01

The Goals and Activities of

Financial Management
Block, Hirt, and Danielsen

© Copyright
2014, The McGraw-Hill Companies
© 2011 by The McGraw-Hill Companies, Inc. All rights reserved.
 Modern Issues in Finance

• Focus has been on

• Risk-return relationships
• Maximizing return for given risk level
• Portfolio management
• Capital structure theory
• New financial products with focus on hedging
are now widely used
• Inflation – key variable in financial decisions

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 Modern Issues in Finance

• Significant factors during decision making

• Effects of inflation/deflation on financial forecast
• Required rates of return for capital budgeting
decisions
• Cost of capital

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 Risk Management and the Financial
Crisis
• Reasons for recent financial crisis
• Unwarranted extension of credit
• Creation/sale of mortgage-backed securities
• Losses from credit defaults in excess of banks’
capital in many cases
• Creation of complicated, unregulated financial
products like credit default swaps (CDS)
• Government action and bail-outs
• New regulations for financial institutions

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 The Dodd-Frank Act

• Wall Street Reform and Consumer Protection

Act of 2010
• Passed in response to financial crisis
• Purports to improve accountability, transparency
• Financial Stability Oversight Council and Office of
Financial Research
• Created to maintain stability of financial system

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 The Dodd-Frank Act

• Provides for orderly bankruptcy/liquidation of

non-bank financial companies
• Consolidates regulators
• Hedge funds, investment advisors must
register with Securities Exchange Commission
• Established Federal Insurance Office
• Volcker Rule
• Limits speculative investing by regulated
institutions

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 The Dodd-Frank Act

• Bureau of Consumer Financial Protection

• Issues
• Rulemaking, implementation left to agencies
charged with enforcement
• Final rules delayed
• Grey area between many financial activities

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 Activities of Financial Management

 Financial management concerned with

managing entity’s money
 Functions
• Allocate funds to current, fixed assets
• Obtain best mix of financing alternatives
• Develop appropriate dividend policy within
context of firm’s objectives

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 Functions of the Financial Manager

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 Risk-Return Trade-Off

• Influences operational side (capital vs. labor /

product A vs. product B)
• Influences financial mix (stock vs. bonds vs.
retained earnings)

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 Forms of Organization

• Sole Proprietorship
• Represents single-person ownership
• Advantages
• Simplicity of decision-making
• Low organizational and operational costs
• Drawback — unlimited liability to owner
• Profits and losses taxed as though they belong to
individual owner

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 Forms of Organization

• Partnership
• Similar to sole proprietorship except with two or
more owners
• Articles of partnership specify:
• Ownership interest
• Methods for distributing profits
• Means of withdrawing from the partnership
• Carries unlimited liability for the owners

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 Forms of Organization

• Partnership (cont’d)
• Limited partnership
• One or more partners designated general
partners and have unlimited liability for debts
of firm
• Other partners designated limited partners and
liable only for initial contribution
• Not all financial institutions extend funds to
limited partnership firms

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 Forms of Organization

• Corporation
• Unique; legal entity unto itself
• Formed through articles of incorporation, which
specify rights and limitations of entity
• Owned by shareholders who enjoy limited liability
• Has continual life
• Key feature – easy divisibility of ownership
interest by issuing shares of stock

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 Forms of Organization
• Corporation (cont’d)
• Disadvantage
• Potential of double taxation of earnings
• S corporation
• Income taxed as direct income to stockholders, thus
taxed only once as normal income
• Limited liability company (LLC)
• Provides limited liability for the owners
• Can be taxed as sole proprietorship, partnership,
corporation, or S corporation, depending upon elections
made by owners

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 Corporate Governance

• Agency theory
• Examines relationship between owners and
managers of firm
• Institutional investors
• Have more to say about how publicly-owned
companies are managed

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 Sarbanes-Oxley Act
• Set up five-member Public Company Accounting Oversight
Board (PCAOB) with responsibility for
• Auditing standards within companies
• Controlling quality of audits
• Setting rules and standards for independence of the
auditors
• Major focus is to make sure publicly-traded corporations
accurately present
• Assets
• Liabilities
• Equity and income on financial statements
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 Goals of Financial Management

• Primary goal – maximization of profit

• Drawbacks
• Change in profit may also represent change in risk
• Fails to consider timing of benefits
• Impossible task of accurately measuring key
variable “profit”
• Broader goal – maximizing shareholder wealth
• Achieving highest possible value for firm

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 Management and Stockholder Wealth

• Only way to retain power in long run is by

becoming sensitive to shareholder concerns
• Sufficient stock-option incentives to motivate
achievement of market-value maximization
• Powerful institutional investors making
management more responsive to shareholders

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 Valuation Approach
• Ultimate measure of performance – how earnings are
valued by investor
• In analyzing firm, investor will consider
• Risk inherent in firm’s operation
• Time pattern over which firm’s earnings increase or
decrease
• Quality and reliability of reported earnings
• Finance manager must question impact of each
decision on firm’s overall valuation
• If decision maintains or increases firm’s overall value, it
is acceptable; otherwise, it should be rejected
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 Social Responsibility and Ethical Behavior

• Adopting policies that

• Maximize values in market
• Attract capital
• Provide employment
• Offer benefits to society
• Certain cost-increasing activities may initially
have to be mandatory rather than voluntary,
to ensure burden falls equally over all business
firms

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 Social Responsibility and Ethical Behavior

• Insider trading
• Using information not available to public, making
undue profit from trading
• Unethical and illegal practice
• Protected against by SEC
• Ethical behavior creates invaluable reputation

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 Role of Financial Markets

• Serve as indicators for maximizing shareholder

value, report ethical or unethical behavior that
influences company value
• Participants can be individuals or public/
private/government institutions
• Public financial markets
• Corporate financial markets

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 Structure and Functions
of the Financial Markets
• Distinct parts of financial markets
• Domestic and international markets
• Corporate and government markets
• Money and capital markets

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 Structure and Functions
of the Financial Markets
• Money markets
• Deal with short-term securities with life of
one year or less
• Securities include
• Commercial paper sold by corporations to
finance daily operations
• Certificates of deposit with maturities of less
than 12 months sold by banks

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 Structure and Functions
of the Financial Markets
• Capital markets
• Deal with securities that have life of more than
one year
• Long-term markets
• Securities include
• Common stock
• Preferred stock
• Corporate and government bonds

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 Allocation of Capital

• Primary market
• When corporation uses financial markets to raise
new funds, sale of securities made through new
issue is called initial public offering (IPO)
• Secondary market
• Securities bought/sold amongst investors
• Prices of securities keep changing continually
• Financial managers given feedback about firms’
performance

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 Return Maximization
and Risk Minimization
• Investors can choose risk level that meets
objective, maximizes return for given risk level
• Companies rewarded with high-priced
securities can raise new funds in
money/capital markets at lower cost than
competitors
• Firms pay penalty for failing to perform
competitively

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 Restructuring

• Restructuring can result in:

• Changes in capital structure (liabilities and equity
on balance sheet)
• Sale of low-profit-margin divisions with proceeds
from sale reinvested in better investment
opportunities
• Removal of current management team or large
reductions in workforce
• Also includes mergers and acquisitions

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 Internationalization
of Financial Markets
• Allocation of capital and search for lower-cost
sources of financing in global market
• Impact of international affairs and technology
has resulted in need for managers to
understand
• International capital flows
• Computerized electronic-funds-transfer systems
• Foreign currency-hedging strategies

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 Technological Impact
on Capital Markets
• Cost reduction in trading securities
• Consolidation among major stock markets and
mergers of brokerage firms with domestic and
international partners
• Creation of electronic communication
networks (ECNs)
• Electronic markets like NASDAQ have gained
popularity against traditional organized
exchanges such as NYSE

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