1 Contemporary Financial Management, 10th Edition ©2006 Thomson/South-Western by Moyer and McGuigan Prepared by Michael J. Alderson Saint Louis University

1 The Role and Objective of Financial Management

3 Introduction This chapter introduces the financial management process of the typical firm. It looks at the field of finance, various financial decisions and their implications, and the daily questions faced by the firm’s financial managers.

4 Questions Faced by Financial Managers Will a particular investment be successful? Where will the funds come from to finance the investment? Does the firm have adequate cash or access to cash to meet its daily operating needs?

5 Things to Think About How is finance related to other fields of study? What are the goals and objectives of a financial manager? How has the finance field evolved over history? How is the field of finance changing today? More questions are listed in the text.

6 Principal Forms of Business Organizations Sole proprietorship Partnership Corporation

7 Sole Proprietorship Owned by one person Easy formation: advantage Unlimited liability: disadvantage Difficulty raising funds: disadvantage Represent 75 percent of all businesses Account for less than 5% of total business revenues For more information from the SBA, go to

8 Partnership Owned by two or more persons Classified as general or limited Partnership dissolves when a general partner dies: disadvantage

9 Liability of Partners General Partner Has unlimited liability for all obligations of the business: disadvantage Limited Partner Liability limited to the partnership agreement: advantage

10 Corporation Limited liability Permanency Ability to raise capital Has a board of directors Owners are stockholders Flexibility Legal entity Easy marketability of shares of ownership All advantages

11 Board of Directors Stockholders elect a board of directors Board of directors then elect the officers  Chairman of the board  Chief executive officer (CEO)  Chief operating officer (COO)  President  Chief financial officer (CFO)  Vice presidents  Treasurer  Secretary Management

12 Who Does What? Board of directors deals with broad policy 3 to 5 year strategic plan Management makes most of the decisions Day-to-day decisions following the strategic plan

13 Stockholder Rights Dividends Asset Voting for board members, major policy Preemptive rights on new shares

14 Priority of Corporate Securities Debt Securities (Bonds) (highest) Preferred stock (P/S) Common stock (C/S) (lowest) Major corporate Web sites

15 Optimal Form of Organization Influenced by Cost Complexity Liability Continuity Raising capital Decision making Tax considerations

16 Shareholder Wealth Maximization (SWM) NOT NOT Profit maximization! Objective of the financial manager Objective of financialmanagement Shareholder Wealth Maximization

17 SWM Considers the timing and risk of the benefits from stock ownership Determines that a good decision increases the price of the firm’s common stock (C/S) Is an impersonal objective Is concerned for social responsibility

18 Social Responsibility To sustain an optimum return on investment for stockholders To be perceived by customers as a provider for quality service To demonstrate that employees are our most valued resource To provide corporate leadership to our community To operate in compatibly with environmental standards and initiate programs that are sensitive to environmental issues

19 Job security Job security Management may maximize its own welfare instead of the owners’ wealth. Owners (shareholders) Management and Employees Problem created by separation of Divergent Objectives

20 Job Security Management decisions based on retaining management rather than SWM Example  A decision to retain suppliers rather than selecting new suppliers providing higher quality and/or lower cost  Why? If a change is made management will be scrutinized, but if no change is made, the issue will be ignored

21 More Divergent Objectives Problem created by separation of Owners Creditors Caused by conflicting interests concerning risk and returns Protective covenants in loan agreements

22 Examples of Protective Covenants Limitations on  common stock dividends  the type of investments  divestitures  poison puts  additional debts

23 Agency Costs Corporate governance Management compensation Threat of takeovers Recent Development Sarbanes-Oxley Act

24 Shareholder Wealth Maximizing is a Market Concept and Results in  Maximizing PV of E(R) Important note!  Success is measured by Market Value of Common Stock---  Not by profit maximization!

25 Limitations of Profit Maximization Static nature of standard microeconomic model (Lack of time dimension) Variable definition of profit Provides no direct way for managers to consider the risk of alternative decisions

26 Three Basic Factors Determine C/S Market Value 1) Amount of 2) Timing of 3) Risk of Expected cash flows

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28 Conditions affecting market value Economic environment factors Decisions under management control Conditions in financial markets Expected cash flows

29 Managers deal with these competitive forces New entrants Substitute products Bargaining power of buyers Bargaining power of suppliers Rivalry among current competitors

30 Cash flow generation

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32 Cash Flow Concept central to: Financial analysis Planning Resource allocation CF does not equal accounting profit External sources Cash Internal sources

33 NPV of an investment NPV = PV of future cash flows minus cash outlays The NPV of an investment represents the contributions of that investment to the value of the firm and passes on to SWM.

34 Controller’s Activities Financial accounting Cost accounting Taxes Data processing

35 Treasurer’s Activities Management of cash and marketable securities Capital budgeting Financial planning Credit analysis Investors relations Pension fund management

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37 Economics Accounting Marketing Production Human Resources Quantitative Analysis MIS Finance Disciplines Impacting Finance

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39 Professional Organizations Financial Executive Institute Institute of Charted Financial Analysis Financial Management Association Institute of Management Accounting

40 Exciting Career Opportunities VP of Finance Director Investor Relations Assistant Treasurer Tax Manager Financial Analyst Account Executive Security Broker Mortgage Analyst Banking Check out

41 Different Size Businesses Small Business vs. Large Corporations Fundamental concepts are the same

42 Small Business Not the dominant firm in the industry Tend to grow more rapidly Limited access to financial market Lack management resources Have a high failure rate Stock is not publicly traded Poorly diversified Owner/manager frequently the same