The Role of Financial Management & Decision Making

The document discusses the goals of firms and financial decision making. It explains that the goal is to maximize shareholder wealth over time, rather than just profits in a single year, by maximizing the flow of dividends to shareholders. Accounting profits are an imperfect measure that ignore the time value of money. The document also outlines different forms of business entities and how corporations interact with financial markets through issuing securities and paying out dividends and taxes over time.

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The Role of Financial Management & Decision Making

Uploaded by

Robel Guiseppe

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Download as PPT, PDF, TXT or read online on Scribd

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Lecture 2

Role of Financial Management

&
Financial Decision Making
Goal of the Firm

1) Profit Maximization?
this goal ignores:
a) TIMING of Returns
(Time Value of Money)
b) UNCERTAINTY of Returns
(Risk)
Goal of the Firm

2) Shareholder Wealth
Maximization?
this is the same as:
a) Maximizing Firm Value
b) Maximizing Stock Price
Defining wealth:
 Wealth can be defined as purchasing power, or
 Money or cash
 Thus company management’s objective becomes the
maximization of shareholders’ purchasing power
 Which can be achieved by maximizing the amount of cash
paid out to shareholders in the form of dividends.
 But which dividend should a company’s management
try to maximize, this year’s , next year’s or what?
 The point here is that it would be a relatively easy task for
a company to maximize a single year’s dividend,
 Simply by selling up all the assets and paying a final
liquidation dividend.
Defining wealth Cont.
 Obviously this is not what is meant by our
decision objective of maximizing dividends.
 And the trouble arises through the omission of
the time dimension.
 When fully defined, including the time dimension,
the objective of a company’s financial decision
makers becomes

 The maximizing of the flow of dividends to

shareholder over or through time.
The role of accounting profit:
 Now there are two points of fundamental importance that
arise from the development of this decision objective.
 Firstly, the word profit has not been mentioned and
 The emphasis has been laid on wealth defined as cash.
 Secondly, the introduction of time means that decision
must be analyzed not only in terms of immediate cash
gains and losses, but also in terms of future gains and
losses.

 The two points are interlinked

 The absence of the term profit can be explained by the
introduction of the time dimension.
The role of accounting profit Cont.
 Profit when used in a business sense, is purely an
accounting concept introduced by accountants
 In order to perform their function as auditors for the
owners of companies.

 In very general terms, profit represents the increased

wealth of a company that has been achieved by
management within the confines of an arbitrary period of
time
 The accounting year

 But profit is only a very rough approximation of increased

wealth as we have defined it in our decision objective
The role of accounting profit Cont.
 As it is based on a whole range of arbitrary
and somewhat inconsistent accounting
conventions.
 That have been made necessary in order to
split what is a continuous flow i.e.
 Changes of wealth into artificial time periods.
 A company does not increase its wealth in
discrete twelve-month steps. Therefore, the
concern is on cash flows.
Legal Forms of Business

1) Sole Proprietorship
 A business owned by a single individual.
 Owner maintains title to the firm’s assets.
 Owner has unlimited liability.

2) Partnership
 Similar to a sole proprietorship, except
that there are two or more owners.
Legal Forms of Business

2a) General Partnership

 All partners have unlimited liability.

2b) Limited Partnership

 Consists of one or more general partners,
who have unlimited liability.
 One or more limited partners (investors)
whose liability is limited to the amount of
their investment in the business.
Legal Forms of Business

2c) Limited Liability Company (LLC)

 Cross between a partnership and a
corporation.
 ( LLCs can be seen as a hybrid structure that combines features
of both a corporation and a partnership. Like a corporation,
LLCs provide their owners with limited liability in the event the
business fails. But like a partnership i.e.

 Owners have limited liability, but the firm runs

and is taxed like a partnership.
Legal Forms of Business

3) Corporation
 A business entity that legally functions
separate and apart from its owners.
 Owners’ liability is limited to the amount of
their investment in the firm.
 Owners hold common stock certificates,
and ownership can be transferred by
selling the certificates.
The Corporation and
Financial Markets
The Corporation and
Financial Markets

Corporation
The Corporation and
Financial Markets

Corporation Investors
The Corporation and
Financial Markets

Corporation Investors