7/31/2019 Ch01 - The Nature of Financial Management
1/33
Click to edit Master subtitle style
5/16/12
Chapter 1
The Role of FinancialManagement
Sujit Dhanuka
7/31/2019 Ch01 - The Nature of Financial Management
2/33
5/16/12
er s u y ngChapter 1, you
should be able to:1. Explain the nature of finance and its integration with other
management functions2. Evaluate the actions of a finance manager3. Describe the changing role of the finance manager and
his/her position in the management hierarchy4. Discuss the shareholders wealth maximization (SWM)
principles as an operationally desirable finance decisioncriterion
5. Discuss agency problems arising from the relationship
between shareholders and managers6. Describe the organization of the finance function
7/31/2019 Ch01 - The Nature of Financial Management
3/33
5/16/12
e o e oFinancial
ManagementWhat is Financial Management?
The Goal of the Firm
Corporate Governance Organization of the Financial Management
Function
7/31/2019 Ch01 - The Nature of Financial Management
4/33
5/16/12
What is FinancialManagement?
Financial management is
that managerial activitywhich is concerned with
the acquisition,financing, andmanagement of assets
with some overall oal in
7/31/2019 Ch01 - The Nature of Financial Management
5/33
5/16/12
Finance FunctionsThe functions ofraising funds, investing them
is assets and distributing returns earned fromassets t the shareholders are known as
financing decision, investment decision, anddividend decision respectively.
7/31/2019 Ch01 - The Nature of Financial Management
6/33
5/16/12
Investment
DecisionsA Firms investment decisions involve capitalexpenditures and are called Capital
Budgeting decision. It involves decision of allocation of capital or
funds to long-term assets that would yieldbenefits (cash flows) in future.
The two important aspects of Investmentdecision are
Evaluation of prospective profitability of newinvestment
The measurement of a cut-off (required rate of
return or opportunity cost of capital) againstwhich the prospective return could be compared
7/31/2019 Ch01 - The Nature of Financial Management
7/33
5/16/12
Financing Decisions
How and from where to acquirefundsDeciding for the best mix of debtand equity know as CapitalStructureWhat is the best dividend policy(e.g., dividend-payout ratio)?
The change in the shareholdersreturn caused b the chan e in
Determine how the assets (LHS of balance sheet)will be financed (RHS of balance sheet).
7/31/2019 Ch01 - The Nature of Financial Management
8/33
5/16/12
Dividend DecisionThe manager must decide whether the firm
should distribute all profits or retain them, ordistribute a portion and retain the balance
The proportion of profits distributed is calleddividend-payout-ratio and the retainedportion is called retention-ratio
The optimum dividend policy one thatmaximises the market value of firms shares
A firm may also issue shares to existingshareholders at zero charges known as bonusshares
7/31/2019 Ch01 - The Nature of Financial Management
9/33
5/16/12
Liquidity DecisionCurrent assets management that effects the
firms liquidity is yet another importantfunction.
Current assets should be managed efficientlyfor safeguarding the firm against the risk of ill-liquidity
The profitability-liquidity trade-offrequires that the financial manager shoulddevelop sound techniques of managingcurrent assets
7/31/2019 Ch01 - The Nature of Financial Management
10/33
5/16/12
Asset ManagementDecisions
How do we manage existing assetsefficiently?
Financial Manager has varyingdegrees of operating responsibilityover assets.
Greater emphasis on current assetmanagement than fixed assetmanagement.
7/31/2019 Ch01 - The Nature of Financial Management
11/33
5/16/12
Financial Managers RoleA financial manager is a person who is
responsible , in a significant way, to carry outfinance functions. His role include
Fund Raising
Funds Allocation
Profit planning
Understanding Capital markets
7/31/2019 Ch01 - The Nature of Financial Management
12/33
5/16/12
nanc a oa : romaximization vs. Wealth
maximization
Maximization of
Shareholder Wealth!Value creation occurs when we
maximize the share price for current
shareholders.
7/31/2019 Ch01 - The Nature of Financial Management
13/33
5/16/12
Profit Maximization
Profit Maximizationu Maximizing a firms earnings after taxes.u
It implies that a firm either producesmaximum output for a given amount ofinput or uses minimum input for producinga given output
Problemsu Ignores changes in the risk level of the
firm.u Could increase current profits while
harming firm (e.g., defer maintenance,
7/31/2019 Ch01 - The Nature of Financial Management
14/33
5/16/12
Profit Maximization
Profit Maximizationu Maximizing a firms earnings after taxes.
u It implies that a firm either producesmaximum output for a given amount ofinput or uses minimum input forproducing a given output
uThe underlying logic of profitmaximization is efficiency
7/31/2019 Ch01 - The Nature of Financial Management
15/33
5/16/12
Objections to ProfitMaximization
Definition of Profit:The precise meaning of profitis unclear. It does not specify timing or duration ofexpected returns. It is unclear whether it mean totaloperating profit or profit accruing to shareholders
Time value of Money: It does not make anexplicit distinction between returns received indifferent time periods. It gives no consideration to
time value of moneyUncertainty or returns: Ignores changes in the
risk level of the firm. Owners of the firm wouldprefer smaller but surer profits to a potentially
larger but less certain stream of benefits
7/31/2019 Ch01 - The Nature of Financial Management
16/33
5/16/12
Shareholders Wealth
Maximization (SWM)It Means maximization the net present valueof a course of action to shareholders.
Net Present Value of wealth of a course ofaction is the difference between the presentvalue of its benefits ad the present value of itscosts
It emphasize that the benefits should bemeasured in terms ofCash Flows.
Maximizing the shareholders economicwelfare is equivalent to maximizing the utilityof their consumption over time.
7/31/2019 Ch01 - The Nature of Financial Management
17/33
5/16/12
reng s oShareholder Wealth
MaximizationNeed for Valuation Approach: SWM requires
a valuation model. The financial manager mustknow or at least assume the factors that
influence the market price of shares. Thus, sharepriceserves as a barometer for businessperformance.
Takes account of: current and future profits and
EPS; the timing, duration, and risk of profits andEPS; dividend policy; and all other relevantfactors.
7/31/2019 Ch01 - The Nature of Financial Management
18/33
5/16/12
reng s oShareholder Wealth
MaximizationRisk-return Trade-off : Financial decisions
incur different degrees of risk. Risk and expectedreturn move in tandem; greater the risk, the
greater the expected returnReturn = Risk-free rate + Risk Premium
Risk free rate is obtained from a risk-freegovernment security
Risk Premium is over and above risk free rate
7/31/2019 Ch01 - The Nature of Financial Management
19/33
5/16/12
AgencyProblemManagers Vs. ShareholdersGoals
7/31/2019 Ch01 - The Nature of Financial Management
20/33
5/16/12
The Modern
Corporation
There exists a SEPARATION between ownersand managers.
Modern
CorporationShareholders
Management
7/31/2019 Ch01 - The Nature of Financial Management
21/33
5/16/12
Role of Management
An agentis an individual authorized byanother person, called the principal, to
act in the latters behalf.
Management acts as an agentfor the owners (shareholders)
of the firm.
7/31/2019 Ch01 - The Nature of Financial Management
22/33
5/16/12
Agency Theory
Agency Theoryis a branch of economics
relating to the behavior of principals andtheir agents.
uJensen and Meckling developeda theory of the firm based onagency theory.
7/31/2019 Ch01 - The Nature of Financial Management
23/33
5/16/12
Agency Theory
Incentives include,stock options,perquisites,andbonuses.
u Principals must provideincentives so that managementacts in the principals bestinterests and then monitorresults.
7/31/2019 Ch01 - The Nature of Financial Management
24/33
5/16/12
Social Responsibility
Wealth maximization does notpreclude the firm from being socially
responsible.Assume we view the firm as
producing both private and social
goods.Thenshareholder wealthmaximization remains the
appropriate goal in governing thefirm.
7/31/2019 Ch01 - The Nature of Financial Management
25/33
5/16/12
Corporate
GovernanceCorporate governance: represents
the system by which corporations are
managed and controlled.Includes shareholders, board ofdirectors, and senior management.
Thenshareholder wealthmaximization remains theappropriate goal in governing thefirm.
7/31/2019 Ch01 - The Nature of Financial Management
26/33
5/16/12
Board of Directors
Typical responsibilities:Set 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 financialreports to common shareholders.
CEO/Chairman roles commonly same person in US,but separate in Britain (US moving this direction).
O i ti f th
7/31/2019 Ch01 - The Nature of Financial Management
27/33
5/16/12
Organization of theFinancial Management
FunctionBoard ofDirectors
President(Chief Executive
Officer)
VicePresident
Operations
VicePresidentMarketing
VP ofFinance
Organi ation of the
7/31/2019 Ch01 - The Nature of Financial Management
28/33
5/16/12
TreasurerCapital BudgetingCash ManagementCredit Management
Dividend DisbursementFin Analysis/PlanningPension ManagementInsurance/Risk MngmtTax Analysis/Planning
Organization of theFinancial Management
Function
VP of
Finance ControllerCost Accounting
Cost ManagementData ProcessingGeneral Ledger
Government ReportingInternal Control
Preparing Fin StmtsPreparing Budgets
Preparing Forecasts
7/31/2019 Ch01 - The Nature of Financial Management
29/33
5/16/12
GlossaryReal Assets: Assets required by a firm, in form of fixedassets and floating assets to carry on its business
Share: A part or portion that represents the ownership rightsof the holder
Opportunity Cost of capital: The Expected rate of return thatan investor could earn by investing money in financialassets of equivalent risk
Capital Structure: The firms mix of debt and equity
Bonus share : Shares issued to an existing shareholder freeof cost
Financial Manager: A person responsible for carrying out thefinance functions of a firm
Liquidity: The degree to which an asset 0r security can be
bought or sold in the market without effecting the price ofthe assets
7/31/2019 Ch01 - The Nature of Financial Management
30/33
5/16/12
Self Assessment
Questions1. Fill in the blanks1. The Three most important activities of a business are production, marketing and
________
2. Plant, machinery, office, factory, furniture and building are all ______________ realassets
3. _________ in investment arises because of uncertain returns4. The mix of debt and ___________ is known as the firms capital sturcture.
5. The modern financial manager is mainly concerned with the __________________
6. The Change in profits due to the change in sales is referred to as _______________
7. Variable costs change in direct proportion to ___________ changes
8. Profit planning anticipates the relationships between volume, costs and _______and helps develop action plans to face unexpected surprises
9. The underlying logic of profit maximization is _______________
10. The important ________________of the firm are customers, employees, governmentand society
11. __________________are the principals of a company while managers are their agents
12. The conflict between the interest of the shareholders and managers is referred toas _____________ problem
13. Goals or _______________ directs the firms action14. The management is not only the agent of the owners, but also the _____________ for
7/31/2019 Ch01 - The Nature of Financial Management
31/33
5/16/12
Self Assessment
Questions1. Fill in the blanks1. The Three most important activities of a business are production, marketing and
finance
2. Plant, machinery, office, factory, furniture and building are all tangible realassets
3. Riskin investment arises because of uncertain returns4. The mix of debt and Equity is known as the firms capital sturcture.
5. The modern financial manager is mainly concerned with the Efficient allocationof funds
6. The Change in profits due to the change in sales is referred to as Operatingleverage
7. Variable costs change in direct proportion to Volume changes
8. Profit planning anticipates the relationships between volume, costs and profitsand helps develop action plans to face unexpected surprises
9. The underlying logic of profit maximization is Efficiency
10. The important stakeholders of the firm are customers, employees, governmentand society
11. Shareholders are the principals of a company while managers are their agents
12. The conflict between the interest of the shareholders and managers is referred toas agency problem
7/31/2019 Ch01 - The Nature of Financial Management
32/33
5/16/12
Self Assessment
Questions1. True or false1. Preference share holders receive dividend at a fixed rate
2. Share represent ownership rights of their holders
3. The Existing shareholders are required to pay a nominal sumfor bonus shares
4. The optimum dividend policy is one that maximizes the marketvalue of the firms shares
5. Between mutually exclusive projects, the one with highest NPVshould be accepted
6. The return from government bonds is lower than from share7. The higher the risk of action, the lower is the risk premium
8. The financial controller controls finances
9. The main function of the treasurer is to manage the firmsfunds
7/31/2019 Ch01 - The Nature of Financial Management
33/33
5/16/12
Self Assessment
Questions1. True or false1. Preference share holders receive dividend at a fixed rate True
2. Share represent ownership rights of their holders True
3. The Existing shareholders are required to pay a nominal sumfor bonus shares False
4. The optimum dividend policy is one that maximizes the marketvalue of the firms shares True
5. Between mutually exclusive projects, the one with highest NPVshould be accepted True
6. The return from government bonds is lower than from shareTrue
7. The higher the risk of action, the lower is the risk premiumFalse
8. The financial controller controls finances False
9 The main function of the treasurer is to manage the firmsf d