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The Goals and Activities of
Financial Management
Author's Overview
The major thrust of this chapter is to establish the objectives of financial management and
the importance of the financial manager to the organization. The introduction focuses on the
financial decisions that a company like 3M makes and allows the instructor to bring the real
world into the classroom immediately. Although the financial crisis might not be at the
forefront of the student’s mind, it provides a good example of the risk that management and
investors face. The Dodd-Frank Act can be used to discuss legislative reaction to the
behavior of financial institutions and to talk about the unintended consequences that often
come out of such regulations. The various forms of organizations should be developed, and
the Finance in Action Box “The Endangered Public Company” points out the problems of
public companies and discusses state owned enterprises (SOEs) found in many foreign
countries. This provides a good place to start the discussion of the various forms of
organization. The instructor should highlight the importance of owner wealth maximization
as a goal and briefly relate it to valuation concepts associated with risk and return. In
addition, the role and functions of the financial markets in allocating capital should be
emphasized as well as the pressures of institutional investors on financial managers. The
student should also be directed to the shortfalls of profit maximization as the ultimate goal
of the firm. A short discussion of social responsibility and its relationship to the financial
objectives of the firm can engage students in a discussion of how wealth maximization and
social responsibility can co-exist. The Finance in Action box on The 3M Company is a
good example of this co-existence. We end the chapter with a short discussion of the
impact of internationalization and information technology on financial markets.
Chapter Concepts
LO1. The field of finance integrates concepts from economics, accounting, and a number
of other areas.
LO2. A firm can have many different forms of organization.
LO3. The relationship of risk to return is a central focus of finance.
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1
LO4. The primary goal of financial managers is to maximize the wealth of the
shareholders.
LO5. Financial managers attempt to achieve wealth maximization through daily activities
such as credit and inventory management and through longer-term decisions related
to raising funds.
LO6. The financial turmoil that roiled the markets between 2001 and 2012 resulted in
more regulatory oversight of the financial markets.
Annotated Outline and Strategy
I. The Field of Finance
A. Finance is a link between accounting, economics, and other related fields of
study. A financial manager must understand the Federal Reserve System, the
commercial banking system, and the interrelationships between various
sectors of the economy.
B The financial manager must know how to interpret and use financial
statements in assessing the firm’s performance and allocating the firm’s
financial resources to generate the best return possible in the long run.
C. The demand for financial management skills exists in many sectors of our
society including corporate management, financial institutions, consulting
and even non-profit organizations.
II. Evolution of the Field of Finance
A. The field of finance is closely tied to economics and accounting but achieved
recognition as a separate field of study in response to the mergers,
acquisitions and growth of corporations in the early 1900s.
B. As a result of the Great Depression, emphasis shifted from raising capital, to
capital preservation, maintenance of liquidity, and increased government
intervention in the financial aspects of businesses.
C. By the mid-1950s the field of finance had become more decision oriented
with an emphasis on the analysis of resource utilization within the firm. This
decision-making focus was manifested in the increased study of:
1. Fixed asset management: capital budgeting.
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2. Efficient utilization of current assets.
3. Capital structure composition.
4. Dividend policy.
D. For the past 30 years, emphasis has been placed on the risk-return
relationship. The study of finance has received increased recognition
including Nobel Prize awards.
E. In the 21st century, finance has become more mathematical and analytical, it
has also become more focused on behavioral finance, or the psychology of
financial decision making. Behavioral finance helps us understand how
financial managers make risk reward tradeoff. There also has been an
increased emphasis on risk minimization and governmental regulation.
III. Risk Management and a Review of the Financial Crises
A. Risk management will assume an even greater role as the economy recovers
from the housing mortgage crisis that began in the early part of the new
millennium. Poor risk management practices, bad credit approval guidelines,
and inaccurate investment rating practices lead to several bank failures and
economic chaos.
B. The Dodd-Frank Act, officially known as the Wall Street Reform and
Consumer Protection Act of 2010, is the first major financial regulatory
change in the United States since the great depression. It is a complex law
with many provisions for oversight of financial institutions and their
investing and lending activities as well as setting up the Bureau of Consumer
Financial Protection.
C. Impact of Information Technology: The question for the 21st century is how
technology will impact financial decision-making. The Internet has changed
the way businesses interact with consumers (B2C) and with other businesses
(B2B) and will have a major impact on financial management.
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Perspective 1-1: Mention finance professors who have won Nobel prizes for their work
on risk and return, portfolio management, and CAPM theory. Also mention the prizes for
what we now call behavioral finance.
IV. Activities of Financial Management. A financial manager is responsible for the
proper allocation of funds between current and fixed assets, for achieving the best mix of
financing alternatives, and for developing an appropriate dividend policy within the context
of the firm’s objectives.
A. Daily financial management activities
1. Credit management
2. Inventory control
3. Receipt and disbursement of funds
B. Less-routine activities
1. Sale of stocks and bonds
2. Capital budgeting
3. Dividend decisions
C. Forms of organization: The finance function may be carried out within a
number of different forms of organizations.
Finance in Action: The Endangered Public Company
This box highlights some of the problems of being a public company and also the
use of state-owned enterprises used by many foreign governments.
1. Sole proprietorship
a. Single ownership
b. Simplicity of decision making
c. Low organizational and operating costs
d. Unlimited liability
e. Earnings are taxed as personal earnings of the individual
owner
2. Partnership
a. Two or more partners
b. Usually formed by articles of partnership agreement
c. Unlimited liability for all partners unless a limited partnership
is formed which provides limited liability for one or more
partners. At least one partner must be a general partner.
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PPT Functions of the Financial Manager (Figure 1-1)
d. Earnings are taxed as personal earnings of partners
e. Special forms of partnerships such as the limited partnership
and the limited liability partnership can be used to circumvent
the liability issue of partnerships.
3. Corporation
a. Most important form of business in terms of revenue and
profits
b. Legal entity
c. Formed by articles of incorporation
d. Stockholders (owners) have limited liability
e. Easy divisibility of ownership
f. Managed by the board of directors
g. Double taxation of earnings: Earnings of the corporation are
subject to the corporate income tax; dividends (distributed net
income) are subject to personal taxation
h. Subchapter S corporations, however, avoid the double taxation
disadvantage. S Corporations are limited to 75 shareholders.
4. Limited Liability Company (LLC)
a. Popular for its highly flexible structure
b. Provides limited liability for the owners
c. Not technically a corporation
d. Can be taxed many different ways elected by the owners
V. Corporate Governance.
A. Enron and other failures of corporate governance are discussed.
B. During the last decade much attention has been devoted to the relationship
between the owners of the firm and the managers of the firm. In large
corporations, the hired management acts as agents for owners. The study of
the relationship between owners and managers as well as other agent
relationships is referred to as agency theory.
C. Included in agency theory is a trend that developed in the 1990s for large
institutional shareholders to exert pressure on management to be responsive
to shareholder goals. Institutional investors have more and more impact on
decisions made by corporate boards of directors
D. The Sarbanes-Oxley Act imposed greater accountability on corporate
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executives and independent auditors. It has also created additional
compliance burdens on publicly traded companies.
VI. Goals of Financial Management.
A. The integration of the external investor point of view with the internal
management orientation is evidenced by the goal of financial management:
To make those decisions and engage in those activities that will maximize the
overall value of the firm for the benefit of the stockholders.
B. The goal of maximizing profits is not the same as maximizing shareholder
wealth.
C. The valuation approach to wealth maximization focuses on how investors
value the future earnings stream.
D. Shareholder wealth maximization is a long-term goal. Changing investor
expectations and emphasis may influence its achievability.
E. While not all managements focus on maximizing shareholder wealth,
ignoring wealth maximization for publicly traded firms can result in hostile
takeovers or institutional investor pressure on the board of directors.
F. The goal of maximizing shareholder wealth cannot ignore corporate
responsibility to social issues and cannot operate without ethical standards.
Eventually, long-term abuse and irresponsible corporate social behavior will
negatively impact the overall value of the firm.
Finance in Action: The 3M Company – Good Corporate Citizen
Balancing wealth maximization and social responsibility is difficult. You may want to
focus on The 3M Company as a way of showing that good management can accomplish
both goals, of wealth maximization and social responsibility.
VII. The Role of Financial Markets. Wealth maximization depends on the perception
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Perspective 1-2: Discuss the role of social responsibility in finance. The mention of
Professor Roger Blackwell, Jeffrey Skilling along with insider trading engages student
interest. Martha Stewart is also a candidate for discussion. More recently there have been a
number of famous hedge fund managers that have been indicted and convicted of insider
trading.
and expectations of the market. Through daily price changes in the common stock
of each publicly traded company, the market provides managers with a performance
report card.
A. Structure and Functions of the Financial Markets. Money markets (Chapter
7) and Capital markets (Chapter 14) are more fully presented in later chapters
but the students may find that some current examples from the Wall Street
Journal will create a sense of realism about this course.
B. Allocation of Capital. Students need to understand how the market price
reflects risk and return expectations and how a company’s ability to raise
funds is influenced by its financial performance and corporate behavior.
C. Reemphasize the impact that institutional investors have on publicly owned
companies. While this was touched on previously in the chapter in the area
of agency theory, here we emphasize the power of these investors to force
restructuring of public companies. Many examples are included.
D. Internationalization of the Financial Markets. Emphasize the globalization of
the capital markets and the worldwide pool of capital available to many
companies. Use the international companies highlighted in the text to get
across the point that the search for capital is global.
E. The Internet and technology have dramatically changed the way the capital
markets operate. Technology is responsible for the rise in on-line retail
brokers such as E-Trade and electronic markets have put pressure on the
exchanges to become more efficient. This has led to worldwide
consolidations in restructuring of the world’s stock, bond and futures
exchanges. We think the next decade will continue this trend.
VIII. Format of the Text: The Text is divided into the following parts:
A. Introduction: This section examines the goals and objectives of financial
management with emphasis on decision-making and risk management.
Discussion includes an update of significant events influencing the study of
finance.
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Perspective 1-3: Mention that U.S. and foreign firms often trade on each other’s financial
markets.
B. Financial Analysis and Planning: Includes a review the basic principles of
accounting, which is required for understanding major financial topics.
C. Working Capital Management: A discussion of the short-term assets and
liabilities of the firm and the related analysis of risk-return issues.
D. The Capital Budgeting Process: This section begins with a discussion of “time
value of money” and continues on to cover the valuation of bonds and stocks,
emphasizing the traditional dividend valuation model. The text then covers
capital budgeting decisions including the use of risk-return analysis in capital
budgeting.
E. Long-Term Financing: This section discusses the U.S. financial markets as
they relate to corporate financial management. The student will consider sources
and uses of funds, the role of the investment banker, and leasing as a form of
debt.
F. Expanding the Perspective of Corporate Finance: This section addresses
corporate mergers and external growth strategies. It describes the growth of
international financial markets, the rise of multinational business, and the related
effects on corporate financial management.
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