Chapter 1

Financial Management and

Environment

Sanjay Ghimire
1 SOM-TU
 Course Contents

Meaning, functions and goal of financial

management;
The agency problem
Place of Finance in organization structure;
Business ethic and social responsibility;
Financial markets and financial institutions;
Tax environment.

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Meaning of Finance
Defined as the art and science of managing money.
Thus the method of acquiring, managing and allocating the
fund is known as finance.
Moving scarce resources over time and states of nature
Examples:
Time Car loan
States of nature Car insurance

Involves three interrelated areas

Money and Capital Markets: this subject refers to the security
market and financial institutions.
Meaning of Finance
Investment: is the activities of individual or
organization relating to the investment of their saving
on real or financial assets with an expectation of
earning income or appreciation in the values of assets.
Financial Management: is also known as business
finance or corporate finance, concerned with all the
financial activities carried out a business organization.
Thus, it is that managerial activities which is concerned with
the planning and controlling of the firms financial resources
Finance Functions
A. Strategic Finance Functions
1. Investment Decision
a) Long term investment decision: refers to acceptance or
rejection of long term investment proposal related to acquisition,
modification and replacement of assets.
estimate the expected risk and return of the long term investment,
and then he should evaluate the investment proposals in terms of
both expected return and risk.
The financial manager accepts the long term investment proposal
only if the investment maximizes the value of shareholders.
b) Working capital decision: refers to the commitment of fund to
current assets such as inventory, receivables, cash balance, prepaid
expenses etc. This decision is also known as current assets
management. Investment on current assets affects firms
profitability, liquidity and risk.
Finance Functions...
2. Financing Decision
Finance decision is concerned with the collection of funds
short-term and long term sources.
the sources of funds may be more beneficial to the firm than any
other
carefully consider the right timing terms and condition of
financing.
3. Dividend Decisions
is allocation of net profit after tax and preference dividend to
equity shareholders. Therefore, company is free to decide in
following there alternatives.
Payment of all net earning as dividend
Retention of all earning in the company
Payment of certain portion of earning and retain the remaining.
The financial manager must decide the optimal dividend payout.
Finance Functions....

A. Routine finance function: It is incidental finance

function. This function does not require specialized skill
of finance. They are clerical in nature. So they are known
as clerical finance function as well. Some of the routine
finance functions as follows:
1. Supervision of cash receipts and disbursement.
2. Safeguarding of cash balance.
3. Custody and safeguarding of valuable documents like securities and
insurance policy.
4. Record keeping of the financial performance of the firm.
5. Reporting to the top management.
6. Supervision of fixed assets and current assets.
Goals of the Corporation (Financial
Goals)
The goal is the purpose that a firm aims to achieve. Every
decision in a firm is made to contribute towards the firms
goal.
A firm may set its goal as increase thee sale, minimize
loss, avoid insolvency, maximize profit, beat competition
etc.
Managerial finance deals with financial decision making.
These decisions relating to corporation are continuous. To
apply these decisions, the corporation should have to set
the goals. These can be divided in to following two sets:
Profit Maximization
the financial managers select assets, projects and the
decisions that are profitable and reject those which are
not.
a firm earning sound is considered as being able to
achieve its goal. The argument in favour of this
approach is as follows
simple and straightforward, easy to understand.
work as the criteria for decision making, every alternative is
evaluated on the basis of maximizing profit and allocation of
resources will be made.
indicates efficiency of management, thus it measures
efficiency.
Profit Maximization

Problems with Profit Maximization

Not a clear goal.
Profit before tax or after tax or EPS?
Profit in the short run or long run?
It ignores time value of money.
It ignores risk or uncertainty.
Shareholders Wealth Maximization
Wealth maximization means maximization of net present value
of future cash inflow form business.
Stockholders wealth maximization is to maximize market value
of their stocks.
Thus the maximization of the value of the firm and stockholders
wealth maximization is same thing.
includes the maximization of profit as well as capital gain due to
appreciation in market value of stock.
considers time value of money as well as risk elements.
also considers the goal of social responsibility., the consumers or
society gets better quality products at lower price.
Shareholders Wealth Maximization
The wealth maximization is superior to profit maximization
due to:
Wealth maximization is not vague (unclear)
It considers time value of money.
It considers both qualitative and quantitative aspects of future
activities.
Problems with Wealth Maximization
Non-traded sock? Proprietorship? Partnership? Not-for-profit
organization?
Main challenge lies in obtaining information & assesses the
likely impact of its decision on firms value
Agency Problem
Agency relationship explain contract with one or more
people. Agency relationship is established when the
principles hire another (agent) to perform some
services and delegate decision making authority to that
agent. The agency problem demonstrates the conflict
of interest between the principal and agent. An agency
problem is potential conflict of interest between:
The shareholder and manager
Shareholders and creditors
The shareholder and manager
Agency problem arise when managers have less ownership than
stockholders.
the manager does not necessarily act in the best interest of the
stockholders with purpose of benefiting themselves.
Managers may try to maximize there own benefits and not work
hard to maximize shareholders wealth because part of those costs
goes to outsiders and less of it affect them
Following are some of the typical cost that arise from the agency
problem
Monitoring cost; Structuring cost; Opportunity cost
An organization may pursue following strategy to reduce the cost of
conflict
Managerial compensation plan; Direct intervention; Threat of firing
Treat of takeover
Shareholders and creditors
Creditors have claim on part of firms earning and they
have claim on the firms assets in the case of bankruptcy.
Creditors do not want to take high risk because they do
not receive additional return for taking high risk.
On the other hand shareholders are emphasizing the
value of their investment by taking high risk.
Such type of agency problem can be solved by fairness
and abiding both the letter and spirit of credit
agreements.
Manager as an agent of both shareholders and creditors
must act in a manner that brings a fair balance between
the interests of two classes of security holders.
 Finance in the Organizational Structure
Board of
Directors

President

VP: Sales VP: Finance VP: Operations

Treasurer Controller

Credit Manager Cost Accounting

Inventory Financial
Manager Accounting

Capital
Budgeting Tax Department
16 Director
Finance in the Organizational
Structure

Treasures Functions: Controllers Functions:

Acquisitions and use of
funds
Working capital
management
Capital expenditure
Financial planning and
control
Preparation of cash budget
Pension Fund
Relation with bankers
Financial accounting
Cost accounting
Reporting and Control
Data processing
Prepare financial
statements/pay
roll/budgets
Taxes
Auditing
 Business ethic and social
responsibility
Standards of conduct or moral judgment on doing the right
thing.
The moral values by which an individual or business operates.
Ethical standard for financial manager means establishing
boundaries that prevent professional and personal interests
from appearing to conflict with the interest of the employer.
A finance manager must provide competent, accurate and
timely information that fairly presents any potential disclosure
issues, such as legal ramifications.
The manager is also ethically responsible for protecting the
confidentiality of the employer and staying within the
18 boundaries of law.
 Business ethic and social
responsibility

Are there financial returns to socially

responsible business practices?
The benefits a company receives/obtains
from having a strong community and healthy
environment may not generally be expressed
in dollars, but these elements do have a
financial impact on a businesses.

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 Financial markets and financial
institutions

F in a n c ia l In s titu tio n s
D e p o s i t o r y I n s t i t u t io n s C o n t r a c t u a l s a v in g s In v e s t m e n t
in s t i t u t i o n s in t e r m e d i a r i e s

C o m m e r c ia l b a n k s L i f e in s u r a n c e c o m p a n ie s F i n a n c e c o m p a n ie s

S a v i n g & lo a n s F i r e & c a u a lt y M u tu a ls f u n d s
a s s o c ia t io n s in s u r a n c e c o m p a n y

M u t u a l s a v in g b a n k s P e n s io n f u n d s , g o v e r n m e n t M o n e y m a rk e ts
r e tir e m e n t f u n d s m u tu a l f u n d s

C r e d i t l u n io n s
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 Capital Formation Process
Direct Transfers
Securities (Stock and Bond )
Business Savers
Money
Indirect Transfers through Investment Bankers
Investment
Business Savers
Banking
Indirect Transfers through a Financial Intermediary

Business Financial Savers

Intermediaries
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 Financial Intermediaries

Commercial Banks
Saving and Loan, Mutual saving banks and
credit unions
Insurance companies
Mutual funds
Pension funds

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 Financial Markets

A marketis a method of exchanging one

assets (usually cash) for another assets
Physical vs. financial assets
Spot vs. future markets
Money vs capital markets
Mortgage vs. consumer credit market
Primary vs. secondary markets
Private vs. public market

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 Recent Trends

Technological advances in computers and

telecommunications, along with the
globalization of banking and commerce
Increased use of derivatives
Stock ownership patterns: the number of
individuals who have a stake in the stock
market is increasing, but the percentage of
corporate shares owned by individuals is
decreasing
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 Secondary Market Organization

By location
Physical location exchanges
Computer/telephone networks
By the way that orders from the buyers and
sellers are matched
Open outcry auction
Dealers (ie, market makers)
Electronic communication network (ECNs)

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 Tax environment

Form of organization and tax

Corporate and individual tax
Progressive tax rates
Marginal and average tax rate
Cost of money and tax

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The Objective in Corporate Finance

If you dont know where you are going, it does

not matter how you get there

Aswath Damodaran
Stern School of Business
 Invest in projects that yield a return greater than
the minimum acceptable hurdle rate.
Choose a financing mix that minimizes the hurdle
rate and matches the assets being financed.
If there are not enough investments that earn the
hurdle rate, return the cash to the owners of the
firm (if public, these would be stockholders).

Objective: Maximize the Value of the Firm

The Classical Viewpoint
Van Horne: "In this book, we assume that the objective of
the firm is to maximize its value to its stockholders"
Brealey & Myers: "Success is usually judged by value:
Shareholders are made better off by any decision which
increases the value of their stake in the firm... The secret of
success in financial management is to increase value.
Copeland & Weston: The most important theme is that the
objective of the firm is to maximize the wealth of its
stockholders."
Brigham and Gapenski: Throughout this book we operate
on the assumption that the management's primary goal is
stockholder wealth maximization which translates into
maximizing the price of the common stock.
 The Classical Objective Function

STOCKHOLDERS

Hire & fire Maximize

managers stockholder
- Board wealth
- Annual Meeting

Lend Money No Social Costs

BONDHOLDERS Managers SOCIETY

Protect
bondholder Costs can be
Interests traced to firm
Reveal
information Markets are
honestly and efficient and
on time assess effect on
value

FINANCIAL MARKETS
What can go wrong?

I. Stockholder Interests vs. Management

Interests
Theory: The stockholders have significant control
over management. The mechanisms for
disciplining management are the annual meeting
and the board of directors.
Practice: Neither mechanism is as effective in
disciplining management as theory posits.
What can go wrong?

II. Stockholders' objectives vs. Bondholders

objectives
In theory: there is no conflict of interests between
stockholders and bondholders.
In practice: Stockholders may maximize their
wealth at the expense of bondholders.
Increasing dividends significantly
Taking riskier projects than those agreed to at the outset
Borrowing more on the same assets:
What can go wrong?
III. Firms and Financial Markets
In theory: Financial markets are efficient. Managers convey
information honestly and truthfully to financial markets, and
financial markets make reasoned judgments of 'true value'. As a
consequence-
A company that invests in good long term projects will be rewarded.
Short term accounting gimmicks will not lead to increases in market
value.
Stock price performance is a good measure of management
performance.
In practice: There are some holes in the 'Efficient Markets
assumption.
What can go wrong?
IV. Firms and Society
In theory: There are no costs associated with the firm that
cannot be traced to the firm and charged to it.
In practice: Financial decisions can create social costs and
benefits.
A social cost or benefit is a cost or benefit that accrues to society as
a whole and NOT to the firm making the decision.
Social Costs and Benefits are difficult to quantify because ..
They might not be known at the time of the decision
They are 'person-specific' (different decision makers weight them differently)
They can be paralyzing if carried to extremes
 What can go wrong?
STOCKHOLDERS

Have little control Managers put

over managers their interests
above stockholders

Lend Money Significant Social Costs

BONDHOLDERS Managers SOCIETY

Bondholders Some costs
can get ripped cannot be
off traced to firm
Delay bad
news or Markets make
provide mistakes and
misleading can over react
information

FINANCIAL MARKETS
Traditional corporate financial theory breaks
down when ...

The interests/objectives of the decision makers in

the firm conflict with the interests of stockholders.
Bondholders (Lenders) are not protected against
expropriation by stockholders.
Financial markets do not operate efficiently, and
stock prices do not reflect the underlying value of
the firm.
Significant social costs can be created as a by-
product of stock price maximization.
 The Counter Reaction
STOCKHOLDERS

1. More activist Managers of poorly

investors run firms are put
2. Hostile on notice
takeovers

Protect themselves Corporate Good Citizen

Constraints
BONDHOLDERS Managers SOCIETY
1. Covenants 1. More laws
2. New Types 2. Investor/Customer
Backlash
Firms are
punished Investors and
for misleading analysts
markets become
more skeptical
FINANCIAL MARKETS
The Modified Objective Function
For publicly traded firms in reasonably efficient markets, where
bondholders (lenders) are protected:
Maximize Stock Price: This will also maximize firm value
For publicly traded firms in inefficient markets, where
bondholders are protected:
Maximize stockholder wealth: This will also maximize firm value, but
might not maximize the stock price.
For publicly traded firms in inefficient markets, where
bondholders are not fully protected
Maximize firm value, though stockholder wealth and stock prices may
not be maximized at the same point.
For private firms, maximize stockholder wealth (if lenders are
protected) or firm value (if they are not)
Discussion Questions
Generally a business organization is criticized for
focusing on short-term performance at the expense
of long-term results. Explain why a firm that strives to
maximize stock price should be less subject to an
overemphasis on short-term results than one that
maximizes profits.
When a companys stock is widely held, it may not
pay an individual shareholder to spend time
monitoring the managers performance and trying to
replace poor management. Explain why. What
consequences are resulted due to this provision?
 Can the goal of maximizing the value of the stock conflict with
other goals, such as avoiding unethical or illegal behavior? In
particular, do you think subjects like customer and employee
safety, the environment, and the general good of society fit in
this framework, or are they essentially ignored?
Suppose you own stock in a company. The current price per
share is $25. Another company has just announced that it
wants to buy your company and will pay $35 per share to
acquire all the outstanding stock. Your companys
management immediately begins fighting off this hostile bid.
Is management acting in the shareholders best interests?
Why or why not?
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