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Chapter 1/The Role and Objective of Financial Management
Chapter
1
The Role and Objective of
Financial Management
This introductory chapter provides an overview of corporate finance. Included in this chapter are discussions of the types of business organizations, the objective of financial management and that of the corporation, and the decision areas of the financial manager. Also discussed in Chapter 1 are the major elements of the financial decision making process, the interrelationship between finance and other functional areas of business, possible careers in finance, and professional finance affiliations.
I. Finance is concerned with several important questions that confront all business firms. Examples of financial management questions include:
A. The assets that a firm should acquire;
B. The acquisition of assets to be financed; i.e., what are the costs and sources of funds?
C. The proper mix of the various sources of funds used to finance a firm's activities; i.e. what is the optimal capital structure?
D. The distribution of the profits from an enterprise; i.e., what is the optimal dividend policy?
E. The nature of the trade‑offs between risk and expected return that have to be made in financial management decisions;
F. The level of inventory that a firm should hold;
G. Determination of a firm's credit policy;
H. Is a merger or acquisition advisable?
I. How much cash, or access to cash, does the firm need to meet its daily operating needs?
J. Are there “intangible” benefits from an investment project that will impact the decision?
II. The three principal forms of business organization are the sole proprietorship, partnership, and corporation.
A. A sole proprietorship is simply a business owned by one person.
1. Ease of formation is an advantage of sole proprietorships.
2. The primary disadvantages are unlimited personal liability and difficulty raising funds to finance growth.
3. About 75 percent of all businesses in the United States are sole proprietorships accounting for less than 6 percent of total U.S. business revenues.
B. A partnership is a business organization of two or more persons.
1. Partnerships may be classified as either general or limited partnerships. In a general partnership, each partner has unlimited liability for all the obligations of the business. In a limited partnership, the one or more general partners have unlimited liability and the one or more limited partners have limited liability (the extent to which is spelled out in the partnership agreement). Approximately 90 percent of all partnerships in the United States are classified as general partnerships. Overall, partnerships account for 7 percent of all U.S. businesses and less than 5 percent of total U.S. business revenues.
2. When one partner dies or quits, the partnership is dissolved and another one must be formed.
C. A corporation is a "legal person" composed of one or more natural persons and is separate and distinct from these persons. As a “legal person,” a corporation can purchase and own assets, borrow money, sue, and be sued.
1. The owners of a corporation are called shareholders or stockholders. The money shareholders invest in the corporation is called capital stock.
2. The corporate form of organization has four major advantages.
a. The stockholders have limited liability. The most they can lose is their investment in the shares of the company.
b. The corporation continues in existence even if shareholders die or sell their shares giving the company the benefit of continuity.
c. It is very easy to change ownership (compared to partnerships)--just sell your shares to someone else.
d. A major advantage of the corporate form of organization is the ability to raise large amounts of capital. This is due to limited liability of owners and the easy marketability of shares of ownership.
3. In theory the board of directors is responsible for managing the corporation. The board of directors is elected by the shareholders. The board in turn hires officers who do the actual managing of the company on a day-to-day basis. The officers are considered to be agents of the corporation who act on behalf of the owners (shareholders) of the company. The officers might include a president, one or more vice presidents, a treasurer, and a secretary.
4. Corporations issue debt and equity securities to fund corporate operations.
a. Debt securities promise periodic interest payments as well as the return of the principal amount of the debt.
b. Preferred stockholders have priority over common stockholders with regard to the earnings and assets of the corporation. Creditors have priority over preferred stockholders.
c. Common stockholders are the true residual owners of the corporation. Their claims on earnings and assets of the firm are considered only after all other claims have been met.
5. Common stockholders possess several specific rights including dividend rights, asset rights, voting rights, and preemptive rights.
D. There are other types of organizations referred to as hybrid organizations, that have features of each of the above basic forms.
1. Subchapter S corporations, with fewer than 75 domestic stockholders, avoid the double taxation of earnings, and pay taxes similar to partnerships.
2. The limited liability company (LLC) avoids double taxation of earnings and is taxed at the individual level. The LLC has fewer restrictions than the S corporation.
3. The limited liability partnership (LLP), with all partners having limited liability, is taxed like any other partnership.
III. To understand the content of this book as well as the real world practice of finance, it is crucial to understand the objective of financial management.
A. The most widely accepted objective of the firm is to maximize the value of the firm for its owners; that is, to maximize shareholders’ wealth. Shareholder wealth is represented by the market price of the firm’s common stock. Stock prices reflect the magnitude, timing, and risk associated with the expected future benefits accruing to stockholders. Profit maximization is inadequate for handling many finance decisions.
B. The advantages of shareholder wealth maximization are that it is a conceptually clear guide for decisions, that it does consider risk, and that it is impersonal.
C. Wealth maximization does not deny the existence of social objectives and obligations. In many respects, these other objectives are consistent with shareholder wealth maximization and, in addition, the government may place regulations and laws on businesses (as well as individuals) whenever it feels that private and public goals are in conflict. Many corporations recognize their responsibilities to various constituencies, including stockholders, customers, employees, the community, and the environment.
D. Due to a separation of ownership and control in many corporations, a divergence frequently exists between the owners' goals (shareholder wealth maximization) and the managers' goals (such as job security). For example, managers may be more concerned with long-run survival (job security) causing them to minimize (or limit) the amount of risk incurred by the firm.
E. Agency relationships occur when one or more individuals (the principals) hire another individual (the agent) to perform a service on behalf of the principals. In an agency relationship, decision‑making authority is often delegated to the agent. In the context of finance, two of the most important agency relationships are the relationship between stockholders and creditors and the relationship between stockholders and managers.
1. A potential agency conflict is between stockholders and creditors. If the firm engages in high-risk activities, the creditors (because they have fixed claims against the firm) may not share the rewards if the risky venture works out well, but the creditors are left holding the bag if things don't work out well. In order to protect their interests, creditors often insist on certain protective covenants in their contracts with the firm.
2. An important agency relationship in corporate finance is between stockholders (the principals) and managers (the agents).
3. Inefficiencies that arise in agency relationships are called agency problems. Agency problems occur when managers maximize their own welfare instead of that of the principals. Examples of agency problems can include a preoccupation by management with their job security, excessive perquisite (perk) consumption, and managerial shirking.
4. Shareholders incur agency costs to minimize agency problems. Agency costs include:
a. the cost of management incentives designed to induce managers to act in the shareholders' interests;
b. expenditures to monitor management's actions and performance;
c. bonding expenditures to protect shareholders from managerial fraud; and
d. the opportunity cost of lost profits arising from complex organizational structures that prevent timely responses to opportunities.
5. A number of different mechanisms are available to reduce the agency conflict between shareholders and managers. These include corporate governance, managerial compensation, and the threat of takeovers.
IV. How do managers maximize shareholder wealth?
A. One misconception is that managers maximize shareholder wealth by maximizing profits. Unfortunately, profit maximization has too many shortcomings to provide consistent guidance to the practicing manager.
1. The profit-maximization rule is that an economic action should be continued up to the point where marginal revenue (benefit) equals marginal costs.
2. While the rule offers excellent insights, it frequently fails because (1) it is static, ignoring the time value of money, (2) it is vague with many different definitions, and (3) it ignores risk.
B. Maximization of shareholder wealth is a market concept. Managers should attempt to maximize the market value of the company's shares, not accounting or book value per share.
C. The three major factors that determine the market value of a company's stock are:
(1) the amount of the cash flows expected to be generated for the benefit of stockholders;
(2) the timing of these cash flows; and,
(3) the risk of the cash flows.
Management decisions affect these three factors. In addition, economic environment factors and conditions in financial markets outside of management control affect the amount, timing, and risk of expected cash flows and, hence, the market price of the company's stock. Examples of decisions under management control, economic environment factors, and conditions in financial markets that affect stock prices are summarized in the figure on page 7.
D. Michael E. Porter and Alfred Rappaport recommend that managers formulate an overall competitive strategy analyzing five competitive forces that can influence an industry’s structure and can thereby, in turn, ultimately affect the market prices of stocks of individual companies in a particular industry. The five competitive forces are
1. The threat of new entrants
2. The threat of substitute products
3. The bargaining power of buyers
4. The bargaining power of suppliers
5. The rivalry among current competitors
V. The cash flow concept is one of the central elements of financial analysis, planning, and resource allocation decisions. Firms need cash flows to pay creditors, employees, suppliers, and owners. Cash, not net income, can be spent.
A. A firm raises funds externally by selling shares to owners (equity) and by borrowing from creditors (debt). It may raise funds internally from cash flows from operations or by selling assets. These funds are used to acquire assets that, in turn, are used to produce and sell products or services. After paying for the cost of producing these products or services, any remaining cash flow can be used for reinvestment or distributed to owners and creditors.
B. The valuation of debt and equity securities is based on the present value of the cash flows that these securities are expected to provide to investors.
C. By emphasizing cash flows rather than accounting-based measures of performance when making decisions, a manager is more likely to achieve the objective of shareholder wealth maximization.
D. The net present value (NPV) of an investment is equal to the present value of the expected future cash flows generated by the investment minus the initial investment of cash, or
NPV = Present value of future cash flows minus initial outlay.
The net present value of an investment represents the contribution of that investment to the value of the firm and, accordingly, to the wealth of shareholders.
The net present value concept is the bridge between cash flows and the goal of shareholder wealth maximization.
VI. The ethical dimensions of business practice do much more than provide explosive news stories. Ethical issues will confront financial managers as they make important financial decisions.
A. Ethics is the "discipline dealing with what is good or bad, right or wrong, or with moral duty and obligation," according to Webster's.
B. Business ethics involves hardheaded thought, not just sentimentality. Several managerial approaches to addressing ethical dimensions of a business problem exist. These techniques include:
· Clarify the parameters of the problem,
· Involve the right team of participants,
· Collect all facts bearing on the problem,
· Articulate the benefits and harms from the proposed actions,
· Weigh the consequences of alternatives, and
· Seek equity for those who may be affected.
C. Some good ethical guidelines for managers include:
· Avoid personal conflicts with business decisions.
· Maintain the confidentiality of information given to you.
· Make decisions on an objective business basis rather than on inappropriate factors such as race, sex, or religion.
· Act fairly in dealing with customers while maintaining the legitimate interests of the business.
VII. Entrepreneurial finance deals with the financing issues facing small businesses.
A. Small businesses generally are not the dominant firm in the industries in which they compete. They tend to grow more rapidly than larger firms. They have limited access to financial markets. They do not have the depth of specialized managerial resources available to larger firms. And they often have a high failure rate.
B. For many entrepreneurial firms that are corporations, their stock is not publicly traded and current stock prices are not good signals of performance. Other entrepreneurial firms are proprietorships and partnerships. The owners of these firms are often poorly diversified because so much of their wealth is invested in the firm.
C. The owners and managers are frequently the same persons, thus, the agency conflict between owners and managers is not as severe as in large corporations. Other agency conflicts, such as between owners and lenders, still remain, however.
D. The fundamental concepts are the same for large and small businesses. However, expensive, sophisticated analysis is often not justified in a small firm because it lacks the economies of scale that large firms possess. Small firms also may lack the depth of managerial talent to apply sophisticated financial techniques.
VIII. In a large corporation, the finance area is headed by a person normally titled the financial vice president or chief financial officer.
A. The financial vice president or chief financial officer reports directly to the president.