The Goals and Functions of

Financial Management

Chapter 1

Chapter 1 - Outline

Introduction to FinanceShort-Term vs. Long-Term Financing

DecisionsRisk-Return Trade-OffFinancial vs. Real CapitalStocks vs. BondsForms of OrganizationGoals of Financial ManagementCorporate Governance

Finance Is a Combination of Accountingand Economics

Financial Management (or Business Finance) is concerned with managing a corporation’s money

For example, a company must decide:–where to invest its money– whether or not to replace an old asset– when to issue new stocks and bonds– whether or not to pay dividends

Relationship between Finance, Economics and Accounting

1-4

Economics provides structure for decision making in many important areas− Provides a broad picture of economic

environmentAccounting provides financial data in

various formsIncome statementsBalance sheetsStatement of cash flows

Finance links economic theory with the numbers of accounting

Financial Management

1-5

Financial management or business finance is concerned with managing an entity’s money

Functions:Allocate funds to current and fixed assetsObtain the best mix of financing alternativesDevelop an appropriate dividend policy

within the context of the firm’s objectives

FIGURE 1-1Functions of thefinancial manager

Short-Term vs. Long-TermFinancing

Working Capital is concerned with short-term (S/T) financing decisions <1 yearex., managing cash and other current assets

Capital Budgeting is concerned with long-term (L/T) financing decisions >1 yearex., purchasing a new machine in the future

The Risk-Return Tradeoff

Profitability Risk Profitability Risk

ex., investing in stocks vs.savings accountsStocks are more profitable but riskierSavings accounts are less profitable and less

risky(or safer)

Financial manager must choose appropriate combinations

Financial capital vs.Real capital

Financial Capital (or Accounting Capital) = money

Real Capital (or Economic Capital) =

plant and equipment

Stocks vs. Bonds

Stock = ownership or equityStockholders own the company

Bond = debt or IOUBondholders are owed $ by company

Forms of Organization

Sole 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 revenue

Sole Proprietorship

1-12

Represents single-person ownership Advantages:

Simplicity of decision-makingLow organizational and operational costs

DrawbacksUnlimited liability to the ownerProfits and losses are taxed as though they

belong to the individual owner

Partnership

1-13

Similar to sole proprietorship except there are two or more ownersArticles of partnership specifies:

The ownership interestThe methods for distributing profitsThe means of withdrawing from the partnership

Carries unlimited liability for the owners

Partnership (cont’d)

1-14

Limited partnershipOne or more partners are designated general

partners and have unlimited liability for the debts of the firm

Other partners designated limited partners and are liable only for their initial contribution

Not all financial institutions will extend funds to a limited partnership

Corporation

1-15

CorporationIs unique—it is a legal entity unto itself− Articles of incorporation− Specify the rights and limitations of the entity

− Owned by shareholders who enjoy the privilege of limited liability

− Has a continual life− Key feature− Easy divisibility of ownership interest by

issuing shares of stock

Corporation (cont’d)

1-16

Disadvantage:The potential of double taxation of earnings

Subchapter S corporationIncome is taxed as direct income to

stockholders and thus is taxed only once as normal income

Goals of Financial Management

Maximizing Shareholder Wealth

Corporate Social Responsibility

Ethical Behavior

Social Responsibility

1-18

Adopting policies that:Maximize values in the market Attracts capitalProvides employmentOffers benefits to the society

Certain cost-increasing activities may have to be mandatory rather than voluntary initially, to ensure burden falls equally over all business firms

Corporate Governance

1-19

Agency theoryExamines the relationship between the

owners and managers of the firmInstitutional investors

Have more to say about the way publicly owned companies are managed

Sarbanes-Oxley Act

1-20

Set up a five-member Public Company Accounting Oversight Board (PCAOB) with responsibility for:Auditing standards within companiesControlling the quality of auditsSetting rules and standards for the independence

of the auditorsMajor focus is to make sure that publicly-

traded corporations accurately present theirAssetsLiabilitiesEquity and income on their financial statements