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CHAPTER 1

The Financial

Manager and the

Firm

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Legal Forms of Business Organizations

Quick Links

The Role of the Financial Manager

Managing the Financial Function

The Goal of the Firm

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The role of financial

manager

 The financial manager is responsible for

making decisions that are in the best interests of firm owners or maximize the owner’s wealth.

 Stakeholder is someone other than an owners.

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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.

 _{The firm can pay the remaining cash, called}

residual cash flows, to the owners as a cash dividend, or reinvest the cash in the business. It is all About Cash Flows

 _{The firm is successful when these cash}

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Exhibit 1.1: Cash Flow

Diagram

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Manager

It is all about cash flows

 _{A firm is unprofitable when it fails to generate}

sufficient cash flows.

 _{In bankruptcy, the company will either be}

reorganized, or the company’s assets will be liquidated.

 _{Firms that are unprofitable over time will be}

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Three Fundamental Decisions in Financial Management

 _{The capital budgeting decision}_{: Which}

productive assets should the firm buy?

 _{A good capital budgeting decision is one}

in which the benefits are worth more for the firm than the cost of the assets.

The Role of the Financial

Manager

 _{The financing decision}_{: How should the firm}

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Three Fundamental Decisions in Financial Management

 _{Financing decisions involve trade-offs}

between advantages and disadvantages of debt and equity financing.

 _{Working capital management decisions}_{: How}

should day-to-day financial matters be managed?

The Role of the Financial

Manager

 _{The mismanagement of working capital can}

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Exhibit 1.2: How Financial

Manager’s Decisions Affect

the Balance Sheet

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Legal Forms of Business

Organizations

Sole Proprietorship

 _{No legal distinction between personal and}

business income for a sole proprietor.

 _{All business income is taxed as personal}

income.

 _{A sole proprietorship has unlimited liability for}

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Partnership

 _{Has the same basic advantages and}

disadvantages as a sole proprietorship.

 _{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.

Legal Forms of Business

Organizations

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Corporation

 _{In a legal sense, it is a “person” distinct from}

its owners.

 _{The owners of a corporation are its}

stockholders, or shareholders.

 _{A major advantage of the corporate}

form of business is that stockholders have limited liability.

Legal Forms of Business

Organizations

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Corporation

 _{The owners of corporations are subject to}

double taxation first at the corporate level and then at the personal level when dividends are paid to them.

 _{Public corporations can sell their debt or}

equity in the public securities markets.

 _{Private corporations are held by a small}

number of investors.

Legal Forms of Business

Organizations

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Hybrid Forms of Business Organization

 _{Limited liability partnerships (LLPs)}

combine the limited liability of a corporation with the tax advantage of a partnership.

 _{Limited liability companies (LLCs)}

 _{Professional corporations (PCs)}

Organizations

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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}

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Chief Financial Officer (CFO)

 _{Responsible for the best possible financial}

analysis that is presented to the CEO.

_{Positions that report to the CFO:}

 _{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

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 _{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.

 _{CFO’s Key Financial Reports}

Managing the Financial

Function

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 _{The Internal Auditor is responsible for}

in-depth risk assessments, performing audits of high-risk areas.

 _{CFO’s Key Financial Reports}

Function

 _{The Risk Manager manages the firm’s}

risk exposure in financial markets and the relationships with insurance

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External Auditors (big Four)

 _{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

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Audit Committee

 _{Approves the external auditor’s fees and}

engagement letter. The external auditor cannot be fired or terminated without the audit committee’s approval.

Function

Compliance and Ethics Director

 _{Oversees the compliance program, ethics}

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Exhibit 1.3: Simplified

Corporate Organization Chart

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What Should Management Maximize?

 _{Minimizing risk or maximizing profits}

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The Goal of the Firm

What Should Management Maximize?

 _{Profit maximization does not tell}

us when cash flows are to be received.

 _{Why not maximize profits?}

 _{Profit maximization ignores the}

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Maximize the Value of the Firm’s Stock Price

 _{When analysts and investors determine}

the value of a firm’s stock, they

consider. _{The size of the expected cash flows.}  _{The timing of the cash flows.}

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The Goal of the Firm

Maximize the Value of the Firm’s Stock Price

 _{An appropriate goal for financial}

management is to maximize the current value of the firm’s stock.

 _{For private corporations and}

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Exhibit 1.4: Major Factors

Affecting Stock Prices

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The Goal of the Firm

Can Management Decisions Affect Stock Prices?

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Agency Conflicts:

Separation of Ownership and

Control

Ownership and Control

 _{For large corporations, the ownership of the}

firm is spread over huge number of

shareholders and the firm’s owners may effectively have little control over

management .

 _{Management may make decisions that}

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Agency Relationships

 _{An agency relationship arises whenever}

one party, called the principal, hires another party, called the agent.

Agency Conflicts:

Control

 _{The relationship between stockholders}

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Do Managers Really Want to Maximize Stock Price?

 _{Shareholders own the corporation, but}

managers control the money and have the opportunity to use it for their own benefit.

Agency Costs

Agency Conflicts:

Control

 _{The costs of the conflict of interest between}

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Aligning the Interests of Management and Stockholders

 _{Management Compensation}

 _{A significant portion of management}

compensation should be tied to firm performance (e.g. stock price).

Agency Conflicts:

Control

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Aligning the Interests of Management and Stockholders

 _{Managerial Labor Market}

 _{Firms with unethical behavior have}

difficulty hiring top managers.

 _{Executives with poor performance or}

criminal convictions can rarely secure good positions in the future.

Agency Conflicts:

Control

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Aligning the Interests of Management and Stockholders Board of Directors

 _{Lack of board independence is a key factor in}

the misalignment between board members’ and stockholders’ interests

Agency Conflicts:

Control

Other Managers