ch01 - the nature of financial management

7/31/2019 Ch01 - The Nature of Financial Management

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Chapter 1

The Role of FinancialManagement

Sujit Dhanuka


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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


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e o e oFinancial

ManagementWhat is Financial Management?

The Goal of the Firm

Corporate Governance Organization of the Financial Management

Function


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What is FinancialManagement?

Financial management is

that managerial activitywhich is concerned with

the acquisition,financing, andmanagement of assets

with some overall oal in


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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.


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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


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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).


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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


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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


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Asset ManagementDecisions

How do we manage existing assetsefficiently?

Financial Manager has varyingdegrees of operating responsibilityover assets.

Greater emphasis on current assetmanagement than fixed assetmanagement.


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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


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nanc a oa : romaximization vs. Wealth

maximization

Maximization of

Shareholder Wealth!Value creation occurs when we

maximize the share price for current

shareholders.


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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,


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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


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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


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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.


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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.


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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


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AgencyProblemManagers Vs. ShareholdersGoals


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The Modern

Corporation

There exists a SEPARATION between ownersand managers.

Modern

CorporationShareholders

Management


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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.


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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.


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Agency Theory

Incentives include,stock options,perquisites,andbonuses.

u Principals must provideincentives so that managementacts in the principals bestinterests and then monitorresults.


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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.


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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.


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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


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Organization of theFinancial Management

FunctionBoard ofDirectors

President(Chief Executive

Officer)

VicePresident

Operations

VicePresidentMarketing

VP ofFinance

Organi ation of the


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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


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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


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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


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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


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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


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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

ch01 - the nature of financial management

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