INTRODUCTION TO
FINANCIAL
MANAGEMENT
What is Financial
Management?
Concerns the acquisition,
financing, and management
of assets with some overall
goals in mind.
What is Financial
Management?
The Decision Function of Financial
Management can be broken down into
three major areas:
Investment decision
Financing decision
Asset management decision
Investment Decisions
•Most important of the three decisions functions.
Determine the total amount of assets needed to be held
by the firm.
Assets that can no longer be economically justified may
need to be reduced, eliminated or replaced.
What is the optimal firm size?
What specific assets should be
acquired?
What assets (if any) should be reduced
or eliminated?
Financing Decisions
•Determine how the assets (LHS of balance sheet) will
be financed (RHS of balance sheet).
•Have large amount of debt or debt free.
•Dividend payout ratio:
annual cash dividends divided by annual
earnings
dividend per share divided by earning per share.
What is the best type of financing?
What is the best financing mix?
What is the best dividend policy?
How will the funds be physically acquired?
Asset Management
Decisions
Once assets have been acquired and appropriate
financing provided, these assets must be managed
efficiently.
Financial Manager has varying degrees of operating
responsibility over assets.
Greater emphasis on current asset management than
fixed asset management.
How do we manage existing assets efficiently?
What is the Goal of the
Firm?
Maximization of Shareholder’s
Wealth!
What is shareholder’s wealth?
The
total shareholders’ wealth is the outstanding
number of shares times market value per share.
Themarket price per share of the firm’s common stock
which is a reflection of a firm’s investment, financing
and asset management decisions.
Value creation occurs when we maximize the share
price for current shareholders.
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, issue common
stock to buy T-bills, etc.).
May result in a decrease in earning per share
Ignores changes in the risk level of the firm.
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. A firm will
want to improve EPS by retaining earning and
investing them in any positive rate of return.
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.
Financial Manager’s
Responsibilities
Raise funds from investors
Invest funds in value-enhancing
projects
Manage funds generated by
operations
Return funds to investors -
dividends
Reinvest funds in new projects
The Financial Manager’s
Role
1
2
Financial Capital
Firm Manager 5
Market
3 4
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 latter’s behalf.
When there is a conflict of interest
between the agent and principal it
leads to Agency problem.
Agency Theory
Jensen and Meckling developed a
theory of the firm based on agency
arrangement known as the agency
theory.
theory
According to the Agency Theory the
agents will make optimal decisions if
appropriate incentives are given and
only if agents are monitored.
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
Monitoring involves auditing financial
statements, reviewing management
perquisites and limit management decisions.
Social Responsibility
Wealth maximization does not preclude
the firm from being socially
responsible, such as protecting the
customer, paying fair wages to
employees, fair hiring practices, safe
working conditions, and becoming
involved in environmental issues like
clean air and water.
Consider the interests of stakeholders
other than shareholders.
Organizational Stakeholders
3–18
End of Chapter 1
