The Goals and

1 Functions of
Finance/Financial
Management

Chapter

McGraw-Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All

 Chapter Outline
• Introduction to Finance
• Scope of Finance
• Relationship with Other Disciplines
• Evolution of Finance
• Functions of FM/Risk-Return Tradeoff
• Forms of Organizations
• Goals of Financial Management
• Corporate Social Responsibility (CSR)
• Sources of Finance
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 Important Terms in This Chapter
• Finance, Business Finance, Financial
Management, Asset Mix, Optimum Capital
Structure, Inflation, Profit vs. Wealth
Maximization, CSR, Sources of Funds

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 Introduction to Finance
• Finance serves as the lifeline of all economic
activities of a firm. Be it investment, production or
marketing activities -finance has a definite role in
all of them.

• Business finance involves those financial activities,

which are concerned with planning and controlling
of the firms’ financial resources.
 Introduction to Finance

• Finance or business finance or financial

management as an independent discipline has not
a long origin. It was a branch of economics till
1890.

• Ezra Solomon first used the term “Financial

Management” in the 1960s.
 Introduction to Finance
However, finance could be used in two senses:

• Narrow Sense: In earlier days of evolution, finance

was treated synonymously with the raising of
funds.

• Broader Sense: The modern thinking of finance

function covers acquisition of funds as well as the
efficient allocation of funds to various uses.
 Assumptions of Finance
Finance/Business Finance/Financial Management
is based on some Assumptions. They are –

•No fund is free (of cost).

•Higher the return, higher the risk and vice-versa
•Long term sources of fund are more costly than
short-term sources
•Long term investment earns more return than short
term investment.
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 Scope of Finance –
Under Broader View
The scope of finance could be explored by posing
three questions and by getting their answers. The
questions are:

• What is the total volume of fund a firm should

commit?
• What specific assets should an enterprise acquire?
• How should the funds required be financed?
 Scope of Finance
The answers to these questions draw the scope of
finance in the areas of–

1. Investment Decision of a Firm

2. Financing of Those Investment
3. Dividend Policy Making
 Investment Decision
Investment decision relates to the selection of
assets for investment by a firm. The assets
could be:
– Long-Term Assets
– Short-Term Assets or Current Assets

The investment decision is broadly concerned

with the asset mix or composition of assets of
a firm.
 Financing Decision
The concern of the financing decision is with the
financing mix or capital structure or leverage. The
financial requirements of a firm could be met by
debt or/and equity capital.

The objective of financing decision may be to

establish an “Optimal Structure” of capital or
maximizing the wealth of the shareholders.
 Dividend Policy Decision
The dividend should be analyzed in relation to the
financing decision of a firm.

Profits of a firm could be treated in the following ways

– Distributed to the shareholders in the form of dividend
– Retained in the business itself.

The final decision will depend upon the preference of

the shareholders and investment opportunities
available within the firm.
 Relationship between Finance,
Economics and Accounting
• Economics provides structure for decision making
in many important areas.
− Provides a broad picture of economic environment.

• Accounting provides financial data in various

forms.
– Income statements, balance sheets, and statement of
cash flows.

• Finance links economic theory with the numbers of

accounting.

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 Finance Vs. Accounting

• Accounting is said to be the language of finance because it

provides financial data through Income Statements,
Balance Sheets and Statement of Cash Flows.

• Finance links economic theory with the numbers of

accounting, and all corporate managers – whether in
production, sales, research, marketing, management or
long-term strategic planning – must know what it means to
assess the financial performance of the firm.

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 Finance Vs. Accounting

Grounds Accounting Finance

Treatment of The measurement of Treatment of fund is

Funds funds (income or based on cash flows. That
expenses) is based on is revenues are recognized
the Accrual Method of when the cash flows take
Accounting. place and expenses when
actual payments are
made. This is the
realization concept.
 Finance Vs. Accounting

Grounds Accounting Finance

Decision The purpose of The finance

Making Accounting is to collect manager uses such
and present financial data data for decision
and not to make decision. making
 Finance Vs. Accounting

Grounds Accounting Finance

Beginning/ Accounting ends with the Finance begins where

Ending preparation of three financial accounting ends. It
statements - Income uses the statements for
Statement, Balance Sheet further evaluations and
and Statement of Cash calculations for
Flows. decision making.
 Accounting: Treatment of Fund
• Under the accrual method, you record
business income when a sale occurs,
whether it be the delivery of a product or the
rendering of a service on your part,
regardless of when you get paid. You record
an expense when you receive goods or
services, even though you may not pay for
them until later.
 Evolution in the Field of Finance
• At the turn of the 20th century: Emerged as a
field separate from economics.
• By 1930s: Financial practices revolved
around such topics as:
– Preservation of capital.
– Maintenance of liquidity.
– Reorganization of financially troubled
corporation.
– Bankruptcy.
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 Evolution in the Field of Finance
(cont’d)
• By mid-1950s: Finance becomes more
analytical.
– Financial Capital (accounting capital/ money)
was used to purchase Real Capital (economic
capital/ long-term plant and equipment).
– Cash and inventory management
– Capital structure theory
– Dividend policy

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 Recent Issues in Finance
• Focus has been on:
– Risk-return relationships
– Maximization of return for a given level of risk
– Portfolio management
– Capital structure theory

• New financial products with a focus on hedging are

being widely used

• Inflation – a key variable in financial decisions

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 Recent Issues in Finance (cont’d)
• The following are significant to financial
managers during decision making:
– Effects of inflation and disinflation on financial
forecasting.
– Required rates of return for capital budgeting
decisions.
– Cost of capital.

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Functions of the Financial Manager

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 Risk-Return Trade-Off
• Influences operational side (capital versus labor/
Product A versus Product B)

• Influences financial mix (stocks versus bonds

versus retained earnings)
− Stocks are more profitable but riskier.
− Savings accounts are less profitable and less risky (or
safer)

• Financial manager must choose appropriate

combinations
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 Sole Proprietorship
• Represents single-person ownership
• Advantages:
– Simplicity of decision-making.
– Low organizational and operational costs.
• Drawback
– Unlimited liability to the owner.
– Profits and losses are taxed as though they
belong to the individual owner.

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 Partnership
• Similar to sole proprietorship except there are two
or more owners.

– Articles of partnership: Specifies ownership interest, the

methods for distributing profits, and the means of
withdrawing from the partnership.

– Limited partnership: One or more partners are

designated as general partners and have unlimited
liability of the debts of the firm; other partners designated
limited partners and are liable only for their initial
contribution.
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 Corporation
• Corporation
− Articles of incorporation: Specify the rights and limitations of the
entity.
− Its owned by shareholders who enjoy the privilege of limited liability.
− Has a continual life.
− Key feature is the easy divisibility of ownership interest by
issuing shares of stock.

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 Corporation (cont’d)
• Disadvantage:
– The potential of double taxation of earnings.
– S corporation (special type of corporation): Income is taxed as a direct
income to stockholders and thus is taxed only once as normal income.
– Limited liability company (LLC)
 Provides limited liability for the owners
 Can be taxed as sole proprietorship, partnership,
corporation, or S corporation, depending upon elections
made by owners

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 Corporate Governance

• Agency theory
– Examines relationship between owners and managers
of firm
– Identify and reduce potential conflicts of interest
• Institutional investors
– Have more to say about how publicly-owned
companies are managed
– Able to vote large blocks of shares for election of
board of directors
 Goals of Financial Management
• Profit Maximization
• Valuation Approach
• Maximizing Shareholders’ Wealth
(Shareholders’ Wealth Maximization)

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 Profit Maximization Goal

Under this approach, the goal for financial

management is to “earn the highest possible
profit for the firm”.

Each decision would be evaluated on the basis

of its overall contribution to the firm’s
earnings. Actives that increase profits should
be undertaken and those that decrease profits
are avoided.
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 Profit Maximization Goal
In specific operational terms, the profit maximization
criterion implies that the investment and financing
decisions are oriented to the maximization of profits.

The rationale behind profit maximization, as a guide to

financial decision-making, is simple.

– Profit is the test of economic efficiency.

– It provides the yardstick by which economic performance
could be judged.
– It leads to efficient allocation of resources.

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Profit Maximization - Technical Flaws

Applying “profit maximization” criterion poses

some difficulty in actual situations.
1. Risk Issue
2. Ambiguity
3. Timing of Benefit
4. Quality of Benefits

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 Risk Issue
A change in profit may also represent a change in
risk. For a conservative form

EPS Risk
US$ 5.00 Risk
US$ 7.00 Risk

• So the maximization of profit may make the

operations of the firm more risky.

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 Ambiguity
The term profit is a vague and ambiguous concept. It has no precise connotation. It
is amenable to different interpretations by different people.

Profit may be – Short term On total assets

Long term On equity
Total profit Total capital etc.
Rate of profit
Before-tax Accounting Definition
After-tax Economic Definition

Out of this which variant of profit should a firm maximize?

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 Timing of Benefit
The goal fails to consider the timing of the benefits. For example if we could choose
between the following two alternatives, we might be indifferent if our emphasis
were solely on maximizing earnings.

Time - Pattern of Profits

Period Alternative A Alternative B
1 US$ 50 mn 0
2 US$ 100 mn US$ 100 mn
3 US$ 50 mn US$ 100 mn
Total US$ 200 mn US$ 200 mn

• Alternative A is superior because the large benefits occur earlier.

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 Quality of Benefits
More certain is the expected return, the higher is the quality of return and the vice versa. This is

Certainty of Expected Return Quality of Return

Certainty of ER Q of Return

State of Economy Alternative A Alternative B

Recession US$ 9 mn US$0
Normal 10 10 mn
Boom 11 20 m
Total US$ 30 mn US$ 30 mn

In this the quality of benefit of Alternative A is higher as the returns in the three states of the economic are more certain
and less fluctuating.

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 A Valuation Approach
• This approach considers that the ultimate measure of
performance is not what the firm earns, but how the
earnings are valued by the investors.

• Investors analyze firm’s inherent risk, earnings behaviors,

quality of earnings and many other factors and value it
accordingly.

• So financial manager must accept such decisions that

maintain or increase the firm’s overall value and reject
others.

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 Maximizing Shareholders’ Wealth
Current academic literature accepts this as an
appropriate goal to pursue. Because its operational
features satisfy all the three requirements of a suitable
operational objective of financial course of action,
namely –
• Exactness
• Quality of Benefits
• Time Value of Money

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Maximizing Shareholders’ Wealth
• The value of an asset should be viewed in terms of
the benefits it can produce. The worth of a course
of action/project can be judged in terms of the
value of the benefits it produces less the cost of
undertaking it.

Worth = Benefits - Costs

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Maximizing Shareholders’ Wealth
Wealth maximization goal is based on-
• Exactness: As it considers only cash flows
generated by the decision rather than accounting
profit.
• Quality of Benefit: By taking into view the risk
factor involved in the decision.
• Time Value of Money: An allowance for difference
in timing of benefits is being done by the discount
or capitalization rate or RRR.

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 Social Responsibility and Ethical Behavior
(1 of 2)
• Adopting policies that maximize values in market
– Attract capital
– Provide employment
– Offer benefits to society
• Certain cost-increasing activities may initially have to
be mandatory rather than voluntary, to ensure burden
falls equally over all business firms
 Social Responsibility and Ethical Behavior
(2 of 2)
• Insider trading
– Using information not available to public, making
undue profit from trading in company’s publicly traded
securities
– Unethical and illegal practice protected against by
Securities Exchange Commission (SEC)
– Has a negative impact on shareholder’s interest
• Ethical behavior creates invaluable reputation
 Role of the Financial Markets

• Financial markets – meeting place for people,

corporations and institutions
– Have either a need to lend, borrow or invest money
• Participants can be national, state and local
governments
– Their markets are Public financial markets
• Corporate participants raise funds in corporate
financial markets
 Structure and Functions of the Financial
Markets (1 of 2)
• Distinct parts of financial markets
– Domestic and international markets
– Corporate and government markets
– Money and capital markets
• Money markets
– Deal with short-term securities with life of one year or
less
– Securities include
 Commercial paper sold by corporations to finance daily
operations
 Certificates of deposit with maturities of less than 12
months sold by banks
 Structure and Functions of the Financial
Markets (2 of 2)
• Capital markets
– Deal with securities that have life of more than one
year
– Long-term markets
 Defined as either 1-10 years or greater than 10 years
– Securities include
 Common stock
 Preferred stock
 Corporate and government bonds
 Allocation of Capital (1 of 2)

• Primary market
– When corporation uses financial markets to raise new
funds, sale of securities made through new issue is
called initial public offering (IPO)
• Secondary market
– Securities bought/sold amongst investors
– Prices of securities keep changing continually
– Financial managers given feedback about firms’
performance
 Allocation of Capital (2 of 2)

• Return maximization and risk minimization

– Investors can choose risk level that meets objective,
maximizes return for given risk level
– Companies rewarded with high-priced securities can
raise new funds in money and capital markets at lower
cost than competitors
– Firms pay penalty for failing to perform competitively
 Institutional Pressure on Public Companies to
Restructure

• Restructuring can result in:

– Changes in capital structure (liabilities and equity on
balance sheet)
– Sale of low-profit-margin divisions with proceeds from
sale reinvested in better investment opportunities
– Removal of current management team or large
reductions in workforce
• Also includes mergers and acquisitions
 Internationalization of Financial Markets

• Allocation of capital and search for lower-cost

sources of financing in global market
• Impact of international affairs and technology has
resulted in need for managers to understand
– International capital flows
– Computerized electronic-funds-transfer systems
– Foreign currency-hedging strategies
 The Internet and Changes in the Capital
Markets (1 of 2)
• Cost reduction in trading securities driven down
• Many stock markets brokerage firms have merged with
domestic and international partners
• Creation of electronic communication networks (ECNs)
– Has speed and cost advantages over traditional markets
• Electronic markets like NASDAQ have gained popularity
against traditional organized exchanges such as NYSE