The Role of Financial

Management
Lecture # 1
Introduction
• Initially (1900’s), financial managers primarily raised funds and
managed their firms’ cash positions
• Present Value concepts expanded their responsibilities and to
become concerned with the selection of capital investment projects
• Today, external factors have an increasing impact on the role of
financial manager i.e.
• Heightened corporate competition • Fluctuating exchange rates
• Technological change • Tax law changes
• Volatility in inflation and interest rates • Environmental issues
• Worldwide economic uncertainty • Ethical concerns over dealings
What Is Financial Management?
Financial management is concerned with the acquisition (investment),
financing, and management of assets with some overall goal in mind
• Investment Decision: Determination of the total amount of assets
needed to be held by the firm (Assets at firm’s balance sheet)
Assets that can no longer be economically justified may need to be reduced,
eliminated, or replaced
• Financing Decision: Determination of the other side of balance sheet
(Liabilities and Equities at firm’s balance sheet)
Dividend policy must be viewed as a vital part of the firm’s financing decision
• Asset Management Decision: After appropriate acquisition and
financing, these assets must still be managed efficiently (Operations)
 The Goal of the Firm
• Although various objectives (goals) are possible, however the key goal
of a firm is to maximize the wealth of the firm’s present owners
• Shares of common stock give evidence of ownership in a corporation
• Shareholder wealth is represented by the current stock price, which is
reflection of the firm’s decisions (investment, financing, and asset management)
Value Creation: Profit maximization is known as the proper objective of
the firm (Firm Performance)
• Earnings per share (EPS) is often advocated as proxy of profit maximization

• Other measures of valuation are ROI, ROA and operating performance (EBIT)
The Goal of the Firm (Cont.)
Agency Problems: The separation of ownership and control in the modern corporation
results in potential conflicts between owners and managers
• The objectives of management may differ from shareholder
• It can create a situation in which management may act in its own best interests rather than those of
the shareholders
• We may think of management as the agents of the owners (shareholders)
• Jensen and Meckling developed a comprehensive theory of the firm under agency
arrangements (Agency theory)
“the shareholders, can assure themselves that the agents will make optimal
decisions only if appropriate incentives are given and only if the agents are monitored”
• Incentives include stock options, bonuses, and perquisites (i.e. Car, Office)
• Monitoring by systematically reviewing management perquisites, auditing financial
statements, and limiting management decisions
The Goal of the Firm (Cont.)
Corporate Social Responsibility (CSR): Management is responsible for
maximizing shareholder wealth by keeping CSR in balance.
CSR activities such as:
• Protecting the consumer
• Paying fair wages to employees
• Maintaining fair hiring practices
• Safe working conditions
• Supporting education
• Dealing with environmental issues as clean air and water
Organization of the
Financial Management
Function
• It is important to understand the role
that financial management plays in
the operations of the firm (Any type)
• Figure 1.1 is an organization chart for
a typical manufacturing firm that
gives special attention to the finance
function
• The controller’s responsibilities are
primarily accounting in nature
• The treasurer’s responsibilities fall
into the decision areas most
commonly associated with financial
management
Overview of Financial
Management and the
Financial Environment
Lecture # 1
Why is corporate finance important
to all managers?
• Corporate finance provides the skills managers need to:
• Identify and select the corporate strategies and individual projects that add
value to their firm.
• Forecast the funding requirements of their company, and devise strategies for
acquiring those funds.

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Business Organization from Start-up to
a Major Corporation
• Sole proprietorship
• Partnership
• Corporation

(More . .)

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Starting as a Proprietorship
• Advantages:
• Ease of formation
• Subject to few regulations
• No corporate income taxes
• Disadvantages:
• Limited life
• Unlimited liability
• Difficult to raise capital to support growth

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Starting as or Growing into a
Partnership
• A partnership has roughly the same advantages and disadvantages as
a sole proprietorship.

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Becoming a Corporation
• A corporation is a legal entity separate from its owners and managers.
• File papers of incorporation with state.
• Charter
• Bylaws

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Advantages and Disadvantages of a
Corporation
• Advantages:
• Unlimited life
• Easy transfer of ownership
• Limited liability
• Ease of raising capital
• Disadvantages:
• Double taxation
• Cost of set-up and report filing

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Becoming a Public Corporation and
Growing Afterwards
• Initial Public Offering (IPO) of Stock
• Raises cash
• Allows founders and pre-IPO investors to “harvest” some of their wealth
• Subsequent issues of debt and equity

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Agency Problems and Corporate
Governance
• Agency problem: managers may act in their own interests and not on
behalf of owners (stockholders)
• Corporate governance is the set of rules that control a company’s
behavior towards its directors, managers, employees, shareholders,
creditors, customers, competitors, and community.
• Corporate governance can help control agency problems.

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What should be management’s primary
objective?
• The primary objective should be shareholder wealth maximization,
which translates to maximizing the fundamental stock price.
• Should firms behave ethically? YES!
• Do firms have any responsibilities to society at large? YES! Shareholders are
also members of society.

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Is maximizing stock price good for society,
employees, and customers?
• Employment growth is higher in firms that try to maximize stock
price. On average, employment goes up in:
• firms that make managers into owners (such as LBO firms)
• firms that were owned by the government but that have been sold to private
investors

(Continued)
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Is maximizing stock price good?
(Continued)
• Consumer welfare is higher in capitalist free market economies than
in communist or socialist economies.
• Fortune lists the most admired firms. In addition to high stock
returns, these firms have:
• high quality from customers’ view
• employees who like working there

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What three aspects of cash flows affect
an investment’s value?
• Amount of expected cash flows (bigger is better)
• Timing of the cash flow stream (sooner is better)
• Risk of the cash flows (less risk is better)

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Free Cash Flows (FCF)
• Free cash flows are the cash flows that are available (or free) for
distribution to all investors (stockholders and creditors).
• FCF = sales revenues - operating costs - operating taxes - required
investments in operating capital.

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What is the weighted average cost
of capital (WACC)?
• WACC is the average rate of return required by all of the company’s
investors.
• WACC is affected by:
• Capital structure (the firm’s relative amounts of debt and equity)
• Interest rates
• Risk of the firm
• Investors’ overall attitude toward risk

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What determines a firm’s fundamental,
or intrinsic, value?

Intrinsic value is the sum of all the future

expected free cash flows when converted into
today’s dollars:

FCF1 + FCF2 +… FCF∞

Value
= (1 + (1 + (1 + WACC)∞
WACC)1 WACC)2

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Who are the providers (savers) and
users (borrowers) of capital?
• Households: Net savers
• Non-financial corporations: Net users (borrowers)
• Governments: Net borrowers
• Financial corporations: Slightly net borrowers, but almost breakeven

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Transfer of Capital from Savers to
Borrowers
• Direct transfer (e.g., corporation issues commercial paper to
insurance company)
• Through an investment banking house (e.g., IPO, seasoned equity
offering, or debt placement)
• Through a financial intermediary (e.g., individual deposits money in
bank, bank makes commercial loan to a company)

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Cost of Money
• What do we call the price, or cost, of debt capital?
• The interest rate
• What do we call the price, or cost, of equity capital?
• Cost of equity = Required return = dividend yield + capital gain

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Primary vs Secondary Markets
• Primary
• New issue (IPO or seasoned)
• Key factor: issuer receives the proceeds from the sale.
• Secondary
• Existing owner sells to another party.
• Issuing firm doesn’t receive proceeds and is not directly involved.

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How are secondary markets
organized?
• By “location”
• Physical location exchanges
• Computer/telephone networks
• By the way that orders from buyers and sellers are matched
• Open outcry auction
• Dealers (i.e., market makers)
• Electronic communications networks (ECNs)

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