Brigham and Ehrhardt: Financial Management:
Theory and Practice, 16th
Chapter 1
An Overview of Financial Management and the Financial Environment
Welcome to the wonderful and exciting world of Finance. You may quickly
realize that Finance is the practical (and ethical) application of the rules of Accounting
and the theory of Economics. Many companies experience financial difficulties when
management bends the rules of Accounting or acts less ethically than it should.
The first key point the chapter identifies is the goal of the firm. “A firm’s principal
goal should be to maximize the wealth of its stockholders, which means maximizing
the value of its stock.” Notice that the appropriate goal of the firm’s management
would be to operate to the benefit of the stockholders rather than itself (i.e.,
management). There have been quite a few instances where management operated
the firm towards its own benefit rather than to the shareholders’ benefit. Management in
these firms tended to end up in jail, but often that was scant consolation to the
stockholders who typically end up losing much of their investment. Thus, when you
invest, you will need to look at the management of the firm to determine if management
is both competent and ethical.
Finance within an Organization
Every corporate will have a Chief Financial Officer (CFO) or Vice President of
Finance (VP Fin) who reports directly to the Chief Executive Officer (CEO). This means
that when the Chief Executive Officer retires or moves on, the CFO or VP Fin frequently
is selected to take over as CEO. Thus, if your long term goal is to become a Chief
Executive Officer, you may first set your sights on becoming a Chief Financial Officer.
The CFO or VP Fin has two individuals who directly report to him or her. One of
these individuals is called the Treasurer. The Treasurer is consider to have an external
function (i.e., tends to deal with people outside of the corporation) in that the Treasurer
is responsible for obtaining capital (through the sale of stock, the sale of bonds, and
borrowing from banks, other financial institutions, or from the money market). The
Treasurer does this by dealing with individuals and institutions “outside” the corporation.
The Treasurer is also responsible for establishing the corporation’s Credit and Capital
Budgeting policies. Thus, the Treasurer is ultimately responsible for dealing with the
Credit Decisions that affect the corporation’s customers. Which customers will get
credit, how much credit will these customers get and how long will this credit be allowed
to be outstanding. Capital Budgeting policy means that the Treasurer is intimately
involved in purchasing Land, Plant and Equipment. Thus, the Treasurer deals with
others “outside” the firm like realtors, construction companies, and equipment
manufacturers so as to help grow the assets used by corporation. The Treasurer needs
to have good interpersonal and quantitative skills.
The other individual who reports directly to the Chief Financial Officer is the
Comptroller or Controller. This individual is considered to have an internal function in
that this individual tends to deal with other individuals within the corporation rather than
external to it. The Comptroller (or Controller) also has major responsibilities. The
Comptroller is responsible for establishing and maintaining the Accounting Policies and
for establishing and maintaining the Cash Budgeting Policies used by the corporation.
The decision to capitalize or expensive an item, the decision to use FIFO, LIFO, or
Average Cost, the decision to use straight line versus accelerated depreciation are all
types of decisions involving “Accounting Policies” that have to be made by the
Comptroller. Cash Budgeting policies deal with short-term (1-year or one accounting
cycle) cash surpluses or shortfalls. Thus, the Comptroller needs to forecast, over the
next 12-month period, when the corporation will need money or have excess cash that it
can invest in the Money Market. If the corporation will need money, in say six months, a
decision as to how to obtain that money needs to be made now. It is not prudent to
approach a banker and ask for cash for operating purposes and say you need it today
to cover this week’s payroll.
Chief Financial Officer
Treasurer – External Function Comptroller – Internal Function
Duties Duties
1. Raise Capital 1. Establish and Maintain the
2. Establish and Maintain the Corporation’s Accounting
Corporation’s Credit and and Cash Budgeting Policies
Capital Budgeting Policies
Corporate Finance, Capital Markets, and Investments
This course will expose you to (1) Corporate Finance (also called Financial
Management), (2) Financial Markets (sometimes called Money and Banking or
Management of Financial Institutions or Capital Markets), and (3) Investments.
Corporate Finance deals with making the daily and long-term decisions that allow
a corporation to grow and maximize shareholder wealth. Corporations are always
growing. If a corporation is not growing, then something is wrong (inferior products or
inferior management).
Financial Markets encompasses Financial Instruments (various types of Stocks
and various types of bonds—basically IOUs), Financial Institutions (depository or non–
depository) and Financial Markets (Capital Markets and Money Markets). Financial
Markets are the arena in which savers (individuals or entities with money to lend or
invest) interface with borrowers (individuals or corporations needing money). Many of
these entities are Financial Institutions and the piece of paper representing the claim the
saver has on the borrower is called a Financial Instrument.
“Investments” is one word that means many things. For some it represents
Security Analysis—determining if the “return” associated with a particular IOU is in line
with the “risk” associated with that IOU. In other words, there is a risk/return tradeoff.
You want high return and low risk. But, then again, so does everybody. If markets are
“efficient” then there will be enough individuals always looking at these IOUs to make
sure that their return is related to the associated risk. To get a higher return you are
going to have to accept some additional risk. But, you don’t want to accept too much
risk given a particular level of return. There is an old saying that expresses this point,
“There is no such thing as a free lunch.” To get a higher return, you are going to have
to accept higher risk.
“Investments” also encompasses Portfolio Theory. Portfolio theory shows that
one should diversify one’s investments across a spectrum of stocks or bonds or even
money market instruments and alternative investments (such as real estate and
collectibles). Portfolio theory is a reflection of the old adage “don’t put all your eggs in
one basket.”
“Investments” can also mean Market Analysis. Will a particular market (the Stock
Market, the Bond Market, the Commodities Market) go up in the next year (or so), stay
steady, or drop. Astute investors know that there are good times to be in the market
and there are times when it is better to be out of the market. Thus, there are individuals
whose forte is being able to predict the direction of the market.
A new area of research in Finance is Behavioral Finance which tries to delve into
the psychology of the players in the market. What leads the players to excessive
pessimism or optimism? Why do people sometimes behave irrationally?
Forms of Business Organization
Although we are going to concentrate on the “Corporate” form of a business
enterprise in this course, it is important for you to know the other forms a business
enterprise or organization might take because some of you will spend your careers in
them and probably do quite well financially in them.
A proprietorship is the most basic form of business enterprise. It is owned by
an individual and it has a number of advantages and disadvantages.
Advantages Disadvantages
1. Easily and Inexpensively Formed 1. Unlimited Liability
2. Subject to Few Government Regs 2. Limited Life
3. Lower Income Taxes 3. Hard to Raise Capital
Proprietorship Income is taxed at the “Individual” Income Tax Level. This means
that the earnings of the Proprietorship are reported on the Proprietor’s Income Tax
Form. The Proprietor does not pay dividends to anyone, because the Proprietor is the
owner—there are no other owners. Since a Proprietorship tends to be very small in size
(Sales and Assets), it tends to have difficulty raising capital (money). Proprietors tend
to start operations using money from family and friends (like Michael Dell did). If the
enterprise is terrifically successful, it eventually changes into a Corporation.
The Proprietorship has unlimited liability and this means that not only are the
enterprise assets at risk of being confiscated by the courts (because of injury to a
customer), but the personal assets (house, savings, etc) of the Proprietor are also
subject to being confiscated by the courts to compensate the injured for “pain and
suffering.” When the Proprietor dies, the Proprietorship is, for tax purposes, considered
ended so that the internal revenue service can get what it is owed. Once this is
concluded the spouse or offspring of the Proprietor can continue on with the newly
reconstituted Proprietorship.
A partnership is a business enterprise owned by two or more individuals. It has
similar advantages and disadvantages.
Advantages Disadvantages
1. Easily and Inexpensively Formed 1. Unlimited Liability
2. Subject to Few Government Regs. 2. Limited Life
3. Lower Income Taxes 3. Hard to Raise Capital
The Partnership has a little easier time raising capital because each partner can
tap friends and family for money. But still, a Partnership cannot issue stocks or bonds
and frequently has difficulty borrowing money from a Financial Institution until the
