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University of Technology, Jamaica

Unit 1: Introduction To Financial Management


What is Financial Management?
At the macro level, finance is the study of financial institutions and financial markets and how
they operate within the financial system. At the micro level, Financial Management involves the
management of money and/or funds of an organization. It involves (i) Financing decisions ie
making decisions regarding financial planning, fund raising,(ii) Investment decisions eg.
Acquisition of assets (iii)Management of assets for businesses and financial institutions with
some overall goal in mind. This goal is usually that of maximizing shareholders wealth.
The Financial Manager is primarily concerned with analyzing and interpreting financial
information including that captured in the firms accounts for decision-making purposes.
Some functions and responsibilities of the financial manager include:
Acquisition of funds short term financing bank loans, etc. and long term financing stocks
(equity) and bonds (debt) for investment in assets.
Allocation (uses) of funds: Short term working capital management, and long term capital
management (stocks and bonds)
Forecasting and planning this includes providing advice and recommendations to executive
management.
Investing and financing decisions
Coordination and control as a member of the management team financial managers need to
work closely with other managers in the organization in order to determine the best financial
decisions to make and also to communicate those decisions to the rest of the organization.
Interaction with financial markets link between financial markets and the organization.
Managing risk ensuring that financing, allocation and management of assets is done with
minimal risk.
The goal of the firm remains, primarily, the maximizing of the wealth of the stockholders, its owners.
Wealth maximization is not the same thing as profit maximization. Profit maximization is more short
term and (i) ignores the relative riskiness of different projects (ii) ignores the time value of money (iii)
ignores the profit to the stockholder in favor of profit to the firm. Wealth maximization comes about from
actions that increase or maximize the stock price. The stock price is determined as the present value of
all the firms future expected cash flows, a long-term goal.
To illustrate: One way to raise the profit level of a firm would be to sell off assets such as plant and
equipment. Such sales would increase income in the short run, they would likely be detrimental to the
firms ability to generate income in the future since the firm no longer had the needed assets.
The usual method of maximizing the wealth of the stockholders is to maximize the price of the
corporations common stock.
Factors affecting the goal of the firm (Stock Price)
Neither managers nor stockholders can set the price of the common stock; the market determines the
price.
The usual (but not the only) way to maximize the price of the common stock is to maximize the earnings
per share, EPS, not just the total earnings of the corporation.
The market price of the common stock reflects the markets estimation of the expected performance of the
economy and the corporation. Many factors are involved in determining that estimation. The main ones
are:
(i) Expected Cash Flows (ii) Timing of Cash Flows (iii) Perceived Riskiness of Cash Flows
Cash Flows Cash, not profits shown in the accounts, is king. The ability of a company to generate cash
inflows and reduce outflows will eventually lead to an increase in its value.
Timing will be examined in more detail later in the course when we look at the time value of money.
Essentially, a dollar received today is worth more than a dollar received in the future because a dollar
received today can earn a days interest by tomorrow. Alternatively, a dollar received today can be
employed in purchasing resources to produce goods and services that can earn a profit.

Uncertainty (Risk) The less certain owners and investors are about a firm's future cash flows, then the
lower they'll value the company. The more certain they are about the future cash flows, then the higher
they'll value the company. This concept of risk and return will also be examined later in the course.
Financial managers can maximize the price of a companys stock through (i) Dividend policy: the
amount of net income paid out to shareholders versus the amount retained for ongoing investment. (ii)
Financing decisions such as how much debt versus equity it uses to finance its operations. Debt might be
bonds which are rated according to the perceived risk of the firm issuing them, or loans, on which the
interest the firm pays is related to its risk. Bond rating systems vary, but range from AAA for investment
grade to CCC and lower for so-called junk bonds. The higher the bond rating, the lower their interest
(or coupon) rate. Equity refers to a firms common stock (iii) Investment decisions including Research
and Development efforts and plant expansion (iv)Strategic decisions as to types of products and services
produced and production methods used
External factors affecting the firm's stock price include: (i)Legal constraints e.g. workplace and
product safety regulations, employment practice rules (ii) Environmental regulations (iii) International
rules e.g. trade regulations (WTO, NAFTA, etc.) (iv) Economic activity levels central bank
regulations, interest rates, foreign exchange availability and rates, unemployment levels, inflation rates
(v) Tax laws (vi) Stock Market conditions bull or bear market. These factors are outside the control of
management. However, proper analysis and formulation of strategies take these factors into consideration
when making decisions aimed at maximising stockholder wealth.
Social and Ethical Challenges: In their desire to achieve the goal of shareholders wealth maximisation,
managers face a number of social and ethical challenges. These include the following:
(i)Agency relationships between managers and shareholders and between shareholders (through
managers) and creditors (ii) Considering the interests of other stakeholders of the organization and the
society in general
Agency Relationship: Managers vs. Stockholders
Firms are usually owned by a large number of investors who employ directors and managers to operate
the business on their behalf, as it would be impossible to have the owners manage the business directly.
The managers are therefore agents of the owners (sharekholders) thus allowing continuity in management
which is unaffected by changes in ownership. Sometimes conflicts arise between agent and principal.
With the agency relationship between managers and stockholders, the following conflicts are common:
1. Managers may not work as hard for the shareholders as the owners themselves would have worked. If
the managers want to buy the company themselves, they may even try to minimize the price of the
common stock.
2. Managers may not always act in the best interest of the shareholders. Management often looks out for
its own interest, sometimes to the detriment of the goal of the firm
3. The choice between paying out dividends from profits earned or retaining the profits in the business.
4. The desire of managers to pursue decisions that could result in higher profits even though the element
of risk is high. This is common in cases where managements remuneration is tied to the profit
performance of the company. As a result of bonus packages, managers may do everything to
inflate/maximize profits.
Although managers are naturally inclined to act in their own best interests, some factors may be used to
deter adverse managerial behaviour:
Direct intervention by shareholders. Shareholders can vote out board of directors at meetings.
Threat of firing managers. But shareholders usually just sell their stock rather than try to change
management. Institutions collectively holding large blocks of shares have been known to oust managers
(at annual stockholders meeting where board of directors are elected).
Threat of hostile takeover. If a company is subject to hostile takeover, the managers often lose their
jobs. Hostile takeovers are probable only if the common stock price is undervalued. Therefore, managers
can discourage hostile takeovers by maximizing the common stock price.
Positive incentives such as properly constructed managerial compensation plans. Compensation of
the managers can be tied to the performance of the corporation and its common stock (i.e. its
performance on the stock market): executive stock options, performance share awards, profit-based salary
and bonuses, etc.

Agency Relationship: Stockholders (through managers) vs. Creditors


Creditors have a claim on part of a company's earnings for payment of interest and principal on
the debt. They also have a claim on the company's assets in the event of bankruptcy.
Shareholders (through managers) have control of the decisions that affect the profitability and
risk of the company. When creditors lend money to companies, they charge a particular rate
based on a number of factors including the risk involved. If the shareholders (through
management) cause the company to take on a large new project that is far riskier than was
anticipated, the increased risk will cause the required rate of return on the company's debt to
increase, but since the rate on outstanding debt is fixed, its value decreases. If the risky project is
successful, all the benefits go to the shareholders, because the creditors returns are fixed at the
old, low-risk rate. However, if the project is unsuccessful, the creditors may have to share in the
losses (by receiving the liquidated value of assets only).
Creditors can refuse to deal further with the company or charge a higher-than-normal interest rate to
compensate for the risk of possible exploitation. The company could also get a poor credit rating as well
as risk being placed in receivership claim on assets secured, bankruptcy and eventual liquidation. In
view of this, it is best that the company's managers try to treat their creditors as fairly as possible as this
will eventually be in the shareholders' best interest. Failure to do so will raise the cost of debt and
ultimately lower stock price.
The interests of other stakeholders ie other people with an interest in a company. They include: (i)
Other non-executive employees (ii)Suppliers (iii)Customers and clients (iv)Government, and (v)General
Society. These people can significantly influence business decisions, which in turn affect the firm's value.
Management should ensure that these stakeholders' welfare has been properly attended to.

Social Responsibility The most common challenge is how to deal with the adverse side effects of the
goods and services a company provides. A typical example is the pollution caused by the emissions from
the bauxite plants in Jamaica. Excessive pollution control costs, eg new technology, lawsuits, medical
bills, etc may result in high outflows of cash, which in turn can reduce the value of the companies in
question. On the other hand, firms often embark upon projects aimed at being socially responsible
including donations to charities, community programs, etc. The long term aim is to provide "Goodwill"
which in turn generates increased sales, cash inflows and ultimately, additional wealth for the owners.
However, these 'social' actions have costs and not all businesses (shareholders) would voluntarily incur
such costs.
Forms of Organization (i) sole proprietorship;- an unincorporated business owned by an individual.
Pros: easily formed, subject to few government regulations, not subject to corporate taxes. Cons: difficult
to access large sums of capital, owner has unlimited personal responsibility for business debts, business
life limited to owners life. These characteristics make this form of organization best suited for small
business.
(ii) partnerships:- similar to a sole proprietorship, but have more than one owner. It might be a general
partnership where each partner bears full responsibility for all the partnerships liabilities or a limited
partnership where (i) at least one partner will not have limited liability, (ii)limited partners names should
not be included in the firms name, and (iii) limited partners cannot be part of the firms management.
(iii) Corporation:-has a legal existence and function separate from its owners. It can buy, sell, and own
property, as well as sue and be sued. It has owners who elect its Board of Directors, who in turn select its
senior corporate officers like president, secretary etc. Ownership expressed as common stock units or
shares (equity). These are transferable, and the corporations ownership can be changed by transferring
shares. Investors liability limited to investment in the firm, thus exempting personal assets from seizure
in settlement of company claims. Because of this limited liability, ease of ownership transfer through
share sales etc corporations have a major advantage over other forms of organization in the ease of raising
capital.

Tutorial Questions
Mini Case: Kato Summers opened Take A Dive 17 years ago; the store is located in Malibu,
California and sells surfing-related equipment. Today, Take A Dive has 50 employees including
Kato and his daughter Amber, who works part-time in the store to help pay for her college
education. Kato's business has boomed in recent years, and he is looking for new ways to take
advantage of his increasing business opportunities. Although Kato's formal business training is
limited, Amber will soon graduate with a degree in finance. Kato has offered her the opportunity
to join the business as a full-fledged partner. Amber is interested, but she's also considering other
career opportunities in finance.
Right now, Amber is leaning toward staying with the family business, partly because she thinks it
faces a number of interesting challenges and opportunities. Amber is interested in further
expanding the business and then incorporating it. Kato is intrigued by her ideas, but he is also
concerned that her plans might change the way in which he does business. In particular, kato has
a strong commitment to social activism and he has always tried to strike a balance between work
and pleasure. He is worried that these goals will be compromised if the company incorporates
and brings in outside shareholders.
Amber and Kato plan to take a long weekend off to sit down and think about all these issues.
Amber, who is highly organized, has outlined a series of questions for them to address
1.

What is the primary goal of the organization?

2.
Would the role of a financial manager be likely to increase or decrease in importance if the rate of
inflation increased? Explain.
3.

Should stockholder wealth maximization be thought of as a long-term or a short-term goal?

4.

What is the difference between stock price maximization and profit maximization?

5.

When might profit maximization not be an adequate goal when making financial decisions?

6.
If you were the president of a large, publicly owned corporation, would you make decisions to
maximize stockholders welfare or your own personal interests? What are some actions stockholders
could take to ensure that managements interests and those of stockholders coincided? What are some
other factors that might influence managements actions?
7.
What are the three principal forms of business organization? What are the advantages and
disadvantages of each?
8.
If the overall stock market is extremely volatile, and if many analysts foresee the possibility of a
stock market crash, how might these factors influence the way corporations choose to compensate their
senior executives?
9.

Is maximizing stock price the same thing as maximizing profit?

10.

What mechanisms exist to influence managers to act in shareholders best interests?

11.

What is an agency relationship?.

12.

What agency relationships exist within a corporation?

13.

What kinds of career opportunities are open to finance majors?