the goals and functions of financial management
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The Goals and Functions of Financial Management. 1. Chapter Outline. Introduction to Finance Risk-Return Tradeoff Forms of Organizations Corporate Governance Goals of Financial Management Social Responsibility and Finance Role of Financial Markets. Financial Management. - PowerPoint PPT PresentationTRANSCRIPT
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McGraw-Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
The Goals and Functions of Financial Management1
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Chapter Outline
• Introduction to Finance
• Risk-Return Tradeoff
• Forms of Organizations
• Corporate Governance
• Goals of Financial Management
• Social Responsibility and Finance
• Role of Financial Markets
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Financial Management
Financial Management or business finance is concerned with managing an entity’s money.
For example, a company must decide:− where to invest its money.− whether or not to replace an old asset.− when to issue new stocks and bonds.− whether or not to pay dividends.
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Relationship between Finance, Economics and Accounting
• Economics provides structure for decision making in many important areas.− Provides a broad picture of economic
environment.
• Accounting provides financial data in various forms.– Income statements, balance sheets, and
statement of cashflows.
• Finance links economic theory with the numbers of accounting.
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Evolution in the Field of Finance
• At the turn of the century: Emerged as a field separate from economics.
• By 1930s: Financial practices revolved around such topics as:– Preservation of capital.– Maintenance of liquidity.– Reorganization of financially troubled
corporation.– Bankruptcy.
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Evolution in the Field of Finance (cont’d)
• By mid-1950s: Finance becomes more analytical.– Financial Capital (accounting capital/ money)
was used to purchase Real Capital (economic capital/ long-term plant and equipment).
– Cash and inventory management– Capital structure theory– Dividend policy
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Recent Issues in Finance
• Recent focus has been on:– Risk-return relationships. – Maximization of returns for a given level of risk.– Portfolio management.– Capital structure theory.
• New financial products with a focus on hedging are being widely used.
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Recent Issues in Finance (cont’d)
• The following are significant to financial managers during decision making:– Effects of inflation and disinflation on financial
forecasting.– Required rates of return for capital budgeting
decisions.– Cost of capital.
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Advances in Internet and Finance
• Internet and its acceptance has enabled acceleration of e-commerce solutions for “old economy” companies.
• E-commerce solutions for existing companies− B2C− B2B
• Spurt in new business models and companies− Amazon.com− eBay
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Advances in Internet and Finance (cont’d)
• For a financial manager e-commerce impacts financial management because it affects the pattern and field through which cash flows through the firm.– B2C Model: Products are bought with credit
cards, credit card checks are performed, and selling firms get the cash flow faster.
– B2B: Orders can be placed, inventory managed, and bids to supply products can be accepted –all online.
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Functions of the Financial Manager
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Risk-Return Trade-Off
• Influences operational side (capital versus labor/ Product A versus Product B)
• Influences financial mix (stocks versus bonds versus retained earnings)− Stocks are more profitable but riskier.− Savings accounts are less profitable and less
risky (or safer)
• Financial manager must choose appropriate combinations
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Sole Proprietorship
• Represents single-person ownership
• Advantages:– Simplicity of decision-making. – Low organizational and operational costs.
• Drawback– Unlimited liability to the owner.– Profits and losses are taxed as though they
belong to the individual owner.
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Partnership
• Similar to sole proprietorship except there are two or more owners. – Articles of partnership: Specifies ownership
interest, the methods for distributing profits, and the means of withdrawing from the partnership.
– Limited partnership: One or more partners are designated as general partners and have unlimited liability of the debts of the firm; other partners designated limited partners and are liable only for their initial contribution.
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Corporation
• Corporation− Articles of incorporation: Specify the rights and
limitations of the entity.− Its owned by shareholders who enjoy the
privilege of limited liability. − Has a continual life.
− Key feature is the easy divisibility of ownership interest by issuing shares of stock.
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Corporation (cont’d)
• Disadvantage:– The potential of double taxation of earnings.
• Subchapter S corporation: Income is taxed as a direct income to stockholders and thus is taxed only once as normal income.
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Corporate Governance
• Agency theory– Examines the relationship between the owners
and managers of the firm.
• Institutional investors– Have more to say about the way publicly owned
companies are managed.− Public Company Accounting Oversight Board
(PCAOB)
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Sarbanes-Oxley Act of 2002
• Set up a five member Public Company Accounting Oversight Board (PCAOB) with responsibility for:– Auditing standards within companies– Controlling the quality of audits– Setting rules and standards for the
independence of the auditors.• Major focus is to make sure that publicly-
traded corporations accurately present their assets, liabilities, and equity and income on their financial statements.
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Goals of Financial Management
• Valuation Approach• Maximizing shareholder wealth (shareholder
wealth maximization)• Management and stockholder wealth
− Retention of position of power in long run is by becoming sensitized to shareholder concerns.
− Sufficient stock option incentives to motivate achievement of market value maximization.
− Powerful institutional investors are increasing management more responsive to shareholders.
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Social Responsibility
• Adoption of policies that maximize values in the market attracts capital, provides employment and offers benefits to the society.
• Certain cost-increasing activities may have to be mandatory rather than voluntary initially, to ensure burden falls equally over all business firms.
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Ethical Behavior
• Ethical behavior creates invaluable reputation.
• Insider trading
• Protected against by the Securities and Exchange Commission (SEC).
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The Role of Financial Markets
• Financial markets are indicators of maximization of shareholder value and the ethical or the unethical behavior that may influence the value of the company.
• Participants in the financial market range over the public, private and government institutions.– Public financial markets– Corporate financial markets
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Structure and Functions of the Financial Markets
• Money markets− Securities in this market include commercial
paper sold by corporations to finance their daily operations or certificates of deposit with maturities of less than 12 months sold by banks.
• Capital markets− Long-term markets− Securities include common stock, preferred
stock and corporate and government bonds.
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Stocks versus Bonds
• Stock = ownership or equity− Stockholders own the company
• Bond = debt or IOU− Bondholders are owed $ by company
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Allocation of Capital
• Primary market– When a corporation uses the financial markets
to raise new funds, the sale of securities is made by way of a new issue.
• Secondary market– When the securities are sold to the public
(institutions and individuals).– Financial managers are given a feedback about
their firms’ performance.
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Return Maximization and Risk Minimization
• Investors can choose risk level that meets their objective and maximizes return for that given level of risk.
• Companies that are rewarded with high-priced securities can raise new funds in the money and capital markets at a lower cost compared to competitors.
• Firms pay a penalty for failing to perform competitively.
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Restructuring
• Restructuring can result in: – Changes in the capital structure (liabilities and
equity on the balance sheet).– Selling of low-profit-margin divisions with the
proceeds of the sale reinvested in better investment opportunities.
– Removal or large reductions in the of current management team.
• It has resulted in acquisitions and mergers.
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Internationalization of Financial Markets
• Allocation of capital and the search for low cost sources of financing on the rise in global market.
• The impact of international affairs and technology has resulted in the need for future financial managers to understand − International capital flows.− Computerized electronic funds transfer systems.− Foreign currency hedging strategies.
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Technological Impact on Capital Market
• Consolidation among major stock markets and mergers of brokerage firms with domestic and international partners.
• Electronic markets have gained popularity as against traditional organized exchanges and NASDAQ.
• Resulted in the merger of NYSE with Archipelago and NASDAQ bought out Insinet from Reuters.