organization
Goals of the corporation
Agency relationships
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Career Opportunities in Finance

Money and capital markets

Investments
Financial management

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Responsibilities of the Financial

Staf
Forecasting and planning
Investment and financing decisions
Coordination and control
Transactions in the financial markets
Managing risk
Working Capital Management

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Financial Management
Issues of the New Millennium
Use of computers and
electronic transfers of
information
The globalization of business

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Finance in the organizational structure of the

firm
Board of Directors

Vice President

President
CEO
Vice President
Finance
Vice President
CFO

Treasurer

Vice president

Controller

Credit Manager

Tax Dept

Inventory Manager

Cost Acc.

Director of capital budgeting Finan. Acc.

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Alternative Forms of Business

Organization
Sole proprietorship
Partnership
Corporation

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Sole Proprietorship
Advantages:
Ease of formation
Subject to few regulations
No corporate income taxes

Disadvantages:
Limited life
Unlimited liability
Difficult to raise capital
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Partnership

A partnership has roughly the

same advantages and
disadvantages as a sole
proprietorship.

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Corporation
Advantages:
Unlimited life
Easy transfer of ownership
Limited liability
Ease of raising capital

Disadvantages:
Double taxation
Cost of set-up and report filing
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Goals of the Corporation

The primary 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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The Goal of the Firm

The goal of the firm is maximization of
shareholder wealth
or
Maximization of the price of the existing
common stock

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Profit Maximization
- Most commonly cited goal
- Maximizing a firms earnings after taxes.
- Stresses the efficient use of capital resources
- Real test of fin. criteria over the long run
- Formal purpose for which companies are
established
- Pursuit of maximum profits creates greatest
economic welfare
- Ensures natural selection Stresses the efficient use
of capital resources
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Profit maximization
Problems with profit max.:

Not a clear goal. It is vague. Ambiguous.

Profit before tax? After tax? or EPS?
Profit in the short-run or in the long-run?
Profit max. ignores time value of money
Profit max. ignores risk or uncertainty
Not specific to time frame for profits to be measured
Goals are not precise, allow for misinterpretation
Ignores uncertainty and timing
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Profit Maximization

Problems
Could increase current profits while
harming firm (e.g., defer maintenance, issue
common stock to buy T-bills, etc.).
Ignores changes in the risk level of the firm.

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Maximization of Shareholder Wealth!

Value creation occurs when we maximize the share
price for current shareholders.
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
g Maximize the current market value per share
g No ambiguity
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Wealth Maximization
No short-run vs. long-run issue
One dimensional goal: If stockholders are
winning, everybody else will be winning.
Stockholders are residual owners.
Non-traded stock? Proprietorship? Partnership?
Corporation? Not-for-profit organizations?
Main challenge lies in obtaining information &
assess the likely impact of its decision on firms
value.
Discipline of the financial markets is maintained.
Also considers the goal of social responsibility.
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Contd
Social responsibility; May include welfare of the employees,
customer satisfaction and the community at large. Ethical
Responsibility ;providing safe working environment, avoid
polluting the air and to produce safe products.
Socially responsible actions have costs and firms which act in a a
socially responsible manner ,while others do not ,will be at a
disadvantage in attracting funds.
Cost increasing actions associated with social responsibility will
have to be put on a mandatory rather than a voluntary basis to
ensure that the burden falls uniformly on all businesses and to
maintain fair competition.
Stock price maximization and social welfare: Most actions that
help a firm increase the price of its stock also are beneficial to
society at large.
Most executives believe that there is a positive correlation
between ethics and long run profitability of the firm !!!!
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The Modern Corporation

Modern Corporation
Shareholders

Management

There exists a SEPARATION between

owners and managers.
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Agency Theory
Jensen

and Meckling developed a

theory of the firm based on agency
theory.

'Theory of the Firm: Managerial Behavior,

Agency Costs, and Ownership Structure', Journal
of Financial Economics, 3, (October 1976), pp.
350-360.
Agency Theory is a branch of economics relating
to the behavior of principals and their agents.
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Agency Theory contd

Principals

must provide incentives so that

management acts in the principals best
interests and then monitor results.

Incentives include, stock options, perquisites,

and bonuses.
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The Agency Problem

Contractual theory of the nature of the firm has
now become widely held.
It views the firm as a network of contracts, which
specify the roles & responsibilities of the various
participants/stakeholders
(workers,
managers,
owners, and creditors/lenders).
The potential conflict exists between different
stakeholders because they have personal goals as
well.
Agency problem mainly refers to:
(a) stockholders and managers
(b) stockholders and bondholders
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The Agency Problem

Agency Relationships and Management Goals
potential for conflict - is their too much emphasis on
corporate survival, job security and (more recently)
with management wealth creation?
Do managers Act in the Shareholders interests?
They are influenced by:
how they are compensated - does their
compensation encourage them to make decisions
that will enhance shareholder value
how easily are they replaced if they do not pursue
shareholder goals - control here is with the board
of directors
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Mechanisms Used To Ensure That Managers

Act In The Shareholders Best Interest

Managerial compensation (Incentives) plans: include

giving management performance shares, stock options or
restricted stock grants.
The proper structuring of managerial incentives( All
incentive compensation plans are designed to provide
inducements to management to act in a manner that will
contribute to stock price maximization as well as to
attract and retain top-level executives )
The threat of firing.
Shareholders intervention ( institutional shareholders
with large stakes in the firm)
The threat of takeover ( in a hostile takeover, the
managers of the acquired firm generally are fired)

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Shareholders versus Creditors

Shareholders (through managers) could
take risky actions to maximize stock
price, but 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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Does profit maximization equal

stock price maximization?
No, there is generally a high correlation
between EPS, cash flow, and stock price, but
todays stock price relies not only on current
earnings, but future earnings and cash flows.
Some actions may increase earnings, yet
cause stock price to decrease (and vice
versa).
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Factors that Afect Stock Price

Projected cash flows to

shareholders
Timing of the cash flow
stream
Riskiness of the cash flows

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Factors that Afect the Level and

Riskiness of Cash Flows

Decisions made by financial

managers:
Investment decisions
Financing decisions (the
relative use of debt financing)
Dividend policy decisions

The external environment

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