Chapter 1: Goal and Functions of Finance
•Objective of the Firm – the primary goal of the firm is to
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maximize
wealth
•Wealth Maximization versus Profit Maximization
•Timing – profit maximization does not take into account
the timing of earnings, while wealth maximization does.
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•Risk – wealth maximization takes risk into account profit
maximization does not.
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•Dividend payments – if profit maximization was the goal,
a firm would never pay dividends.
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Chapter 1: Goal and Functions of Finance
•Wealth Maximization versus Profit Maximization (cont)
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•Qualitative factors – profit maximization does not take
into account future activities such as sales growth, stability
and diversification.
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•Stock price maximization – since investors want to
maximize their own wealth, they prefer the firm adopt
strategies that will maximize stock price.
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Chapter 1: Goal and Functions of Finance
•Management versus Stockholders
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•Management serves as an agent to the stockholders
(owner)
•Stockholders delegate authority to management to act on
their behalf and are expected to act in their best interest.
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• Management’s objectives may differ from those of
stockholers.
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•In many large corporations, where ownership is largely
diversified, the situation arises where management may act
in their own best interests rather than in the best interests
of the stockholders.
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Chapter 1: Goal and Functions of Finance
•Management versus Stockholders (cont)
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•Management may attempt to amass income, power and
prestige
•Appropriate incentives such as stock options, bonuses and
perquisites, should be given to managers to ensure they act
in the best interest of the stockholders.
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Chapter 1: Goal and Functions of Finance
•Functions of Financial Management
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Planning
and
Control – the financial manager
establishes standards and creates budgets that are used for
monitoring performance.
•Allocation of funds – the financial manager must decide
where the firm’s capital will further the firm’s objective of
stockholder wealth maximization.
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•Acquisition of funds – the financial manager must
determine the most cost effective and efficient means of
obtaining funds that will coincide with the firm’s financing
needs.
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Chapter 1: Goal and Functions of Finance
•Principles of Finance
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•Risk-Return Tradeoff – the more risk one is willing to
accept, the more return that should be expected.
•Time Value of Money – a dollar in hand today is worth
more than a dollar that is due at some point in the future.
The obvious reason is that a dollar today could be invested
in some interest bearing account.
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•Leverage – refers to the degree of fixed costs utilized by
the firm. A firm with high fixed costs will suffer a
substantial loss in earnings with only a small change in
sales.
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Chapter 1: Goal and Functions of Finance
•Principles of Finance (cont)
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•Liquidity versus profitability - liquidity illustrates the
firm’s ability to pay its bill as they come due. Too much
liquidity will reduce profitability.
•Matching Principle – concept that short-term assets
should be financed with short term liabilities and long-term
assets should be financed with long term funds.
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•Portfolio Effect (Diversification) – the concept that as
more assets are added to the portfolio, the risk of the total
portfolio decreases.
•Valuation – the economic value of an asset is equal to the
present value of future (expected) cashflows.
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Chapter 1: Goal and Functions of Finance
•Summary
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