Chapter 1:

THE GOALS AND FUNCTIONS OF

FINANCIAL MANAGEMENT
 Learning Outcome
1. What is Finance?
2. What is Financial Management?
3. Functions of Finance/Financial Management.
4. Financial Management Decision.
5. Financial Managers Responsibilities.
6. The Goal of Financial Management.
7. Wealth Maximization Vs. Profit Maximization.
8. Financial Market and Institutions.
 What is Finance?

“Finance is the Art and Science of Managing Money”

- L.J. Gitman.

• Personal level, finance is concerned with individuals’

decisions about how much of their Earnings they Spend, how
much they Save, and how they Invest their Savings.

• Business context, finance involves the same types of

decisions: how firms Raise money from Investors, how firms
Invest money in an attempt to earn a Profit, and how they
decide whether to Reinvest Profits in the business or distribute
them back to Investors.
The Field of Finance
Finance is related to:
– Accounting, which provides information in financial
statements (Income Statement, Balance Sheet and Cash Flow
Statement)
– In smaller firms, the financial manager generally performs
both functions.
– Economics, which provides
• Decision-making tools such as pricing theory (supply and demand),
risk analysis, comparative return analysis.
• Information on the economic and financial environment in which the
company operates.
• The primary economic policy used in Finance is Marginal Cost-
Benefit Analysis- Financial Decision should be made when Added
benefit exceed the added cost.
 RELATIONSHIP TO ECONOMICS
Marginal Cost–Benefit Analysis
The primary economic principle used in managerial finance is marginal
cost–benefit analysis, the principle that financial decisions should be made and
actions taken only when the added benefits exceed the added costs.

• The new computer would require a cash outlay of $80000 & the old computer
could be sold at $28000,the total benefit from the new computer would be
$100000, the benefit from the old computer for the same time period would be
$35000, Applying Marginal cost benefit analysis;

Benefit with new computer $100000

Less: benefit with old computer $ 35000
Marginal or added benefit $65000
Cost of new computer $80000
Less: sale value of old computer $28000
Marginal cost $52000
Net benefit $13000
 Relationship to Accounting

• One major difference in perspective and emphasis between

Finance and Accounting is that accountants generally use the
accrual method while in finance, the focus is on cash flows.

• Nasa Corporation, a small car dealer, sold one car for $100,000 in the calendar
year just ended. Nasa originally purchased the car for $80,000. Although the
firm paid in full for the car during the year, at year-end it has yet to collect the
$100,000 from the customer.

Sales $100,000 (1 car sold, 100% still uncollected)

Costs $ 80,000 (all paid in full under supplier terms)

INCOME STATEMENT SUMMARY

ACCRUAL CASH
Sales $100,000 $ 0
Less: Costs (80,000) (80,000)
Net Profit/(Loss) $20,000 $(80,000)
 Relationship to Accounting

• Finance and accounting also differ with respect to

decision-making.
• While accounting is primarily concerned with the presentation of
financial data, the financial manager is primarily concerned with
analyzing and interpreting this information for
decision-making purposes.
• The financial manager uses this data as a vital tool for making
decisions about the financial aspects of the firm.
 What is Financial Management?

Financial Management is the process of

planning decisions in order to maximize the
owners’ wealth.

Financial manager has a major role in cash

management, in the acquisition of funds, and
in all aspects raising and allocating financial
capital and taking into consideration of the
risk and return.
Functions of Finance/Financial Management

The functions of finance involve three major

decisions. The optimal combination of these
three functions will create the value of a
business.

1) Investment Function
2) Financing Function
3) Dividend Function
 Investment Function
• The investment decision relates to the selection of assets in which
funds will be invested by a firm.

• The asset selection decision of a firm is of two types: Long term

assets and Short Term Assets.

• The process of planning and managing a firm's long-term

investment (assets) is called capital budgeting. In capital
budgeting, the financial manager tries to identify investment
opportunities that are worth more to the firm than they cost to
acquire.

• The process of planning and managing a firm's short-term

investment (assets) is called working capital management.
 Financing Function
In the financing decision, the financial manager is concerned
with determining the best financing mix or capital structure.

The term capital structure refers to the proportion of debt and

equity capital. A capital structure with a reasonable proportion
of debt and equity capital is called the optimal capital
structure.

•Debt Capital
•Equity Capital
 Dividend Function
The profit of a firm can be dealt in two ways: It can
be distributed to the shareholders in the form of
dividend or it can be retained in the business.
One significant decision in the dividend decision is
the dividend payout ratio, that is, what proportion
of profits should be paid out to the shareholders.
This decision will be depend upon the shareholders
and the investment opportunities of a firm.
 Functions of financial management

Credit management
Inventory control
• DAILY Receipts & disbursement of
fund

• OCCASIONAL
Stock Issue, Bond Issue
Capital Budgeting
Dividend decision

• PROFITABILITY GOAL:
maxi.
TRADE OFF Shareholder
wealth
• RISK
Forms of Organization:
Sole Proprietorships
Disadvantages
Advantages
Unlimited
Freedom Liability
Simplicity
Lack of Continuity
Low Start Up
Difficulty in
Costs A business owned by Raising Money
one person
Tax Benefits
Reliance on One Person
Forms of Organization:
Partnerships
Advantages
Disadvantages
Unlimited Liability
More Capital
Lack of Continuity
Ownership Greater Talent Pool
Transfer
Difficult Ease of Formation
Possibility of Tax Benefits
Conflict
A business venture with two or more owners
 Forms of Organization:
Corporations
Advantages Disadvantages
Limited Liability Potential Shareholder
Revolts
Continuity
Higher Start-Up
Greater Likelihood Costs
of Professional
Management Regulation
Double Taxation
Easier Access to A corporation
Money is a separate legal entity
 What goal should managers pursue?
Profit Maximization vs. Wealth Maximization

• Wealth Maximization: Finance teaches that managers’ primary

goal should be to maximize the wealth of the firm’s owners—the
stockholders. The simplest and best measure of stockholder
wealth is the firm’s share price, This goal translates into a
straightforward decision rule for managers—only take actions
that are expected to increase the share price.
• Profit Maximization: Corporations commonly measure profits in
terms of earnings per share (EPS), which represent the amount
earned during the period on behalf of each outstanding share of
common stock. EPS are calculated by dividing the period’s total
earnings available for the firm’s common stockholders by the
number of shares of common stock outstanding.
 The Goal of Financial Management

• The more specific goal of a firm is wealth maximization,

that is, maximization of current value per share of the
existing
The process of shareholder wealth maximization can be
described using the following flow chart
 Goal of the Firm: Wealth or Profit?
Timing of Cash Flow
The financial manager of Neptune Manufacturing, is
choosing between two investments, Rotor and Valve. The
following table shows the EPS that each investment is
expected to have over its 3-year life.

In terms of the profit maximization goal, Valve would be

preferred over Rotor because it results in higher total earnings
per share over the 3-year period ($3.00 EPS compared with
$2.80 EPS). But does profit maximization lead to the
highest possible share price?
 Goal of the Firm: Wealth or Profit?
Timing of Cash Flow

Because the firm can earn a return on funds it receives, the

receipt of funds sooner rather than later is preferred.
In our example, in spite of the fact that the total earnings
from Rotor are smaller than those from Valve,
Rotor provides much greater earnings per share in the
first year.
The larger returns in year 1 could be reinvested to provide
greater future earnings
 Goal of the Firm: Maximize Profit or Wealth?
Cash Flows
• Profits do not necessarily result in cash flows available to the
stockholders. There is no guarantee that the board of directors will
increase dividends when profits increase.
• Furthermore, higher earnings do not necessarily translate into a higher
stock price. Only when earnings increases are accompanied by increased
future cash flows is a higher stock price expected.
• For example, a firm with a high-quality product sold in a very
competitive market could increase its earnings by significantly reducing
its equipment maintenance expenditures. The firm’s expenses would be
reduced, thereby increasing its profits. But if the reduced maintenance
results in lower product quality, the firm may impair its competitive
position, and its stock price could drop as many well-informed investors
sell the stock in anticipation of lower future cash flows. In this case, the
earnings increase was accompanied by lower future cash flows and
therefore a lower stock price.
 Goal of the Firm: Maximize Profit or Wealth?
Cash Flows
• Moreover, Cash flow is a more straightforward measure
of the money flowing into and out of the company.
Companies have to pay their bills with cash, not earnings,
so cash flow is what matters most to financial managers.
 Goal of the Firm: Maximize Profit or Wealth? Risk
Consideration
• Profit maximization also fails to account for risk—the chance
that actual outcomes may differ from those expected.
• Cash flow and risk affect share price differently: Holding risk
fixed, higher cash flow is generally associated with a higher share
price. In contrast, holding cash flow fixed, higher risk tends to
result in a lower share price because the stockholders do not like
risk.
• For example, Apple’s CEO, Steve Jobs died to a serious health issue, and the
firm’s stock suffered as a result. This occurred not because of any near-term
cash flow reduction but in response to the firm’s increased risk—there’s a
chance that the firm’s lack of near-term leadership could result in reduced
future cash flows.
• In general, stockholders are risk averse—that is, they must be
compensated for bearing risk.
• A firm that earns a low but reliable profit might be more valuable
than another firm with profits that fluctuate a great deal.
 Wealth Maximization Vs. Profit Maximization
advantage disadvantage
1. easy to calculate profit 1. focus on short term
Profit 2. easy to determine the 2. ignore risk &
Maximization uncertainty
link between financial
decisions and profits 3. ignore timing of
return.
4. Profit is a Vague
term, Different
types of Profit.
advantage disadvantage
1. focus on long term 1. offers no clear link
Wealth 2. recognize risk between financial
Maximization 3. consider timing of decisions and profits
return
 WHAT ABOUT STAKEHOLDERS?
• Stakeholders are groups such as employees,
customers, suppliers, creditors, owners, and others
who have a direct economic link to the firm.
• A common misconception is that when firms strive to
make their shareholders happy, they do so at the
expense of other constituencies such as customers,
employees, or suppliers.
• This line of thinking ignores the fact that in most
cases, to enrich shareholders, managers must first
satisfy the demands of these other interest groups.
Recall that dividends that stockholders receive
ultimately come from the firm’s profits.
 WHAT ABOUT STAKEHOLDERS?
• It is unlikely that a firm whose customers are unhappy
with its products, whose employees are looking for jobs
at other firms, or whose suppliers are reluctant to ship
raw materials will make shareholders rich because such
a firm will likely be less profitable in the long run than
one that better manages its relations with these
stakeholder groups.
• A firm with a stakeholder focus consciously avoids
actions that would prove detrimental to stakeholders. The
goal is not to maximize stakeholder well-being but to
preserve it.
• The stakeholder view does not alter the goal of
maximizing shareholder wealth. Such a view is often
considered part of the firm’s “social responsibility.”
 CORPORATE GOVERNANCE
• Corporate governance refers to the rules, processes,
and laws by which companies are operated, controlled,
and regulated.
• It defines the rights and responsibilities of the
corporate participants such as the shareholders, board
of directors, officers and managers, and other
stakeholders, as well as the rules and procedures for
making corporate decisions.
• A firm’s corporate governance is influenced by both
internal factors such as the shareholders, board of
directors, and officers as well as external forces such as
clients, creditors, suppliers, competitors, and
government regulations.
CORPORATE GOVERNANCE
 CORPORATE GOVERNANCE

• The corporate organization, depicted in Figure 1.1 helps

to shape a firm’s corporate governance structure.
• In particular, the stockholders elect a board of directors,
who in turn hire officers or managers to operate the
firm in a manner consistent with the goals, plans, and
policies established and monitored by the board on
behalf of the shareholders.
 THE AGENCY ISSUE

• The duty of the financial manager is to maximize the

wealth of the firm’s owners (principals).
• Shareholders give managers decision-making
authority over the firm; thus managers can be
viewed as the agents of the firm’s shareholders.
• Figure 1.1 represent the classical principal–agent
relationship.
• This arrangement works well when the agent makes
decisions that are in the principal’s best interest but
doesn’t work well when the interests of the principal
and agent differ-Agency Problem.
 Agency Problem
• Agency Problem: The potential conflict of interest between the
principle and agent. The likely hood that manager may place
personal goal ahead of corporate goal.
• In theory, most financial managers would agree with the goal of
shareholder wealth maximization. In reality, however, managers
are also concerned with their personal wealth, job security, and
fringe benefits. Such concerns may cause managers to make
decisions that are not consistent with shareholder wealth
maximization.
• Reluctant or unwilling to take more than moderate risk, the result is
the less than maximum result and a potential loss of owners wealth.
• Market force and Agency cost serves to prevent or minimize
agency problem.
• Major shareholders or Institutional Investors and Hostile
takeover by other firms are the two market forces.
 Agency Problem-Real Example

• One particularly famous example of the agency problem is that of Enron.

Enron's directors had a legal obligation to protect and promote investor
interests but had few other incentives to do so.
• Enron was, at one point, one of the largest companies in the United States.
Despite being a multi-billion dollar company, Enron began losing money in
1997. The company also started racking up a lot of debt. Fearing a drop
in share prices, Enron's management team hid the losses by
misrepresenting them through tricky accounting—namely special purpose
vehicles (SPVs), or special purposes entities (SPEs)—resulting in
confusing financial statements.
• The problems started to unfold in 2001. There were questions about
whether the company was overvalued, leading to a drop in share prices
from over $90 to under $1. The company ended up filing for bankruptcy in
December 2001. Criminal charges were brought up against several key
Enron players including former chief executive officer (CEO), chief
financial officer (CFO).
 Individual versus Institutional Investors
To better understand the governance, it is helpful to
differentiate between the two broad classes of
owners—individuals and institutions.
• Individual investors own relatively small quantities of shares and
as a result do not typically have sufficient means to directly
influence a firm’s corporate governance.
• In order to influence the firm, individual investors often find it
necessary to act as a group by voting collectively on corporate
matters. The most important corporate matter individual
investors vote on is the election of the firm’s board of directors.
• The corporate board’s first responsibility is to the shareholders.
The board not only sets policies that specify ethical practices and
provide for the protection of stakeholder interests, but it also
monitors managerial decision making on behalf of investors.
 Individual versus Institutional Investors
• Institutional investors are investment professionals that are paid
to manage and hold large quantities of securities on behalf of
individuals, businesses, and governments. Institutional investors
include banks, insurance companies, mutual funds, and pension
funds.
• Institutional investors have advantages over individual investors
when it comes to influencing the corporate governance of a firm.
• Unlike individual investors, institutional investors often monitor
and directly influence a firm’s corporate governance by exerting
pressure on management to perform or communicating their
concerns to the firm’s board.
• These large investors can also threaten to exercise their voting
rights or liquidate their holdings if the board does not respond
positively to their concerns.
 The Threat of Takeover
• When a firm’s internal corporate governance structure is unable
to keep agency problems in check, it is likely that rival managers
will try to gain control of the firm.
• Because agency problems represent a misuse of the firm’s
resources and impose agency costs on the firm’s shareholders, the
firm’s stock is generally depressed, making the firm an
attractive takeover target.
• The threat of takeover by another firm that believes it can
enhance the troubled firm’s value by restructuring its
management, operations, and financing can provide a strong
source of external corporate governance.
• The constant threat of a takeover tends to motivate management
to act in the best interests of the firm’s owners.
 Agency Cost
The costs borne by stockholders to maintain a
corporate governance structure that monitor
management behavior to minimizes agency problems
and give manager the financial incentive to contributes
to the maximization of shareholder wealth.
 Agency Cost

they are of three types: monitoring costs, bonding

costs, and residual loss.

Monitoring costs are costs incurred by the principal

to monitor or limit the actions of the agent. In a
corporation, shareholders may require managers to
periodically report on their activities via audited
accounting statements, which are sent to shareholders.
The accountants’ fees and the management time
lost in preparing such statements are monitoring
costs.

Cost of having directors is a monitoring cost.

 Agency Cost
Bonding Costs: Contractual obligations are entered
between the company and the agent. A manager
continues to stay with a company even after it is
acquired, who might forego the employment
opportunities.

Indirect Cost or Implicit cost incurred when

shareholders limit the decision-making power of
managers. By doing so, the owners may miss profitable
investment opportunities.
 Management Compensation Plans
• In addition to the roles played by corporate boards,
institutional investors, and government regulations,
corporate governance can be strengthened by ensuring
that managers’ interests are aligned with those of
shareholders.
• A common approach is to structure management
compensation to correspond with firm performance.
• Performance based compensation packages allow firms
to compete for and hire the best managers available. The
two key types of managerial compensation plans are
incentive plans and performance plans.
 Management Compensation Plans
• The two key types of managerial compensation
plans are incentive plans and performance
plans.
• Incentive plans tie management compensation to
share price.
• Stock option. The right to buy a specified number of
shares of stock in the company at a stated
price—referred to as an exercise price at some time in
the future. The exercise price may be above, at, or below
the current market price of the stock.
 Agency Costs: Performance plans

Performance plans tie management compensation to measures

such as EPS growth; performance shares and/or cash bonuses
are used as compensation under these plans. — how top
management is paid. There are several different ways to
compensate executives, including:
• Performance shares. Shares of stock given the employees, in an
amount based on some measure of operating performance,
such as earnings per share.
• Restricted stock grant. The grant of shares of stock to the
employee at low or no cost, conditional on the shares not being
sold for a specified time.
• Bonus. A cash reward based on some performance measure,
say, earnings of a division or the company.
 Financial Market & Institution
A financial market is a market in which financial assets
(securities) such as stocks and bonds can be purchased or sold.
Funds are transferred in financial markets when one party
purchases financial assets previously held by another party.
Financial markets facilitate the flow of funds and thereby allow
financing and investing by households, firms, and government
agencies.

Financial markets are the meeting place for people, corporations,

and institutions that either need money or have money to lend or
invest.
Financial markets can be broken into many distinct parts.
1)Money market & Capital market
2)Primary market & Secondary market
 Money market & Capital market
Money market refer to those markets dealing with short term
securities that have a life of one year or less
•The securities traded in this market are referred to as money
market securities.
•These generally have a relatively high degree of liquidity, not
only because of their short-term maturity but also because they
commonly have an active secondary market.
•Money market securities tend to have a low expected return but
also a low degree of risk.
•Common types of money market securities include Treasury bills
(issued by the BD Bank), commercial paper (issued by
corporations), and negotiable certificates of deposit (issued by
depository institutions).
 Money market & Capital market
• Capital market refers to those markets dealing with long
term securities that have a life of more than one year.
The securities traded in this market are referred to as
capital market securities.
• Capital market securities are commonly issued to finance
the purchase of capital assets, such as buildings,
equipment, or machinery.
• Three common types of capital market securities are
bonds, mortgages, and stocks.
 Primary market & Secondary market

When a corporation uses the financial markets to raise new

funds, the sale of securities at the first time in the market is
said to be made in the primary market. INITIAL PUBLIC
OFFERING (IPO)

After the securities are sold to the public, they are trade in
the secondary market. So when existing shares are traded
in the market it is said to be made in the secondary market.
 Primary market & Secondary market
• Private placement: the sale of new security issue,
typically bonds or preferred stock, directly to an
investors or group of investors
• Public offering: the non exclusive sale of either bond or
share to the general public. IPO
• Securities Exchange: organization that provide the
marketplace in which firms can raise funds through he
sale of new securities and purchaser can resell the
securities.
• Bid price: the highest price offered to purchase a
security.
• Ask Price: The lowest price at which a security is offered
for sale.
Key Securities Traded: Bonds and Stocks
• Bond Long-term debt instrument used by
business and government to raise large sums
of money, generally from a diverse group of
lenders.
• Common stock is a type of security that
represents ownership of equity in a company.
Also known as ordinary share, or voting share.
• preferred stock A special form of ownership
having a fixed periodic dividend that must be
paid prior to payment of any dividends to
common stockholders
 FINANCIAL INSTITUTIONS

• Financial institutions serve as intermediaries by

channeling the savings of individuals, businesses, and
governments into loans or investments. Many
financial institutions directly or indirectly pay savers
interest on deposited funds

• Financial Intermediaries
Financial institutions that accept money from savers
and use those funds to make loans and other financial
investments in their own name.
They include commercial banks, savings institutions,
insurance companies, pension funds, finance
companies, and mutual funds.
 Major Financial Institutions

• Commercial banks Institutions that provide

savers with a secure place to invest their funds
and that offer loans to individual and business
borrowers.
• Investment banks Institutions that
(1) assist companies in raising capital,
(2) advise firms on major transactions such as
mergers or financial restructurings, and
(3) engage in trading and market making
activities.
 Major Financial Institutions

• The shadow banking system/Non-Banking

Financial Institution describes a group of
institutions that engage in lending activities,
much like traditional banks, but these
institutions do not accept deposits and are
therefore not subject to the same regulations
as traditional banks.
 The Corporation and Financial
Markets

Corporation Investors
 The Corporation and Financial
Markets

Corporation Investors

Government
 The Corporation and Financial
Markets

Corporation cash Investors

Government
 The Corporation and Financial
Markets

Corporation cash Investors

securities

Government
 The Corporation and Financial
Markets

Corporation cash Investors

securities

Secondary
markets

Government
 The Corporation and Financial
Markets

Corporation cash Investors

securities

Secondary
markets

Government
 The Corporation and Financial
Markets

Corporation cash Investors

securities

Secondary
markets

Government
 The Corporation and Financial
Markets

Corporation cash Investors

securities

Secondary
markets
Cash flow

Government
 The Corporation and Financial
Markets

Corporation cash Investors

securities

Secondary
markets
Cash flow

tax

Government
 The Corporation and Financial
Markets

Corporation cash Investors

securities
reinvest
Secondary
markets
Cash flow

tax

Government
 The Corporation and Financial
Markets

Corporation cash Investors

securities
reinvest
Secondary
markets
Cash flow dividends,
etc.

tax

Government