The Goals

and Functions
of Financial
Management

1
McGraw-Hill Ryerson

2005 McGraw-Hill Ryerson Limited

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Chapter 1 - Outline

What is Finance all about?

Goals of Financial Management

Functions of Financial Management

Forms of Business Organization

Financial Markets

Summary

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What is Finance?

Finance is about making decisions that

focus on creating value within the firm.
Finance builds upon the disciplines of
economics and accounting.
-- economics provides theories about economic
system
and decision making,
-- accounting supplies financial data and data
analysis
tools.

Finance has evolved from a purely

descriptive legalistic discipline to an
analytical, decision-oriented discipline
used by financial managers.

2005 McGraw-Hill Ryerson Limited

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What is Finance?
Finance

tries to help financial managers to

answer (i.e. make decisions about) the
following questions:
1. What long-term investments or projects the firm
should undertake? (capital budgeting decision)
2. How the firm should pay for these assets? By issuing
equity or debt? (capital structure decision)
3. How much cash or inventory the firm should carry?
How much trade credit the firm should provide or
use? (working capital management decision)

These

decisions are made within a risk-return

framework.

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Goals of Financial
Management
The primary goal is shareholder wealth
maximization because the firm is
owned by the shareholders.
This goal should be measured in terms
of market share price, which is a value
that investors collectively are
prepared to pay.
The alternative uppermost in the mind
of the public, profit, fails to consider
risk and timing and more importantly,
it is almost impossible to accurately
measure profit.

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Goals of Financial
Management
The goal of maximizing shareholder
wealth may conflict with
- interests of management (their
compensation)
- social/ethical goals
Agency theory is about the potential
conflict between shareholders and
managers.
Tradeoffs exist between the agency costs
of monitoring management actions and
the possible loss of incentives.

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Goals of Financial
Management

The goal of shareholder wealth maximization can

be consistent with a concern for social
responsibility.
Firms should take socially desirable actions even if
certain actions like pollution control may at times
conflict with this goal.
Managers should strictly follow the rules of
fairness and honesty.
Insider trading and manipulation of financial
results are detrimental to confidence in the
financial system.
Ignoring social responsibility can lead to a
backlash of anti business sentiment, reflected in
legislation.

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Functions of Financial
Management

The
-

study of finance covers a variety of topics.

Corporate finance
Banking
Securities trading and underwriting
Money management
Financial planning
Risk management (insurance)

Some

of these functions are performed on a

daily basis and others are less routine.
All these functions are carried out with the
intention to proper balance profitability against
risk.
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Figure 1-1

Functions of the Financial

Manager
Daily
Cash management
(receipt and disbursement of
funds)
Credit management
Inventory control
Short-term financing
Exchange and interest rate
hedging
Bank relations

Occasional
Intermediate financing
Bond issues
Leasing
Stock issues
Capital budgeting
Dividend decisions
Forecasting

Profitability
Goal:
Maximize
Trade-off
shareholder
wealth
Risk

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Risk-Return Tradeoff

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Profitability Risk
Profitability Risk

e.g.,

investing in stocks vs.savings accounts

Stocks

may be more profitable but are riskier

Savings

accounts are less profitable and less risky

(or safer)

Financial manager must choose appropriate combination of potential profit

(return) and level of risk (safety)

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Forms of Organization

Sole Proprietorship (one owner) - largest in actual

number but smallest in total sales revenue

Partnership (two or more owners)

Corporation (legal entity unto itself) - smallest in

actual number but largest in total sales revenue

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Forms of Organization:
Sole Proprietorships
Advantages
Freedom
Simplicity

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Disadvantages
Unlimited
Liability
Lack of Continuity

Low Start Up
Difficulty in
Costs
A business owned by Raising Money
one person
Tax Benefits
Reliance on One Person
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Forms of Organization:
Partnerships
Disadvantages

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Advantages

Unlimited Liability
Lack of Continuity
Ownership
Transfer
Difficult
Possibility of
Conflict

More Capital
Greater Talent Pool
Ease of Formation
Tax Benefits

A business venture with two or more owners

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Forms of Organization:
Corporations
Advantages
Limited Liability
Continuity
Greater Likelihood
of Professional
Management
Easier Access to
Money

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Disadvantages
Potential Shareholder
Revolts
Higher Start-Up
Costs
Regulation
Double Taxation

A corporation
is a separate legal entity

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Role of Financial Markets

Financial markets are a vast global
network of corporations, financial
institutions, governments and
individuals that either need money or
have money to lend or invest.
Public financial markets assist
governments and business to access
funds for investment and operations.
The effect of managerial decisions on
the value of the firm is realized in
financial markets.

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Overview of Financial Markets

Money markets deal in short-term securities

(<1 year)

16

e.g.: Treasury Bills, commercial paper

Capital markets deal in long-term securities

e.g.: common stock, preferred stock, corporate

and government bonds

Primary market: new issues of bonds or

shares
Secondary market: where investors buy and
sell (trade) outstanding bonds or shares.

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Securities in Financial Markets

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Stock (Share) = ownership or equity

Shareholders

own the company

Bond = debt or liability

Bondholders

are owed $ by issuer

Creditors

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Role of Financial Markets

Financial markets determine value.

Well functioning markets allocate resources to their

highest and best use.

To those firm best able to satisfy consumer wants and

needs.

Investors receive an appropriate rate of return for the

risks incurred.

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Figure 1-2

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Prime rate versus percent change

in the CPI

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Summary and Conclusions

Finance links economics and accounting.

It helps managers make decisions to maximize
shareholder wealth.
However, managers may pursue their own
interests instead of those of shareholders.
Agency theory studies the conflicts between
shareholders and management.
Financial managers make investment and
financing decisions.
Financial markets are where financial
managers raise funds and are given feedback
about the effect of their decisions.

2005 McGraw-Hill Ryerson Limited