Chapter 1

The Roles and Objectives of Financial Management

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Introduction

This chapter introduces the financial management process of the typical firm. It looks at the financial manager, the field of finance, financial decisions and their implications, and the daily questions faced by the firms financial management.
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A GENERAL LOOK AT FINANCE

Finance is the art and science of managing money

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Questions Faced in Finance

How is finance related to other fields of study? What are the goals and objectives of financial managers? How has the finance field evolved? How is the finance field changing today?
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THERE ARE THREE MAJOR AREAS OF FINANCE

Investments -- Concerned with analyzing potential investments (including Real Estate) in order to achieve a certain rate of return consistent with a desired level of risk. Return on Investment Financial institutions and markets -Concerned with the management of financial institutions like commercial banks, insurance companies, etc. Also concerned with analyzing financial markets and predicting interest rates.
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AREAS OF FINANCE --continued

Business finance or corporate finance or managerial finance which is concerned with the management of the non-financial corporation. Primarily concerned with the for profit organization, but same principles apply to the not for profit organization. This course is concerned with managerial finance, but we will get into the other areas. That is, at times, we will assume the role of a banker or investor.

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What Activities are Involved in Managerial Finance

Investment of funds or capital budgeting

Risk versus Return Real Options Amount of cash to hold Amount of credit to grant Amount of inventory to hold Where to obtain short term capital Debt versus equity Long term debt versus short term debt Lease versus own
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Working capital management

Acquisition of funds - Financing

Activities in Finance -continued

Distribution or Dividend Decision Financial planning Others

Mergers and acquisitions Bankruptcies Spin-offs Leverage buy-outs (LBO) Valuations

EVA and MVA

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In Making Financial Management Decisions, What is Our Goal?

Some Possibilities

Maximize revenue Maximize profits Maximize EPS Minimize losses Others

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Objective of Financial Management ( FM ) Objective of the financial manager

Owners Wealth Maximization (OWM) or Stockholders Wealth Maximization (SWM)

NOT profit maximization Does not consider time value of money or cash flows or risk
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Principal Forms of Business Organizations are:

Sole

proprietorship Partnership Corporation

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Sole Proprietorship

Owned by one person Easy formation advantage Unlimited liability disadvantage Difficulty raising funds disadvantage Represent 75 percent of all businesses Account for less than 6% of the dollar volume Check out small business info from the SBA http://www.sba.gov/
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Partnership
Owned by two or more persons

Classified as general or limited

Partnership dissolves when a

general partner dies General partner has unlimited liability Limited partners liability limited by partnership agreement
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Corporation

Limited liability Permanency Flexibility Ability to raise capital

Legal entity Have a board of directors Owners are stockholders Easy marketability of shares of ownership

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Optimal Form of Organization Influenced by

Cost Complexity

Liability
Continuity Raising capital Decision making Tax considerations
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Board of Directors

Stockholders elect a board of directors Board of directors then elect the officers

Chairman of the board Chief executive officer (CEO) Chief operating officer (COO) President Chief financial officer (CFO) Vice presidents Treasurer Secretary
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Management

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Major Advantage of Corporation is Limited Liability

We will assume in this course that we are working with corporations Ownership is represented by common stock (CS) Our objective is to maximize the long term value of the common stock (this is the same as OWM or SWM)

MVA and EVA

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Three Basic Factors Determine C/S Market Value

1) Amount of
2) Timing of 3) Risk of Also, interest rates and tenor of the market
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Expected cash flows

Risk-Return Tradeoff

We will assume that firms and investors are risk averse There is no such thing as a free lunch Do you want to sleep well or eat well?
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SWM
Considers the timing and risk of the

benefits from stock ownership Determines that a good decision increases the price of the firm's common stock ( c/s ) Is an impersonal objective Is concerned for social responsibility and ethics
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Social Responsibility

Ethical issues will constantly confront financial managers as they achieve the goal of the firm ( SWM ).

Managers Must
Avoid personal conflicts Maintain confidentiality Be objective Act fairly

(essentially, treat others as you would have them treat you) Finance 311

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Conditions Affecting Market Value

Economic environment factors Managerial Decisions -- Which will determine Expected cash flows Risk of expected cash flows Timing of expected cash flows Conditions in financial markets Interest rates Tenor of the market

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Stockholders elect a board of directors Board of directors then hire management ( officers )
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Who Manages?

Board of directors deals with broad policy

Management makes most of the decisions

3 to 5 year strategic plan

Day-to-day decisions following the strategic plan

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Stockholder Rights

Dividend Voting Asset Preemptive

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Priority of Corporate Securities

Bonds Preferred stock Common stock (C/S) (lowest) Major corporate Web sites http://www.bankofamerica.com/ http://www.ge.com/ http://www.ibm.com/us/ http://www.wachovia.com
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(highest)

One Agency Relationships / Problems

Owners (shareholders)
Problem created

by separation of

Management and Employees

Management maximizes

their own welfare instead of the owners wealth

Job Security
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Job Security

Management decisions based on retaining management rather than SWM ExampleA decision to retain suppliers rather than selecting new suppliers providing higher quality or lower cost WhyIf the transition is mishandled management will be scrutinized but if no change is made the issue will be ignored
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Agency Costs
A. Management incentives (e.g. stock options) B. Monitor performance (e.g. auditing) C. Owners protection (e.g. bonding) D. Complex Organizational Structures

Pervasive Trends
Flatten organization structures to cut costs Incorporate Technology in Managing Eliminate Back Office Operations
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Agency Problem created by separation of

Owners Management

Owners A second and similar Agency problem Creditors

Protective covenants in loan agreements

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Agency Problem between Stockholders and Creditors

Creditors return is limited (fixed) by interest rate on debt Stockholders have limited liability and potential for unlimited returns. They are willing and rewarded for taking risks.

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Examples of Protective Covenants

Limitations on

common stock dividends

the type of investments

divestitures additional debts

poison puts
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Competitive Factors Influencing C/S Market Value

New entrants Substitute products Bargaining power of buyers Bargaining power of suppliers Rivalry among current competitors

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Cash Flow Concept Used for

Financial analysis Planning Resource allocation

CF does not equal accounting profit
Internal sources

Cash
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External sources
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Shareholder Wealth Maximizing Is a Market Concept and Results in

Maximizing PV of E(R) Measured by Market Value of C/S

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NPV of an Investment

NPV = PV of future cash inflows minus PV of cash outflows The NPV of an investment represents the contributions of that investment to the value of the firm and affects the Stockholders Wealth Maximization (SWM)

EVA and MVA

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Small Business Vs. Large Corporations

Fundamental concepts are the same

Small Business
1) 2) 3) 4) 5) 6) 7) 8) Not the dominant firm in the industry Tend to grow more rapidly Limited access to financial markets Lack management resources Have a high failure rate Stock is not publicly traded Poorly diversified Owner/manager frequently the same
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Treasurers Activities

Management of cash and marketable securities Capital Budgeting Financial Planning Credit Analysis Investor Relations Pension Fund Management
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Controllers Activities

Financial Accounting Cost Accounting Taxes Data Processing

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Disciplines Impacting Finance

Economics Accounting Marketing Production Human Resources Quantitative Analysis MIS

Finance

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Professional Organizations

Financial Executives International Institute of Chartered Financial Analysts Financial Management Association Credit Management Association Institute of Certified Financial Planners Institute of Management Accountants
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Exciting Career Opportunities in Finance

Certified Cash Manager Credit Manager Vice President of Finance (CFO) Director, Investor Relations Assistant Treasurer Tax Manager Financial Planner

Banker Financial Analyst Mutual Fund Manager Account Executive, Security Broker Mortgage Analyst Investment Banker Real Estate Analyst Insurance Broker
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Check out http://www.careerpath.com/

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