1The Goals and Functions of Financial ManagementMcGraw-Hill Ryerson2005 McGraw-Hill Ryerson Limited

Chapter 1 - OutlineWhat is Finance all about?Goals of Financial ManagementFunctions of Financial ManagementForms of Business OrganizationFinancial MarketsSummaryPPT 1-22005 McGraw-Hill Ryerson Limited

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. PPT 1-32005 McGraw-Hill Ryerson Limited

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.PPT 1-42005 McGraw-Hill Ryerson Limited

Goals of Financial ManagementThe 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.PPT 1-52005 McGraw-Hill Ryerson Limited

Goals of Financial ManagementThe goal of maximizing shareholder wealth may conflict with - interests of management (their compensation) - social/ethical goalsAgency 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.PPT 1-62005 McGraw-Hill Ryerson Limited

Goals of Financial ManagementThe 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.PPT 1-72005 McGraw-Hill Ryerson Limited

Functions of Financial ManagementThe study of finance covers a variety of topics.Corporate financeBankingSecurities trading and underwritingMoney managementFinancial planningRisk 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.PPT 1-82005 McGraw-Hill Ryerson Limited

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

Intermediate financing Bond issuesLeasingStock issues Capital budgeting Dividend decisionsForecastingProfitability

RiskGoal:MaximizeshareholderwealthFigure 1-1Functions of the Financial ManagerOccasionalPPT 1-92005 McGraw-Hill Ryerson Limited

Profitability Risk Profitability Risk

e.g., investing in stocks vs.savings accountsStocks may be more profitable but are riskierSavings accounts are less profitable and less risky (or safer)Financial manager must choose appropriate combination of potential profit (return) and level of risk (safety)Risk-Return TradeoffPPT 1-102005 McGraw-Hill Ryerson Limited

Forms of OrganizationSole 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 revenuePPT 1-112005 McGraw-Hill Ryerson Limited

A business owned byone person FreedomSimplicityLow Start UpCostsTax BenefitsUnlimited Liability Lack of ContinuityDifficulty in Raising Money Reliance on One PersonAdvantagesDisadvantagesForms of Organization: Sole ProprietorshipsPPT 1-122005 McGraw-Hill Ryerson Limited

Greater Talent PoolMore Capital Ease of FormationTax Benefits Unlimited LiabilityLack of ContinuityOwnershipTransferDifficultPossibility of Conflict A business venture with two or more ownersAdvantages DisadvantagesForms of Organization: PartnershipsPPT 1-132005 McGraw-Hill Ryerson Limited

Limited Liability Continuity Greater Likelihood of Professional Management Easier Access to MoneyPotential Shareholder RevoltsHigher Start-Up CostsRegulation Double TaxationA corporation is a separate legal entityAdvantagesDisadvantagesForms of Organization: CorporationsPPT 1-142005 McGraw-Hill Ryerson Limited

Role of Financial MarketsFinancial 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.

PPT 1-152005 McGraw-Hill Ryerson Limited

Overview of Financial Markets Money markets deal in short-term securities (

Securities in Financial MarketsStock (Share) = ownership or equityShareholders own the company

Bond = debt or liabilityBondholders are owed $ by issuerCreditorsPPT 1-172005 McGraw-Hill Ryerson Limited

Role of Financial MarketsFinancial 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.PPT 1-182005 McGraw-Hill Ryerson Limited

Figure 1-2 Prime rate versus percent change in the CPI PPT 1-192005 McGraw-Hill Ryerson Limited

Chart1

Sheet1

FoodGasMotel

Jan121710

Feb171121

Mar222914

Apr141017

May121710

Jun191520

Summary and ConclusionsFinance 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.PPT 1-202005 McGraw-Hill Ryerson Limited

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