Chapter 1

The financial manager

and the company
 Learning objectives

After studying this presentation, you should be able to:

1.1 identify the key financial decisions facing the
financial manager of any company
1.2 identify the basic forms of business organisation
used in Australia, and review their respective strengths
and weaknesses
1.3 describe the typical organisation of the financial
function in a large company
 Learning objectives

1.4 explain why maximising the current value of the

company’s shares is the appropriate goal for
management
1.5 discuss how agency conflicts affect the goal of
maximising shareholder value
1.6explain why ethics is an appropriate topic in the
study of corporate finance.
 The role of the financial manager

• The objective of managers:

– Should be to maximise the wealth of the
shareholders.
– A company also has other stakeholders that rely on
it, for example:
• Managers: salaries, bonuses.
• Employees: wages.
• Creditors: interest & principle.
• Suppliers: pay for goods/services.
• Government: tax.
 The role of the financial
manager
• A firm generates cash flows by selling the goods and
services produced by its productive assets and human
capital.
• When the cash flows generated from the productive
asset exceed the cash outflows (such as operating cash
flows) the remaining cash is called residual cash flows.
• The company can choose to pay any profit to the owners
as a cash dividend, or reinvest the cash in the business.
 The role of the financial
manager
• Cash flow diagram:
 The role of the financial manager

• It is all about cash flows:

– A company is unprofitable when it fails to generate
sufficient cash inflows to pay operating expenses,
creditors and tax.
– Firms that are unprofitable over time will be forced
into bankruptcy by their creditors.
– In bankruptcy, the company will either be
reorganised, or the company’s assets will be
liquidated.
 The role of the financial manager

• Three fundamental decisions in financial management:

1. The capital budgeting decision:
– Which productive assets should the firm
buy?
2. The financing decision:
– How should the firm finance or pay for assets?
3. Working capital management decisions:
– How should day-to-day financial matters be
managed?
 The role of the financial
manager
• How financial manager’s decisions affect the balance
sheet:
 Forms of business organisation

• Sole traders:
- Is the simplest type of business to start and the
least regulated.
- Keeps all the profits from the business.
- Doesn’t share decision making.
- All company income is taxed as personal income.
- Has unlimited liability for all business debts and
other obligations of the company.
 Forms of business organisation

• Partnership:
- Has the same basic advantages and disadvantages as
a sole trader.
- Has access to more capital, knowledge, experience
and skills.
- When a transfer of ownership takes place the
partnership is terminated, and a new partnership is
formed.
- The problem of unlimited liability can be avoided in
a limited partnership.
 Forms of business organisation

• Company:
- Is a legal entity. In a legal sense, it is a “person”
distinct from its owners.
- The owners of a company are its shareholders.
- A major advantage of the company form of business
is that shareholders have limited liability.
 Forms of business organisation

• Company:
- Starting up is more costly compared to other forms
of business.
- Heavily regulated by the Australian Securities and
Investments Commission (ASIC) and corporate
regulations (Corporations Act 2001).
- Limited liability.
- Directors and employees could be personally liable if
they commit reckless or fraudulent acts.
 Managing the financial function

• Chief Executive Officer (CEO):

- Ultimate management responsibility and decision-
making power in the firm.
- Reports directly to the board of directors, which is
accountable to the company’s owners.
 Managing the financial function

• Company organisation chart:

 Managing the financial function

• Chief Financial Officer (CFO):

– Reports directly to the CEO and manages all aspects
of the company’s financials.
– CFO’s Key Financial Reports:
• The Controller prepares financial statements,
oversees the firm’s cost accounting systems,
prepares taxes, and works closely with the firm’s
external auditors.
 Managing the financial function

• CFO’s Key Financial Reports:

– The Treasurer looks after the collection and
disbursement of cash, invests excess cash, raises new
capital, handles foreign exchange, and oversees the
firm’s pension fund managers.
– Risk manager manages company’s financial and
commodity risk.
– Controller prepares financial statements, accounting
systems, tax and external auditors.
 Managing the financial function

• CFO’s Key Financial Reports:

– The Internal Auditor is responsible for in-depth risk
assessments, performing audits of high-risk areas.
– Risk manager manages company’s financial and
commodity risk.
– Controller prepares financial statements, accounting
systems, tax and external auditors.
– The Internal Auditor is responsible for in-depth risk
assessments, performing audits of high-risk areas.
 Managing the financial function

• External auditors:
– Provide an independent annual audit of the firm’s
financial statements.
– Ensure that the financial numbers are reasonably
accurate, and accounting principles have been
consistently applied.
 Managing the financial function

• Audit committee:
– Has responsibility of overseeing the accounting
function and preparation of the company financial
statements.
– Conducts investigations of fraud and theft and also
ensures that the external auditors are independent
from management.
 The goal of the company

• What should management maximise?

– Minimising risk or maximising profits without
regard to the other is not a successful strategy.
• Why not maximise profits?
• Under creative accounting, a decision that
increases profits under one set of accounting
rules can reduce it under another.
• Under creative accounting, a decision that
increases profits under one set of accounting
rules can reduce it under another.
 The goal of the company

• Why not maximise profits?

- Accounting profits are not necessarily the same as
cash flows.
- Profit maximisation does not tell us the timing cash
flows are to be received.
- Profit maximisation ignores the uncertainty or risk
associated with cash flows.
 The goal of the company

• Maximise the value of the company’s share price:

- When analysts and investors determine the value of
a company’s share price, they consider:
• The size of the expected cash flows.
• The timing of the cash flows.
• The riskiness of the cash flows.
• The mechanism for determining share prices is based
predominately on cash-flows from correct and well
executed business decisions.
 The goal of the company

• Major factors affecting share prices:

 The goal of the company

• Can management decisions affect share prices?

– Yes, there are many factors that can affect this:
• Short term:
- Advertising campaign.
• Long term:
- Investing on new building.
 Agency conflicts: separation of
ownership and control
• Ownership and control:
- For large companies, the ownership of the firm is
spread over a number of shareholders and the
company’s owners may effectively have little control
over management.
- Management may make decisions that benefit their
self-interest rather than those of the shareholders.
 Agency conflicts: separation of
ownership and control
• Agency relationships:
- An agency relationships arises whenever one party,
called the principal, hires another party, called the
agent.
- Agents have a fiduciary duty to shareholders to put
shareholders interests above their own.
 Agency conflicts: separation of
ownership and control
• Do managers really want to maximise share price?
- Shareholders own the company, but managers
control the money and have the opportunity to use
it for their own benefit.
– Agency costs:
• The costs of the conflict of interest between the
company’s owners and its management.
 Agency conflicts: separation of
ownership and control
• Aligning the interests of management and
shareholders:
- Board of directors:
• represent shareholders’ interest in major decisions
regarding the company.
- Management compensation:
• a significant portion of management compensation
is tied to firm performance (e.g. share price).
 Agency conflicts: separation of
ownership and control
• Aligning the interests of management and
shareholders:
- Managerial labour market:
• Companies with poor track record will have
difficulty in attracting quality people.
- The takeover market:
• Corporate raiders may acquire a company at a
discount due to its poor performance and replace
current managers with a new manager.
 Agency conflicts: separation of
ownership and control
• Aligning the interests of management and
shareholders:
- Control of the firm:
• If the interests of the manager and the firm are
not aligned, then eventually the firm will under
perform relative to its true potential.
- An Independent Board of Directors:
• Lack of board independence is a key factor in the
misalignment between board members’ and
shareholders’ interests.
 Agency conflicts: separation of
ownership and control
• Sarbanes-Oxley and CLERP 9:
- Greater Board & Auditor Independence.
- Establish Internal Accounting Controls.
- Establish Ethics Program.
- Expand Audit Committee’s Oversight Powers.
- Enhances disclosure and accountability to
shareholders.
 The importance of ethics
in business
• Business ethics:
- A society’s ideas about what actions are right and
wrong.
• Are business ethics different?
- Traditions of morality are relevant to business and
financial markets.
- Corruption in business creates inefficiencies in an
economy.
 The importance of ethics
in business
• The law is not enough:
- Ethicists argue that laws and market forces are not
enough.
• Serious consequences:
– Legal cost of ethical mistakes can be extremely high.
 Summary

• Identify the key financial decisions facing the financial

manager of any company.
• Strengths, weaknesses of the basic forms of business
organisation.
• Corporate goal should be about maximising the current
value of the company's share.
• Presence of agency conflicts affect the goal of
maximising shareholder value.
• Ethics are important in the study of corporate finance.