Maximize Shareholders’ Wealth and Welfare

Financial Management

Investment Decision

Financial Decision

Dividend Decision

A Framework for Financial Decision-Making

Major Decisions by Financial Manager

• Investment Decision – what assets to own? What mix of fix assets? What mix of current assets?

• Financing Decision – what securities to issue? What mix of short-term credit, long-term debt and equity?

• Dividend Decision – what percentage of earnings should be given out in cash? Or should it be given out as stocks?

Board of Directors

President

VP for Mktg. VP for Finance VP for Prodn/Opn

Treasurer•Cash Mgmt•Customer Credit and Collection•Inventory•Capital Budgeting•Raising of ST and LT Funds

Controller•Cost Acctg.•Financial Acctg.•Internal Auditing•Budgeting•Payroll•Taxes

The Financial Function (by R.K.S. Rao)

Profit Maximization vs. Wealth Maximization(taken from Fundamentals of Financial Mgmt by R.K.S. Rao)

Alternative A:Co. A sells the rights to gold mining on its land to Co. B, for $100M in cash. However, the rights expire in 30 years and Co. A must spend an estimated $101M to eliminate environmental damage caused by the mining operation.Alternative B:Co. A can buy the mining equipment for $150M today and do its own mining and get $151M after 30 years after clean-up. Note that Co. A has no experience in mining.

Maximize Shareholders’ Wealth

Maximize Price of the Firm’s or Company’s Stock

Weaknesses of Profit Maximization(taken from Fundamentals of Financial Mgmt by R.K.S. Rao)

• Difficulty of incorporating risk in a profit based criterion.

• Too much emphasis on profit overshadows the timing when the returns could or would be obtained.

• Profit is an accounting measure that may not necessarily reflect the economic realities of a firm. It is a book concept that is sensitive to how accounting books of the company are kept.

Cash flow calculation not only recognize profits but go a little further and measure the actual cash available for the firm. It captures the economic impact of managerial decisions.

Profits have no earning potential; cash flow does.

Cash Flow

Price of the Firm’s or Company’s Stock

Determines