PART I

Introduction to Financial Management

Chapt er

1
The Rol e of Finan c i a l Man a g e m e n t

Increasi n g shareh ol d er val u e over time is the botto m line of every m o v e we ma k e.

--- ROBERTO GOIZUETA Former CEO, The Coca-Cola Company

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Ch 1: The Role of FinancialManage ment _______________________________________________________________________ A N S W E R S TO Q U E S TIO N S ________________________________________________________________________

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With an objective of maximizing shareholder wealth ca!ital will tend to be allocated to the most !rod"ctive investment o!!ort"nities on a ris#$ adj"sted ret"rn basis. %ther decisions willalso be made to maximize efficienc&. 'fall firms do this !rod"ctivit& will be heightened and the econo m& will realize higher real growth. There will be a greater level of overall econo mic want satisfaction. (res"mabl& !eo!le overallwillbenefit b"t this de!ends in !art on the redistrib"tion of income and wealth via taxation and social !rograms. 'n other words the econo mic !ie will grow larger and ever&bod& sho"ld be better off ifthere is no reslicing. With reslicing itis !ossible some !eo!le will be worse off b"t that is the res"ltof a governmental change in redistrib"tion. 'tisnot d"e to the objective f"nction of cor!orations.

).

Maximizing earnings is a nonf"nctionalobjective for the following reasons: a. *arnings is a time vector. +nless one time vector of earnings clearl& do minates allother time vectors itis im!ossible to select the vector that willmaximize earnings. b. *ach time vector of earning !ossesses a ris# characteristic. Maximizing ex!ected earnings ignores the ris# !arameter. c. *arnings can be increased b& selling stoc# and b"&ing treas"r& bills. *arnings will contin"e to increase since stoc# does not re,"ire o"t$ of$ !oc#et costs. d. The im!act of dividend !olicies is ignored. 'fall earnings are retained f"t"re earnings are increased. -owever stoc# !rices ma& decrease as a res"ltof adverse reaction to the absence of dividends.

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Ch 1: The Role of FinancialManage ment Maximizing wealth ta#es into acco"nt earnings the timing and ris# of these earnings and the dividend !olic& of the firm.

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Financial manage m ent is concerned with the ac,"isition financing and manage m ent of assets with some overallgoal in mind. Th"s the f"nction of financial manage m ent can be bro#en down into three major decision areas: the investment financing and asset manage m ent decisions.

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0es zero acco"nting !rofit while the firm establishes mar#et !osition is consistent with the maximization of wealth objective. %ther investments where short$ r"n !rofitsare sacrificed for the long r"n also are !ossible.

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The goal of the firm gives the financial manager an objective f"nction to maximize. -e2she can j"dge the val"e 3efficienc&4 of an& financialdecision b& itsim!act on that goal. Witho"t s"ch a goal the manager wo"ld be 5at sea5 in that he2she wo"ld have no objective criterion to g"ide his2her actions.

6.

The

financial manager is involved in the ac,"isition

financing

and

manage m ent of assets. These three f"nctional areas are allinterrelated 3e.g. a decision to ac,"ire an asset necessitates the financing and manage m ent of that asset whereas financing and manage m ent costs affect the decision to invest4.

7.

'f managers have sizable stoc# !ositions in the com!an& the& will have a greater "nderstanding for the val"ation of the com!an&. Moreover the& ma& have a greater incentive to maximize shareholder wealth than the& wo"ld in the absence of stoc# holdings. -owever to the extent !ersons have not onl& h" man ca!italb"t also most of their financialca!italtied "! in the com!an& the& ma& be more ris# averse than is desirable. 'fthe com!an& deteriorates

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Ch 1: The Role of FinancialManage ment beca"se a ris#& decision !roves bad the& stand to lose not onl& theirjobs b"t have a dro! in the val"e of their assets. *xcessive ris# aversion can wor# to the detriment of maximizing shareholder wealth as can excessive ris# see#ing ifthe manager is!artic"larl&ris# !rone.

8.

Reg"lations im!osed b& the government constit"te constraints against which shareholder wealth can stil l be maximized. 't is im!ortant that wealth

maximization remain the !rinci!algoal of firms ifecono mic efficienc& is to be achieved in societ& and !eo!le are to have increasing real standards of living. The benefits of reg"lations to societ& m"st be eval"ated relative to the costs im!osed on econo mic efficienc&. W here benefits are small relative to the costs b"sinesses need to ma#e this #nown thro"gh the !olitical!rocess so that the reg"lations can be modified. (resentl& there is considerable attention being given in W ashington to dereg"lation. 9o me things have been done to ma#e reg"lations less onero"s and to allow com!etitive mar#ets to wor#.

:.

;s in other things there is a com!etitive mar#et for good managers. ; com!an& m "st !a& them their o!!ort"nit& cost and indeed this is in the interest of stoc#holders. To the extent managers are !aid in excess of their econo mic contrib"tion the ret"rns available to investors will be less.

-owever stoc#holders can sell their stoc# and invest elsewhere. Therefore there is a balancing factor that wor#s in the direction of e,"ilibrating managers< !a& across b"siness firms for a given level of econo mic contrib"tion.

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'n com!etitive and efficient mar#ets greater rewards can be obtained onl& with greater ris#. The financial manager is constantl& involved in decisions involving a trade$ off between the two. For the com!an& itis im!ortant that it

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Ch 1: The Role of FinancialManage ment do wellwhat it#nows best. There is litt lereason to believe that ifitgets into a new area in which ithas no ex!ertise that the rewards willbe com m e ns"rate with the ris# that is involved. The ris#$ reward trade$ off willbecome

increasingl& a!!arent to the st"dent as thisboo# "nfolds.

11.

The controller<s res!onsibili t ies are !rimaril& acco"nting in nat"re. acco"nting as well as b"dgets and

Cost

forecasts wo"ld be for internal

cons"m!tion. *xternal financial re!orting wo"ld be !rovided to the 'R9 the 9*C and the stoc#holders.

The treas"rer<s res!onsibil it ies fall into the decision areas most com m o nl& associated with financial manage m ent: investment 3ca!ital b"dgeting !ension manage m ent4 financing 3com m ercial ban#ing and investment

ban#ing relationshi!s investor relations dividend disb"rsement4 and asset manage m ent 3cash manage m ent creditmanage m ent4

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