BBA-II

Chapter 1
An Overview of Financial
Management

• The purpose of this chapter is to give you an idea of what financial management is all about .
• Key aspects of this course would include:
– Forces that will affect financial management in future.
– The place of finance in a firm’s organization.
– The relationships between financial managers and their counterparts .
– The goals of a firm.
– The way financial managers can contribute to the attainment of these goals.

Concerns the acquisition , financing , and management of assets with some overall goal in mind.

• Why is financial management important?
• The goal of the firm
• Organization of the financial management function

• Most important of the three decisions.
• Includes issues like:
– What is the optimal firm size?
– What specific assets should be acquired?
– What assets (if any) should be reduced or eliminated?

• Determine how the assets (LHS of balance sheet) will be financed by RHS of the balance sheet.
• Includes issues like:
– 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?

• 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.

Maximization of Shareholder wealth
Value creation occurs when we maximize the share price for current shareholders.

Shortcomings of Alternative
Perspectives
A. Profit Maximization : Maximizing a firm’s earnings after taxes.
Problems:
• Could increase current profits while harming firm (e.g., defer maintenance, issue common stock to buy T-bills, etc.).
• Ignores changes in the risk level of the firm.

B .
Earnings Per Share Maximization :
Maximizing earnings after taxes divided by shares outstanding.
Problems:
• 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.

Strengths of Shareholder Wealth
Maximization
• Takes account of: current and future profits and
EPS; the timing, duration, and risk of profits and EPS; dividend policy; and all other relevant factors.
• Thus, share price serves as a barometer for business performance

Shareholders Management
There exists a SEPARATION between owners and managers.

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

• Jensen & Meckling developed a theory of firm based agency theory.
• Agency theory is a branch of economics relating to behavior of principals & their agents.
• Principals must provide incentives so that management acts in principals’ best interests & then monitor results.
• Incentives include stock options, perquisites & bonuses .

A potential conflict of interests between the agent (manager) and (1) the outside stockholders or (2) the creditors (debt holders)

• Stockholders versus managers
– Managerial compensation
– Direct intervention by shareholders
– The threat of firing.
– The threat of takeovers.
• Stockholders (through managers) versus creditors.

• Money & Capital markets : deals with securities markets and financial institutions.
• Investments : which focuses on the decisions made by both individual and institutional investors as they chose securities for their investment portfolios.
• Financial Management or Business Finance: involves decisions within the firms.

Role of Finance in a Typical
Business Organization
Board of Directors
VP: Sales
Credit Manager
Inventory Manager
Capital Budgeting Director
President
VP: Finance
Treasurer Controller
VP: Operations
Cost Accounting
Financial Accounting
Tax Department

• Maximize stock value by:
– Forecasting and planning
– Investment and financing decisions
– Coordination and control
– Transactions in the financial markets
– Managing risk
Note: The key responsibility of financial staff is to align the goals of the corporation with the maximization of its stock price. Will be covered in following slides.

Financial Management in the New
Millennium
• The effect of changing technology (Information technology).
• Globalization
– Improvement in transportation and communication has lowered shipping costs.
– Increased demand of low cost, high quality products.
– Increased costs of developing new products due to
R&D expenditures.
– International markets have opened new avenues for new and existing products.

• Sole proprietorship
• Partnership
• Corporation

Sole proprietorships & Partnerships
• Advantages
– Ease of formation
– Subject to few regulations
– No corporate income taxes
• Disadvantages
– Difficult to raise capital
– Unlimited liability
– Limited life

• Advantages
– Unlimited life
– Easy transfer of ownership
– Limited liability
– Ease of raising capital
• Disadvantages
– Double taxation
– Cost of set-up and report filing

Managerial Actions to Maximize
Shareholder Wealth
• Dividend Policy Decisions
• DOES IT MAKE SENSE TO TRY TO
MAXIMIZE EARNINGS PER SHARE????

Major Factors Affecting Stock Price
• Projected cash flows to shareholders
• Timing of the cash flow stream
• Riskiness of the cash flows

Factors that Affect Level &
Riskiness of Cash Flows
• Decisions made by financial managers:
– Investment decisions
– Financing decisions (the relative use of debt financing)
– Dividend policy decisions
• The external environment

Do it Yourself