978-1259277160 Chapter 1 Lecture Note

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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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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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