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The Role of Financial Management


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Title: The Role of Financial Management

Chapter 1
  • The Role of Financial Management

The Role of Financial Management
After studying Chapter 1, you should be able to
  1. Explain why the role of the financial manager
    today is so important.
  2. Describe "financial management" in terms of the
    three major decision areas that confront the
    financial manager.
  3. Identify the goal of the firm and understand why
    shareholders' wealth maximisation is preferred
    over other goals.
  4. Understand the potential problems arising when
    management of the corporation and ownership are
    separated (i.e., agency problems).
  5. Demonstrate an understanding of corporate
  6. Discuss the issues underlying social
    responsibility of the firm.
  7. Understand the basic responsibilities of
    financial managers and the differences between a
    "treasurer" and a "controller."

Finance vs Accounting
  • In Finance, we are concerned with transactions
    that are cash, or affect cash flows, only.
  • Accounting deals with transactions that affect
    both cash and non-cash activities.

Key Points
  • Financial management is concerned with achieving
    the goal of the firm maximising the wealth of
    its owners (the shareholders).
  • This is achieved through careful and wise control
    of the acquisition, financing and management of
    its assets and involves three decision functions
  • Investment decisions
  • Financing decisions
  • Asset management decisions

Course Map
  • Introduction - Chapters 1, 2, 6, 7
  • Subject Investment Financing Asset Mgt
  • Time Value Ch3 Ch3
  • Valuation Ch 4
  • Risk Ch 5 Ch 5
  • Mgt Work Cap. Ch 11 Chs 8-11
  • Capital Invest. Chs 12-13 Ch 12
  • Cost of Capital Ch 15
  • Lev. Cap. Struct. Chs 16-17

Definition of Finance
  • Finance
  • is about making decisions regarding what assets
    to buy/sell and when to buy/sell these assets.
  • its main objective is to make individuals and
    their businesses better off.
  • Thus, it concerns the buying/selling of, the
    financing of, and the managment of assets with
    some overall goal in mind.

Three Decisions
  • Investment decision
  • Financing decision
  • Asset management decision

Investment Decision
This is the most important of the three decisions.
  • What is the optimal firm size?
  • What specific assets should be acquired?
  • What assets (if any) should be reduced or sold?

Financing Decision
Determine how the assets (LHS of balance sheet)
will be financed (RHS of balance sheet).
  • What is the best type of financing?
  • What is the best financing mix?
  • What is the best dividend policy (e.g.,
    dividend-payout ratio)?
  • How will the funds be obtained?

Asset Management Decision
  • How do we manage existing assets 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?
  • Maximisation of Shareholder Wealth!
  • Value creation occurs when we maximise the share
    price for current shareholders.

What is the Goal of the Firm?
  • Maximising shareholder wealth
  • The goal of the firm, its managers and employees
  • Measured by share price

Shortcomings of Alternative Goals
  • Profit Maximisation
  • Maximising a firms earnings after taxes.
  • Problems
  • Could increase current profits while harming firm
    (e.g., defer maintenance, issue common stock to
    buy T-bills (treasury bills), etc.).
  • Ignores changes in the risk level of the firm.
  • Can manipulate profits by changing accounting

Shortcomings of Alternative Goals
  • Earnings per Share Maximisation
  • Maximising earnings after taxes divided by number
    of shares on issue.
  • Problems
  • Does not specify timing or duration of expected
  • Ignores changes in the risk level of the firm.
  • Calls for a zero payout dividend policy.

Strengths of Shareholder Wealth Maximisation
  • Takes account of
  • current and future profits and EPS
  • the timing, duration, and risk of profits and
  • dividend policy
  • and all other relevant factors.
  • Thus, share price serves as the best indicator of
    business performance.

The Modern Corporation
Modern Corporation
  • There exists a SEPARATION between owners and

The Agency Model
  • Agency relationship (between the owners
    (shareholders) and managers of the business)
  • Agency conflict
  • Why does it arise?
  • How can it be minimised?
  • Principal-agent problem
  • Agency theory
  • Agency costs

Role of Management
Management acts as an agent for the owners
(shareholders) of the firm.
  • An agent is an individual authorised by another
    person, called the principal, to act in the
    principals behalf.

Agency Theory
  • Agency Theory is a branch of economics relating
    to the behavior of principals and their agents.

Agency Theory
  • Principals must provide incentives so that
    management acts in the principals best interests
    and then monitor results.
  • Incentives include, stock options, perquisites
    (company car, expense account), and bonuses.

Corporate Social Responsibility
  • Wealth maximization does not stop the firm from
    being socially responsible at the corporate
  • Assume we view the firm as producing both private
    and social goods.
  • Then shareholder wealth maximisation remains the
    appropriate goal in governing the firm.

Corporate Governance
  • Corporate governance represents the system by
    which corporations are managed and controlled.
  • Includes shareholders, board of directors, and
    senior management.
  • Then shareholder wealth maximisation remains the
    appropriate goal in governing the firm.

Board of Directors
  • Typical responsibilities
  • Set company-wide policy
  • Advise the CEO and other senior executives
  • Hire, fire, and set the compensation of the CEO
  • Review and approve strategy, significant
    investments, and acquisitions and
  • Oversee operating plans, capital budgets, and
    financial reports to common shareholders.
  • CEO/Chairman roles commonly same person in US,
    but separate in Britain (US moving in this

Sarbanes-Oxley Act of 2002
  • Sarbanes-Oxley Act of 2002 (SOX) addresses
    corporate governance, auditing and accounting,
    executive compensation, and enhanced and timely
    disclosure of corporate information.
  • Arose as a result of major US corporate scandals
    and accounting fraud in the late 1990s and early
    2000s (e.g Enron, WorldCom, and other
  • Imposes new penalties for violations of
    securities laws.
  • Established the Public Company Accounting
    Oversight Board (PCAOB) to adopt auditing,
    quality control, ethics, disclosure standards for
    public companies and their auditors, and policing
  • Generally increasing the standards for corporate

Organisation of the Financial Management Function
Board of Directors
President (Chief Executive Officer)
Executive Vice President (Operations)
Executive Vice President (Marketing)
Executive Vice President (Finance - CFO)
Organisation of the Financial Management Function
EVP of Finance
  • Vice President (Treasurer)
  • Capital Investment
  • Cash Management
  • Commercial/investment banking relationships
  • Credit Management
  • Dividend Disbursement
  • Financial Analysis/Planning
  • Investor Relations
  • Mergers and Acquisitions
  • Pension Management
  • Insurance/Risk Management
  • Tax Analysis/Planning
  • Controller
  • Cost Accounting
  • Cost Management
  • Data Processing
  • General Ledger
  • Government Reporting
  • Internal Control
  • Preparing Financial Statements
  • Preparing Budgets
  • Preparing Forecasts