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Chapter 1 overview of financial management

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Sudipta Saha
Sudipta Saha

Financial management concerns the acquisition, financing, and management of assets to achieve overall goals. It involves three main decision functions: investment decisions about what assets to acquire and manage; financing decisions about obtaining funds and setting dividend policy; and asset management decisions about efficiently operating existing assets. The goal of financial management is to maximize shareholder wealth by increasing the market value of the firm's common stock, which reflects the firm's investment, financing, and asset management decisions.

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INTRODUCTION TO FINANCIAL MANAGEMENT
What is Financial Management? Concerns the acquisition, financing, and management of assets with some overall goalsoverall goals in mind.
What is Financial Management?  The Decision Function of Financial Management can be broken down into three major areas:  Investment decision  Financing decision  Asset management decision
Investment Decisions  What is the optimal firm size?  What specific assets should be acquired?  What assets (if any) should be reduced or eliminated? •Most important of the three decisions functions.Most important of the three decisions functions. Determine the total amount of assets needed to be heldDetermine the total amount of assets needed to be held by the firm.by the firm. Assets that can no longer be economically justified mayAssets that can no longer be economically justified may need to be reduced, eliminated or replaced.need to be reduced, eliminated or replaced.
Financing Decisions  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? •Determine how the assets (LHS of balance sheet) willDetermine how the assets (LHS of balance sheet) will be financed (RHS of balance sheet).be financed (RHS of balance sheet). •Have large amount of debt or debt free.Have large amount of debt or debt free. •Dividend payout ratio:Dividend payout ratio: annual cash dividends divided by annualannual cash dividends divided by annual earningsearnings dividend per share divided by earning per share.dividend per share divided by earning per share.
Asset Management Decisions  How do we manage existing assets e fficie ntly? Once assets have been acquired and appropriate financing provided, these assets must be managed 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? Maxim iz atio n o f Share ho lde r’s We alth!Maxim iz atio n o f Share ho lde r’s We alth! What is share ho lde r’s we alth? The total shareholders’ wealth is the outstanding number of shares times market value per share. The m arke t price pe r share o f the firm ’s co m m o n sto ck which is a re fle ctio n o f a firm ’s inve stm e nt, financing and asse t m anag e m e nt de cisio ns. Value cre atio n o ccurs whe n we m axim iz e the share price fo r curre nt share ho lde rs.
Shortcomings of Alternative Perspectives  Could increase current profits while harming firm (e.g., defer maintenance, issue common stock to buy T-bills, etc.).  May result in a decrease in earning per share  Ignores changes in the risk level of the firm. Profit MaximizationProfit Maximization Maximizing a firm’s earnings after taxes. ProblemsProblems
Shortcomings of Alternative Perspectives  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. A firm will want to improve EPS by retaining earning and investing them in any positive rate of return. Earnings per Share MaximizationEarnings per Share Maximization Maximizing earnings after taxes divided by shares outstanding. ProblemsProblems
Strengths of Shareholder Wealth Maximization  Takes account of: current and future profits andcurrent and future profits and EPSEPS; the timing, duration, and risk of profits andthe timing, duration, and risk of profits and EPSEPS; dividend policydividend policy; and all other relevant factors.  Thus, share priceshare price serves as a barometer for business performance.
Financial Manager’s Responsibilities  Raise funds from investors  Invest funds in value-enhancing projects  Manage funds generated by operations  Return funds to investors - dividends  Reinvest funds in new projects
The Financial Manager’s Role Firm Financial Manager Capital Market 1 2 3 4 5
The Modern Corporation There exists a SEPARATION between owners and managers. Modern Corporation Shareholders Management
Role of Management  An ag e ntag e nt is an individual authorized by another person, called the principal, to act in the latter’s behalf.  When there is a conflict of interest between the agent and principal it leads to Agency problem. Management acts as an agentagent for the owners (shareholders) of the firm.
Agency Theory  According to theAccording to the Ag e ncy The o ryAg e ncy The o ry the agents will make optimal decisions if appropriate incentives are given and only if agents are monitored. Jensen and Meckling developed a theory of the firm based on agency arrangement known as the agencyagency theorytheory.
Agency Theory  Incentives include stock optionsstock options,, perquisitesperquisites,, and bonusesbonuses.  Monitoring involves auditing financialauditing financial statements, reviewing management perquisitesstatements, reviewing management perquisites and limit management decisions.limit management decisions. Principals must provide incentivesincentives so that management acts in the principals’ best interests and then monitormonitor results.
Social Responsibility  Wealth maximization does no t preclude the firm from being socially responsible, such as protecting the customer, paying fair wages to employees, fair hiring practices, safe working conditions, and becoming involved in environmental issues like clean air and water.  Consider the interests of stakeholders other than shareholders.
Organizational Stakeholders 3–18
End of Chapter 1

More Related Content

Chapter 1 overview of financial management

  • 2. What is Financial Management? Concerns the acquisition, financing, and management of assets with some overall goalsoverall goals in mind.
  • 3. What is Financial Management?  The Decision Function of Financial Management can be broken down into three major areas:  Investment decision  Financing decision  Asset management decision
  • 4. Investment Decisions  What is the optimal firm size?  What specific assets should be acquired?  What assets (if any) should be reduced or eliminated? •Most important of the three decisions functions.Most important of the three decisions functions. Determine the total amount of assets needed to be heldDetermine the total amount of assets needed to be held by the firm.by the firm. Assets that can no longer be economically justified mayAssets that can no longer be economically justified may need to be reduced, eliminated or replaced.need to be reduced, eliminated or replaced.
  • 5. Financing Decisions  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? •Determine how the assets (LHS of balance sheet) willDetermine how the assets (LHS of balance sheet) will be financed (RHS of balance sheet).be financed (RHS of balance sheet). •Have large amount of debt or debt free.Have large amount of debt or debt free. •Dividend payout ratio:Dividend payout ratio: annual cash dividends divided by annualannual cash dividends divided by annual earningsearnings dividend per share divided by earning per share.dividend per share divided by earning per share.
  • 6. Asset Management Decisions  How do we manage existing assets e fficie ntly? Once assets have been acquired and appropriate financing provided, these assets must be managed efficiently. Financial Manager has varying degrees of operating responsibility over assets. Greater emphasis on current asset management than fixed asset management.
  • 7. What is the Goal of the Firm? Maxim iz atio n o f Share ho lde r’s We alth!Maxim iz atio n o f Share ho lde r’s We alth! What is share ho lde r’s we alth? The total shareholders’ wealth is the outstanding number of shares times market value per share. The m arke t price pe r share o f the firm ’s co m m o n sto ck which is a re fle ctio n o f a firm ’s inve stm e nt, financing and asse t m anag e m e nt de cisio ns. Value cre atio n o ccurs whe n we m axim iz e the share price fo r curre nt share ho lde rs.
  • 8. Shortcomings of Alternative Perspectives  Could increase current profits while harming firm (e.g., defer maintenance, issue common stock to buy T-bills, etc.).  May result in a decrease in earning per share  Ignores changes in the risk level of the firm. Profit MaximizationProfit Maximization Maximizing a firm’s earnings after taxes. ProblemsProblems
  • 9. Shortcomings of Alternative Perspectives  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. A firm will want to improve EPS by retaining earning and investing them in any positive rate of return. Earnings per Share MaximizationEarnings per Share Maximization Maximizing earnings after taxes divided by shares outstanding. ProblemsProblems
  • 10. Strengths of Shareholder Wealth Maximization  Takes account of: current and future profits andcurrent and future profits and EPSEPS; the timing, duration, and risk of profits andthe timing, duration, and risk of profits and EPSEPS; dividend policydividend policy; and all other relevant factors.  Thus, share priceshare price serves as a barometer for business performance.
  • 11. Financial Manager’s Responsibilities  Raise funds from investors  Invest funds in value-enhancing projects  Manage funds generated by operations  Return funds to investors - dividends  Reinvest funds in new projects
  • 12. The Financial Manager’s Role Firm Financial Manager Capital Market 1 2 3 4 5
  • 13. The Modern Corporation There exists a SEPARATION between owners and managers. Modern Corporation Shareholders Management
  • 14. Role of Management  An ag e ntag e nt is an individual authorized by another person, called the principal, to act in the latter’s behalf.  When there is a conflict of interest between the agent and principal it leads to Agency problem. Management acts as an agentagent for the owners (shareholders) of the firm.
  • 15. Agency Theory  According to theAccording to the Ag e ncy The o ryAg e ncy The o ry the agents will make optimal decisions if appropriate incentives are given and only if agents are monitored. Jensen and Meckling developed a theory of the firm based on agency arrangement known as the agencyagency theorytheory.
  • 16. Agency Theory  Incentives include stock optionsstock options,, perquisitesperquisites,, and bonusesbonuses.  Monitoring involves auditing financialauditing financial statements, reviewing management perquisitesstatements, reviewing management perquisites and limit management decisions.limit management decisions. Principals must provide incentivesincentives so that management acts in the principals’ best interests and then monitormonitor results.
  • 17. Social Responsibility  Wealth maximization does no t preclude the firm from being socially responsible, such as protecting the customer, paying fair wages to employees, fair hiring practices, safe working conditions, and becoming involved in environmental issues like clean air and water.  Consider the interests of stakeholders other than shareholders.