LECTURE NO 1

THE ROLE OF FINANCIAL

MANAGEMENT

WHAT IS FINANCE ???

Finance is the science of funds management.

Finance

includes saving money and often includes

lending money. The field of finance deals with the
concepts of time, money, and risk and how they
are interrelated. It also deals with how money is
spent and budgeted.

WHAT IS BUSINESS
FINANCE?
Raising and managing of funds by
business organizations.

THE ROLE OF
FINANCIAL MANAGEMENT

What is Financial Management?

The Goal of the Firm
Corporate Governance
Organization of the Financial
Management Function

WHAT IS FINANCIAL
MANAGEMENT?
Concerns the acquisition, financing,
and management of assets with
some overall goal in mind.

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?
eg. How much of total cash is
devoted to cash or inventory?

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?
eg. Shortterm loan, long term lease
arrangement, stocks or bonds.

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.

WHAT IS THE GOAL OF THE

FIRM?

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

SHORTCOMINGS OF ALTERNATIVE
PERSPECTIVES
Profit

Maximization

Maximizing

taxes.

Problems

a firms earnings after

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.
Decrease in each owners share of profits i.e
earnings per share.

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.
Calls for a zero payout dividend policy.

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

THE MODERN CORPORATION

Modern Corporation
Shareholders

Management

There exists a SEPARATION between owners and

managers.

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 latters
behalf.

AGENCY THEORY
Jensen

and Meckling developed a

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

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.

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.

CORPORATE GOVERNANCE
Corporate

governance: represents the

system by which corporations are
managed and controlled.
Includes shareholders, board of
directors, and senior management.
Then shareholder wealth
maximization remains the
appropriate goal in governing the
firm.

BOARD OF DIRECTORS
Typical
Set

responsibilities:

company-wide policy;
Advise the CEO and other senior executives;
Hire, fire, and set the compensation of the
CEO;
Review and approve strategy, significant
investments, and acquisitions; and
Oversee operating plans, capital budgets,
and financial reports to common
shareholders.

ORGANIZATION OF THE
FINANCIAL MANAGEMENT
FUNCTION
Board of Directors
President
(Chief Executive Officer)
Vice President
Operations

VP of
Finance

Vice President
Marketing

THE BUSINESS AND FINANCIAL

ENVIRONMENTS

The Business Environment

The Financial Environment

THE BUSINESS ENVIRONMENT

Sole Proprietorships
Partnerships (general and limited)
Corporations
Limited liability companies

THE BUSINESS ENVIRONMENT

Sole Proprietorship -- A business form for
which there is one owner. This single
owner has unlimited liability for all debts of
the firm.

Oldest form of business organization.

Business income is accounted for on the owners
personal income tax form.

SUMMARY FOR
SOLE PROPRIETORSHIP
Advantages
Simplicity
Low setup cost
Quick setup
Single tax filing on
individual form

Disadvantages

Unlimited liability
Hard to raise additional
capital
Transfer of ownership
difficulties

THE BUSINESS
ENVIRONMENT
Partnership -- A business form
in which two or more
individuals act as owners.

Business income is accounted for on each partners

personal income tax form.

SUMMARY FOR PARTNERSHIP

Advantages
Can be simple
Low setup cost, higher than
sole proprietorship
Relatively quick setup
Limited liability for limited
partners

Disadvantages
Unlimited liability for the
general partner
Difficult to raise additional
capital, but easier than sole
proprietorship
Transfer of ownership
difficulties

THE BUSINESS
ENVIRONMENT
Corporation -- A business form
legally separate from its
owners.
An artificial entity that can own assets and incur

liabilities.
Business income is accounted for on the income tax
form of the corporation.

SUMMARY FOR CORPORATION

Advantages
Limited liability
Easy transfer of
ownership
Unlimited life
Easier to raise large
quantities of capital

Disadvantages
Double taxation
More difficult to
establish
More expensive to
set up and maintain

THE BUSINESS
ENVIRONMENT
Limited Liability Companies -- A
business form that provides its
owners (called members) with
corporate-style limited personal
liability and the federal-tax
treatment
ofisaaccounted
partnership.
Business
income
for on each
members individual income tax form.

LIMITED LIABILITY
COMPANY (LLC)
Generally, an LLC will possess only
the first two of the following four
standard corporation characteristics

Limited liability
Centralized management
Unlimited life
Transfer of ownership without other owners prior
consent

SUMMARY FOR LLC

Advantages
Limited liability
Eliminates double
taxation
No restriction on number
or type of owners
Easier to raise additional
capital

Disadvantages
Limited life
(generally)
Transfer of
ownership difficulties
(generally)

FINANCIAL ENVIRONMENT
Businesses

interact continually with the

financial markets.
Financial Markets are composed of all
institutions and procedures for bringing buyers
and sellers of financial instruments together.
The purpose of financial markets is to efficiently
allocate savings to ultimate users.

TYPES OF FINANCIAL
MARKETS
PRIMARY MARKET: IN WHICH

NEWLY ISSUED SECURITIES ARE TRADED.

SECONDARY MARKET: IN WHICH

PREVIOUSLY ISSUED SECURITIES ARE
TRADED

TYPES OF FINANCIAL
MARKETS
MONEY MARKET: IN WHICH

SECURITIES HAVING MATURITY LESS THAN

ONE YEAR ARE TRADED

CAPITAL MARKET: IN WHICH

SECURITIES HAVING MATURITY MORE

THAN A YEAR ARE TRADED