1086. Mobut p41 FINANCIAL MANAGE! FINANCIAL MANAGE! A. Financial management includes the following five functions: 1 nancing function—Raising capital to support the firm’s operations and investment programs, Capital budgeting funetion—Seleeting the best projects in which to invest firm resources, based on & consideration of risks and return, Financial management function—Managing the firm’s intemal cash flows and its capital structure {imix of debt and equity financing) to minimize the financing costs and ensure tha the firm ean pay its obligations when due. 4. Corporate gov on—Developing an ownership and corporate governance system for the fm that will ensure tha s act ethically and in the best interest of stakeholders. isk-management function—Managing the firm’s exposure to all types of risk. B. The ultimate goal of management of a firm is the maximization of value for its owners, the stockholders. For a public company. this equates to maximization of the stack price of the firm, This is nat easy because stock price maximization has a number of considerations and constraints 1. Since stock prices are valued based on expected future cash flows of the firm it would seem that maxi- mization of net income and cash flows would serve to maximize stockholder value, However, this is not necessarily the ease, a. High-risk investments may increase net income but they also make the firm more risky. Stock price may actually decrease. 1b. Measurement of profit is not perfect. Asan example, management may defer maintenance costs and increase profit but this is not in the best interest of the long-term profitability of the firm, ©. Ethical and social responsibilities must also be considered. Socially desirable actions such as pol. lution control, equitable hiring practices, and fair prici mes be inconsistent ‘with eaming the highest possible profit. As indicated above, financial managers are hired to maximize the wealth of the owners of the firm, ‘Therefore, financial managers can be viewed as agents of the owners who hired them. However, managers have other personal goals, such as personal wealth, job security, prestige, and perquisites (e.g., country club memberships) that may cause their aetions not to always be consistent with wealth maximization for stockholders, In agency theory such inconsistent behavior is referred to as agency costs. To control agency costs stockholders a. Rely on market forces to constrain management behavior. If management consistently behaves in its own interest, stock price will fall and eventually market forces will cause the removal of man- agem .Incur monitoring costs to supervise management. As an example, the board of directors may force ‘management to establish and maintain a large. competent, and independent internal audit depart. ‘ment c. Structure executive compensation packages, such as stock option plans, that align the interests of managers and stockholders, C. Maximization of stockholder value is @ complex process that involves making decisions that balanee risk and return. Also, businesses and their economic environments are dynamic. The firm must be able 10 quickly adjust its strategies for production, investment, financing, and marketing de Virtually every financial decision is influenced by tax considerations. Firms operating only in the US must be concemed with federal and state tax laws, Multinational firms are aifected by these laws as well as the tax laws in all of the countries in which they do business. Some important things to remember about taxation include ‘The final returns to the firm and its stockholders are after-tax profits Interest is a tax-deductible expense to the firm. Dividends are not, Alternative tax accounting methods are available that affect taxable income and the amount of taxes paid. For example, management may elect accelerated depreciation methods for eertuin assetsA. Working capital management involves manag MoU 41 FINANCIAL MANAGEMENT 1057 Different tax rates apply to different types of income. As an example, i tax rates on capital gains, Certain tax provisions are designed to stimulate the economy, For example, investment tax credits for investments in certain productive assets have been implemented over the years. ‘The effect of the in- \Vestment tax credit is a direct reduction in the cost of the productive assets, WORKING CAPITAL MANAGEMENT \dividual taxpayers pay lower 1g and financing the c at assets and current liabilities of the firm, The primary focus of working capital management is managing inventories and receivables. Ma naging the Firm's Cash Conversion Cycle ‘The cash conversion cycle of a firm is the length of time between when the firm makes payments ‘and when it receives cash inflows. This cycle is illustrated below Resoives materials Pays Finishes goods Cotlesss from supplies supplies snd sells them receivables (_____}___—_1_____ ‘Cash conversion eyele ‘To enable more detailed analysis, the cash conversion cycle may be analyzed using the following three periods: + Inventory conversion period + Receivables collection period + Payables deferral period. a Inventory conversion perlod—The average time required to convert materials into finished goods and sell those goods. Average inventory Inventory conversion peried == —"Saesperday EXAMPLE: Assume tat average inventory is $10,000,000 and anual sales are $40,000,000: the inventory conversion period is equal 1091 days. as calculated betow $10,000,000 Invomory conversion period = Sa a0 BOGS Taye = 91 days b. Receivables collection period (cays sales outstanding) —The average time required to collect accounts receivable. Ave ab Receivables collston potion Creda por day EXAMPLE: Assume tat the average receivables balance is $3,000,000 and credit sales are $40,000,000; the ‘receivables collection period i egal to 27 days as caeulted below: Bom Receivables collection period FT DOO, 365 Tans = 27 days ©. Payables deferral period—The aver bor and the payment of cash for thes Tength of time between the purchase of materials and la- Average payables Payables deferal peti = Porches per day = __Average payables Cost of goods sld/365Loss MODULE 41 FINANCIAL MANAGEMENT EXAMPLE: Assume that the average payables balance for labor and materials ix $2,500,000 and cost of goods sold is 590,000,000: the pavables deferral period tx 30 days ar calculated below Payables deferral period The cash conver n cycle nets the three periods described above and, therefore, measures thet period from the time the firm pays for its materials and labor to the time it collects its eash from sales of goods. ‘The conversion period calculated from the above examples is shown below’ cast Inventory Receivables Payables conversion conversion + wonversion———derral eyele Pevied peviod evied 8 days + aTdiys = 30 ays = 88 days Effective working capital management involves shortening the cash conversion cyele as much as possible without harming operations. This strategy improves profitability because the longer the cash conversion cyele, the greater the need for financing, We will now curn our attention to the management of each type of current asset sh Management ‘A firm should attempt to minimize the amount of cash on hand while mai amount to (1) take advantage of trade disco needs. ining a sufficient ts, (2) maintain its eredit rating, and (3) meet unexpected a. Firms hold cash for two basic purposes + Transactions, Cash must be held to conduct business operations, + Compensation to financial institution. Financial institutions require mit balances (1) for certain levels of service or (2) as a requirement of loan agreements, Such minimums are re ferred to as compensating balances. b. Firms prepare cash budgets to make sure that they have adequate cash balances to + Take advantage of trade dise of invoices. ‘+ Assure that the firm maintains its credit rating: of favorable business opportunities, such as opportunities for business acquisi- tions. ‘These amounts are sometimes called speculative balances. + Meet emergencies, such as funds for strikes, natural disasters, and ey amounts ate sometimes called precautionary bala ts. Suppliers often offer lucrative discounts for early payment sal downturns, These c. Akey technique for cash management is managing float. Float is the time that elapses relating to ‘mailing, processing. and clearing checks. A float exists for both the firm's payments to suppliers tand the firm's receipts from customers. Effective eash ding the float for disbursements and shortening the float . Zero-balance accounts. This cash management technique involves maintaining a regional bank ‘account to which just enough funds are transferred daily to pay the checks presented. Regional banks typically receive the checks drawn on their customers’ accounts in the moming from the Federal Reserve. The customer can then be notified us to the amount of cash needed to cover the ‘checks and arrange to have that amount of cash transferred to the account, ‘This arrangement has, vo advantages: ‘+ Checks take longer to clear at a regional bank, providing more float for cash disbursements. + Extra cash does not have to be deposited in the account for contingencies. A zero-balance account is cost-effective if the amount the firm saves on interest costs from the longer float is aclequate to cover any additional fees for account maintenance and cash transfe! EXAMPLE. A firm has an opportunity to establish a zero balance account system using thre diferent regional banks: The total amonns of the maintenance and transfer foe is extimated to be $3,000 per sear. The frm believes that i will