CHAPTER

1
THE GOALS AND
FUNCTIONS OF
FINANCIAL
MANAGEMENT

PowerPoint Presentation Prepared by Michel Paquet, SAIT Polytechnic

© 2015 McGraw-Hill Ryerson Ltd. All Rights Reserved 1-1

 Chapter 1 - Outline
• What is Finance?
• Goals of Financial Management
• Functions of Financial Management
• Forms of Organization
• Role of Financial Markets
• Summary and Conclusions

1-2
 Learning Objectives
1. Illustrate how finance builds on the
disciplines of accounting and economics.
(LO1)
2. Identify the analysis and decision-making
nature of finance considering return and risk.
(LO2)
3. Examine the primary goal of finance as the
maximization of shareholder wealth as
measured by share price. (LO3)

1-3
 Learning Objectives
4. Debate alternative goals of the firm on the
basis of social or management interests.
(LO4)
5. Identify financial manager functions
connected to the raising and investing of
funds. (LO5)
6. Outline the role of financial markets in
allocating capital, determining value and
establishing yields. (LO6)
1-4
 What is Finance?
• Finance is about making decisions that focus on
creating value within the firm.
• Finance builds upon the disciplines of
economics and accounting.
• economics provides theories about economic system
and decision making,
• accounting supplies financial data and data analysis
tools.
• Finance has evolved from a pure descriptive
discipline through an analytical, decision-
oriented discipline to now a discipline used by
financial managers.

LO1 1-5
 What is Finance?
• Finance tries to help financial managers to
answer (i.e. make decisions about) the following
questions:
1. What long-term investments or projects the firm
should undertake? (capital budgeting decision)
2. How the firm should pay for these assets? By issuing
equity or debt? (capital structure decision)
3. How much cash or inventory the firm should carry?
How much trade credit the firm should provide or
use? (working capital management decision)
• These decisions are made within a risk-return
framework.
LO2 1-6
 Goals of Financial Management
• The primary goal is shareholder wealth
maximization because the firm is owned by the
shareholders.
• This goal should be measured in terms of
market share price, which is a value that
investors collectively are prepared to pay.
• The closest alternative – profit – fails to consider
risk and timing and more importantly, it is almost
impossible to accurately measure profit.

LO3 1-7
 Goals of Financial Management
• The goal of maximizing shareholder wealth may
conflict with
- interests of management (their compensation)
- social/ethical goals
• Agency theory is about the potential conflict
between shareholders and managers.
• Tradeoffs exist among the agency costs of
monitoring management actions, allowing
sufficient discretion for management and
designing compensation packages to motivate
management.

LO3 1-8
 Goals of Financial Management
• The goal of shareholder wealth maximization
can be consistent with a concern for social
responsibility.
• Firms should take socially desirable actions
even if certain actions like pollution control may
at times conflict with this goal.
• Managers should strictly follow the rules of
fairness and honesty.
• Insider trading and manipulation of financial
results have been proven to serve the
firm/shareholders as well as the management no
good.

LO4 1-9
 Functions of Financial Management

• The study of finance has a variety of functions

- Corporate finance
- Banking
- Securities trading and underwriting
- Money management
- Financial planning
- Risk management (insurance)
• Some of these functions are performed on a
daily basis and others are less routine.
• All these functions are carried out with the
intention to proper balance profitability against
risk.
LO5 1-10
 Figure 1-1
Functions of the Financial Manager

Daily Occasional Profitability/Return

Cash management Intermediate financing Goal:
(receipt and disbursement of
Bond issues Maximize
funds)
Leasing Trade-off
Credit management
Stock issues
shareholder
Inventory control
Short-term financing Capital budgeting wealth
Exchange and interest rate Dividend decisions
hedging Forecasting Risk
Bank relations

LO5 1-11
 Risk-Return Tradeoff
 Profitability   Risk
 Profitability   Risk
• e.g. 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)

LO6 1-12
 Forms of Organization
• Sole Proprietorship (one owner) -
largest in actual number but smallest in
total sales revenue

• Partnership - (two or more owners)

• Corporation (legal entity unto itself) -

smallest in actual number but largest in
total sales revenue

LO5 1-13
 Forms of Organization:
Sole Proprietorships
A business owned by one person
Advantages Disadvantages
• Freedom • Unlimited Liability

• Simplicity • Lack of Continuity

• Low Starting Costs • Difficult to raise

money
• Tax Benefits
• Reliance on one
person
LO5 1-14
 Forms of Organization:
Partnerships
A business owned by two or more persons
Advantages Disadvantages
• More Capital • Unlimited Liability

• Greater Talent Pool • Lack of Continuity

• Ease of Formation • Ownership transfer

is difficult
• Tax Benefits
• Possibility of
Conflicts
LO5 1-15
 Forms of Organization:
Corporations
A corporation is a separate legal entity
Advantages Disadvantages
• Limited Liability • Higher Start-Up
Costs
• Continuity
• More Regulations
• Greater Likelihood
of Professional • Double Taxation
Management
• Potential
• Easier Access to Shareholder
Capital Conflicts
LO5 1-16
 Role of Financial Markets
• Financial markets are a vast global network of
corporations, financial institutions, governments
and individuals that either need money or have
money to lend or invest
• Public financial markets are those markets for
governments to borrow funds for public activities
• Corporate financial markets are those markets
for corporations to raise funds
• The effect of managerial decisions on the value
of the firm is realized in financial markets

LO6 1-17
 Structure and Functions of
Financial Markets
• Money markets deal in short-term securities
(<1 year)
– e.g. Treasury Bills, commercial paper
• Capital markets deal in long-term securities
(>1 year)
– e.g. common stock, preferred stock, corporate bonds,
government bonds
• Primary market is where a firm issues new
bonds or shares to raise new funds
• Secondary market is where investors buy and
LO6 sell (trade) outstanding bonds or shares 1-18
 Securities in Financial Market

Stock (Share) = ownership or equity

• Shareholders own the company

Bond = debt or liability

• Bondholders are owed $ by company

LO6 1-19
 Role of Financial Markets
• Financial markets determine value and allocate
capital to the most productive use on a risk-
return basis
• Debt is an important component of a firm’s
capital structure
– Too much debt can erode the firm’s cash flow and
increases the firm’s risk
– Interest rates or yields help establish the allocation of
capital
– Greater risk increases the spread between inflation
and yield
LO6 1-20
 Figure 1-2
Prime rate versus per cent change in the CPI
20.00

Consumer price index (average annual rate)

18.00

16.00 Prime rate (December)

14.00
Percent

12.00

10.00

8.00

6.00

4.00

2.00

0.00

Source: www.bankofcanada.ca

LO6 1-21
 Summary and Conclusions
• Finance links economics and accounting.
• It helps managers make decisions to maximize
shareholder wealth.
• However, managers may pursue their own interests
instead of those of shareholders.
• Agency theory studies the conflicts between
shareholders and management.
• Financial managers make investment and financing
decisions.
• Financial markets are where financial managers raise
funds and are given feedback about the effect of their
decisions.

1-22