Financial Management I

BBA-II
 Chapter 1
An Overview of Financial
Management
 Learning Objectives
• The purpose of this chapter is to give you an idea
of what financial management is all about.
• Key aspects of this course would include:
– Forces that will affect financial management in future.
– The place of finance in a firm’s organization.
– The relationships between financial managers and their
counterparts .
– The goals of a firm.
– The way financial managers can contribute to the
attainment of these goals.
What is Financial Management?

Concerns the acquisition, financing, and

management of assets with some
overall goal in mind.
 Role of Financial Management

• Why is financial management important?

• The goal of the firm
• Organization of the financial management
function
 Investment Decisions
• Most important of the three decisions.

• Includes issues like:

– What is the optimal firm size?
– What specific assets should be acquired?
– What assets (if any) should be reduced or
eliminated?
 Financing Decisions
• Determine how the assets (LHS of balance
sheet) will be financed by RHS of the balance
sheet.
• Includes issues like:
– 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?
 Asset Management Decision

• How do we manage existing assets 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 wealth

Value creation occurs when we maximize the

share price for current shareholders.
 Shortcomings of Alternative
Perspectives
A. Profit Maximization: Maximizing a firm’s
earnings after taxes.
Problems:
• Could increase current profits while harming
firm (e.g., defer maintenance, issue common
stock to buy T-bills, etc.).
• Ignores changes in the risk level of the firm.
B. Earnings Per Share Maximization:
Maximizing earnings after taxes divided by
shares outstanding.
Problems:
• 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.
 Strengths of Shareholder Wealth
Maximization

• Takes account of: current and future profits and

EPS; the timing, duration, and risk of profits
and EPS; dividend policy; and all other relevant
factors.
• Thus, share price serves as a barometer for
business performance
 The Modern Corporation

Modern Corporation

Shareholders Management

There exists a SEPARATION between owners

and managers.
 Role of Management

• Management acts as an agent for the owners

(shareholders) of the firm.
• An agent is an individual authorized by
another person, called the principal, to act in
the latter’s behalf.
 Agency Theory
• Jensen & Meckling developed a theory of firm
based agency theory.
• Agency theory is a branch of economics
relating to behavior of principals & their agents.
• Principals must provide incentives so that
management acts in principals’ best interests &
then monitor results.
• Incentives include stock options, perquisites &
bonuses.
 Agency Relationships

A potential conflict of interests between the

agent (manager) and (1) the outside
stockholders or (2) the creditors (debt
holders)
 Cont’d
• Stockholders versus managers
– Managerial compensation
– Direct intervention by shareholders
– The threat of firing.
– The threat of takeovers.
• Stockholders (through managers) versus
creditors.
 Career Opportunities in Finance
• Money & Capital markets: deals with securities
markets and financial institutions.
• Investments: which focuses on the decisions made
by both individual and institutional investors as they
chose securities for their investment portfolios.
• Financial Management or Business Finance:
involves decisions within the firms.
 Role of Finance in a Typical
Business Organization
Board of Directors

President

VP: Sales VP: Finance VP: Operations

Treasurer Controller

Credit Manager Cost Accounting

Inventory Manager Financial Accounting

Capital Budgeting Director Tax Department

 Responsibility of Financial Staff
• Maximize stock value by:
– Forecasting and planning
– Investment and financing decisions
– Coordination and control
– Transactions in the financial markets
– Managing risk
Note: The key responsibility of financial staff is to align the
goals of the corporation with the maximization of its
stock price. Will be covered in following slides.
 Financial Management in the New
Millennium
• The effect of changing technology (Information
technology).
• Globalization
– Improvement in transportation and communication has
lowered shipping costs.
– Increased demand of low cost, high quality products.
– Increased costs of developing new products due to
R&D expenditures.
– International markets have opened new avenues for new
and existing products.
Forms of Business Organization

• Sole proprietorship
• Partnership
• Corporation
Sole proprietorships & Partnerships
• Advantages
– Ease of formation
– Subject to few regulations
– No corporate income taxes
• Disadvantages
– Difficult to raise capital
– Unlimited liability
– Limited life
 Corporations
• Advantages
– Unlimited life
– Easy transfer of ownership
– Limited liability
– Ease of raising capital
• Disadvantages
– Double taxation
– Cost of set-up and report filing
 Managerial Actions to Maximize
Shareholder Wealth

• Dividend Policy Decisions

• DOES IT MAKE SENSE TO TRY TO

MAXIMIZE EARNINGS PER SHARE????
 Major Factors Affecting Stock Price

• Projected cash flows to shareholders

• Timing of the cash flow stream
• Riskiness of the cash flows
 Factors that Affect Level &
Riskiness of Cash Flows
• Decisions made by financial managers:
– Investment decisions
– Financing decisions (the relative use of debt
financing)
– Dividend policy decisions
• The external environment
Business Ethics
Do it Yourself