Fundamentals of Financial Management
Chapter 1: The Role of FMStudy Objectives
What is FM
The goal of the firm
Organization of the FM
A brief history about the role of a financial managerUntil around the first half of the
1900s, financial managers primarily raised funds and managed their firm’s cash positions
As the scale of the firm is on the rising, money is always in great need.
In the 1950s, the increasing acceptance of present value concept encouraged financial managers to
expand their responsibilities and to become concerned with the selection of capital investment
projects
Why? The severe competition has rendered some project to low level of profit, even spell loss to
firms
Today, external factors have an increasing impact on the financial manager. As a result, finance is
required to play an even more vital strategic role within the corporation
Case: Kelon Financial Failure: Expand too rapidly, exhaust all its resources with slow return
The Responsibility of Contemporary Financial Manager Forecasting and Planning: The
financial manager must interact with other executives as they look ahead and lay the plans which
will shape the firm’s futureMajor Investment and Financing Decisions
A successful firm usually has rapid growth in sales, which requires investments in plant,
equipment, and inventory. The financial manager must help decide the optimal sales growth rate,
and he or she must help decide what specific assets to acquire and the best way to finance those
assets
Coordination and control
The financial manager must interact with other executives to ensure that the firm is operated as
efficiently as possible. All business decisions have financial implications, and all
managers---financial and otherwise---need to take this into account
Dealing with the financial markets
The firm’s securities are traded in the financial markets
Financial markets offers opportunities for the firm
Useful information
Risk management
All businesses face risks, however, many of these risks can be reduced by purchasing insurance or
by hedging in the derivatives markets. The financial manager is usually responsible for the firm’s
overall risk management program, including identifying the risks that should be hedged and
hedging them in the most efficient manner
What is FM?Why we need FM? How to use funds to maximize the value of the firm with
limited resource. It is not a problem of manufacturing efficiency and minimizing cost.
(2)FM is concerned with the acquisition, financing and management of assets with some overall
goals in mind
Acquisition of assets---investment decision
Two problems to be solved: how much dollar of amount is needed and what is the composition
of these assets
The investment decision is the most important of the firm’s three major decisions when it comes
to value creation
The value creation of the firm is determined to a great extent by the investment decisions,
compared to the financing and assets management
Case of Jiuyao CorporationFinancing decision: concerned with the problem of raising money to
meet the need of investment decision
Financing decision is also very important: it concerns with capital cost, investment opportunities,
and the existence of a firmAsset management decision
The main task of asset management is how to use the acquired assets as efficiently as
possible---to speed up the turnover of the asset
Here financial managers are concerned more with current assets than fixed assets, why?
Financial policies affect the turnover of current asset, and fixed assets are largely determined by
operation needs
It is also very important, for speeding up asset turnover can increasing the profit level in a
certain period
What do others say about FM?
CPA Examination TextbookFM is a management job concerning the raising, using and
distributing of funds
The object of FM is the recycle and turnover of cash
The main contents of FM is financing, investment, and dividend distribution
The main function of FM is deciding, planning and controlling
The Goal of the FirmWhy do we need a goal?
Because judgement as to whether or not a financial decision is efficient must be made in light of
some standards
Profit maximizing is chosen by classic economist as the best goal
However, it is not the case in the real life because it is shaded by a little flaw: it may induce a
manager to increase profit by issuing more stock and using the proceeds to invest in Treasury Bills,
so the earning per share will fall and this will harm the shareholders’ interestMaximizing EPS is
not a fully appropriate goal either, because :
It does not specify the timing or duration of expected returns
It does not consider the risk of the firm
Maximizing the market value of the firm---the stock price is by far the best
MV(market value)=present value of net cash flow/(1+risk)
Why that? Because investors will consider a firm’s current and future earnings, risks, and other
factors which will influence a firm before he decides to make a investment decision, and the
market price of the stock will reflect all the information about these factors
Why maximizing the MV is the best goal?
It takes into account present and future EPS, the timing, the duration, and the risk of these
earnings
It also considers the dividend policy of the firm, and the other factors that bear on the market price
of the stock W hy should managers work hard to maximize stock price?If they do not work
hard to maximize stock price, they will be removed by the firm’s board of directors or by outside
forces
Others said that managers are forced by product and labor markets to work hard for the firm,
why?
Agency Problems
What is agency problem?
The agent do not act in the interest of the principal, but in his own interest
(2)Why does this happen? We assume that people are always self-interested
The object of the agent may differ from that of the principal, so when the behavior of the agent
cannot be closely watched, agent may choose to act in his own interest
In the case of a firm, this can also be the case: Chu Shijian Phenomenon (a good example of agent
problem)
Shareholders---Principal, managers---agent
Wolfgun said that the failure of socialist is due to too much agency problems
How can shareholders solve the agent problem?
Monitor
Motivate---surplus share
Bear loss
All these can bring about contract cost, this cost is also called agency cost
The shareholders’ objective is to minimize agency cost
Social Responsibility
What is social responsibility?
Some responsibility carried on the firm according to social ethics
(2)Why shall the firm carry out social responsibility?
Carrying out social responsibility can create a good environment for the firm
In our modern market economy, social responsibility will be more appreciated by the society.
Paper industry, Coal-mining industry, food and drug industry are all the issues we watch on. For
example, poisonous milk powder event.
The goal of the firm---a linear programMaximize shareholders’ interest
Subject to:
Minimize agency cost
Meet social responsibility
Organization of the FM FunctionFig. 1-1, Page 7