Chapter 1 overview of financial management

INTRODUCTION TO FINANCIAL MANAGEMENT

What is Financial Management?

Concerns the acquisition, financing, and management of assets with some overall overall goalsgoals 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

What is the optimal firm size? What specific assets should be

acquired? What assets (if any) should be reduced

or eliminated?

•Most important of the three decisions functions.Most important of the three decisions functions.

Determine the total amount of assets needed to be held Determine the total amount of assets needed to be held by the firm.by the firm.

Assets that can no longer be economically justified may Assets that can no longer be economically justified may need to be reduced, eliminated or replaced.need to be reduced, eliminated or replaced.

Financing Decisions

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?

•Determine how the assets (LHS of balance sheet) will Determine how the assets (LHS of balance sheet) will be financed (RHS of balance sheet).be financed (RHS of balance sheet).

•Have large amount of debt or debt free.Have large amount of debt or debt free.

•Dividend payout ratio: Dividend payout ratio:

annual cash dividends divided by annual annual cash dividends divided by annual earnings earnings

dividend per share divided by earning per share.dividend per share divided by earning per share.

Asset Management Decisions

How do we manage existing assets efficiently?

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.

What is the Goal of the Firm? Maximization of Shareholder’s Maximization of Shareholder’s Wealth!Wealth!

What is shareholder’s wealth?

The total shareholders’ wealth is the outstanding number of shares times market value per share.

The market 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

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.

Profit MaximizationProfit Maximization Maximizing a firm’s earnings after taxes.

ProblemsProblems

Shortcomings of Alternative Perspectives

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.

Earnings per Share MaximizationEarnings per Share Maximization Maximizing earnings after taxes divided

by shares outstanding.

ProblemsProblems

Strengths of Shareholder Wealth Maximization

Takes account of: current and future profits current and future profits and EPSand EPS; the timing, duration, and risk of the timing, duration, and risk of profits and EPSprofits and EPS; dividend policydividend policy; and all other relevant factors.

Thus, share priceshare 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

FirmFinancial Manager

Capital Market

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The Modern Corporation

There exists a SEPARATION between owners and managers.

Modern Corporation

Shareholders Management

Role of Management

An agentagent 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.

Management acts as an agentagent for the owners (shareholders) of the

firm.

Agency Theory

According to the According to the Agency TheoryAgency Theory the agents will make optimal decisions if appropriate incentives are given and only if agents are monitored.

Jensen and Meckling developed a theory of the firm based on agency arrangement known as the agency agency theorytheory.

Agency Theory

Incentives include stock optionsstock options,, perquisitesperquisites,, and bonusesbonuses.

Monitoring involves auditing financial auditing financial statements, reviewing management statements, reviewing management perquisites perquisites and limit management decisions.limit management decisions.

Principals must provide incentivesincentives so that management acts in the principals’ best interests and then monitormonitor results.

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

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End of Chapter 1