Overview of Financial Management

Meaning of Finance
- Art and science of managing money.
- Function is the procurement of funds and their effective utilization in business concerns.
- Concept of finance includes capital, funds, money, and amount.

Definition of Business Finance

- business activity which concerns with the acquisition and conversation of capital funds in meeting
financial needs and overall objectives of a business enterprise” Wheeler

- Broadly be defined as the activity concerned with planning, raising, controlling, administering of
the funds used in the business”. Guthumann and Dougall

- Deals primarily with raising, administering and disbursing funds by privately owned business units
operating in non- financial fields of industry”. Pahrter and Wert

Definition of Financial Management

- concerned with the efficient use of an important economic resource namely, capital funds”
Solomon

- Deals with procurement of funds and their effective utilization in the business”. S.C. Kuchal

- Howard and Upton : Financial management “as an application of general managerial principles to
the area of financial decision-making.”

Types of Finance
Scope of Financial Management
Financial Management and Accounting
Accounting records includes the financial information of the business concern. Hence, we can easily
understand the relationship between the financial management and accounting. In the olden periods,
both financial management and accounting are treated as a same discipline and then it has been merged
as Management Accounting because this part is very much helpful to finance manager to take
decisions. But nowadays financial management and accounting discipline are separate and interrelated.
Financial Management or Mathematics
Modern approaches of the financial management applied large number of mathematical and statistical
tools and techniques. They are also called as econometrics. Economic order quantity, discount factor,
time value of money, present value of money, cost of capital, capital structure theories, dividend
theories, ratio analysis and working capital analysis are used as mathematical and statistical tools and
techniques in the field of financial management

Financial Management and Production Management

Production management is the operational part of the business concern, which helps to multiple the
money into profit. Profit of the concern depends upon the production performance. Production
performance needs finance, because production department requires raw material, machinery, wages,
operating expenses etc. These expenditures are decided and estimated by the financial department and
the finance manager allocates the appropriate finance to production department.

Financial Management and Marketing

Produced goods are sold in the market with innovative and modern approaches. For this, the marketing
department needs finance to meet their requirements. The financial manager or finance department is
responsible to allocate the adequate finance to the marketing department. Hence, marketing and
financial management are interrelated and depends on each other.

Financial Management and Human Resource

Financial management is also related with human resource department, which provides manpower to
all the functional areas of the management. Financial manager should carefully evaluate the
requirement of manpower to each department and allocate the finance to the human resource
department as wages, salary, remuneration, commission, bonus, pension and other monetary benefits to
the human resource department. Hence, financial management is directly related with human resource
management.
Objectives of Financial Management
- Profit Maximization
- Wealth Maximization

Profit Maximization
- Profit maximization is also called as cashing per share maximization. It leads to maximize the
business operation for profit maximization.

- Ultimate aim of the business concern is earning profit, hence, it considers all the possible ways to
increase the profitability of the concern.

- Profit is the parameter of measuring the efficiency of the business concern. So it shows the entire
position of the business concern.

- Profit maximization objectives help to reduce the risk of the business.

Profit Maximization: Favorable Arguments

(i) Main aim is earning profit.
(ii) Profit is the parameter of the business operation.
(iii) Profit reduces risk of the business concern.
(iv) Profit is the main source of finance.
(v) Profitability meets the social needs also.
Profit Maximization: Unfavorable Arguments
(i) Profit maximization leads to exploiting workers and consumers.
(ii) Profit maximization creates immoral practices such as corrupt practice, unfair trade practice, etc.
(iii) Profit maximization objectives leads to inequalities among the stake holders such as customers,
suppliers, public shareholders, etc.

Profit Maximization: Drawbacks

- It is vague: In this objective, profit is not defined precisely or correctly. It creates some unnecessary
opinion regarding earning habits of the business concern.

- It ignores the time value of money: Profit maximization does not consider the time value of
money or the net present value of the cash inflow. It leads certain differences between the actual
cash inflow and net present cash flow during a particular period.

- It ignores risk: Profit maximization does not consider risk of the business concern. Risks may be
internal or external which will affect the overall operation of the business concern.
 Wealth Maximization

- Wealth maximization is one of the modern approaches, which involves latest innovations and
improvements in the field of the business concern.

- The term wealth means shareholder wealth or the wealth of the persons those who are involved in
the business concern.

- It is also known as value maximization or net present worth maximization. This objective is a
universally accepted concept in the field of business.

Wealth Maximization: Favorable Arguments

- Wealth maximization is superior to the profit maximization because the main aim of the business
concern under this concept is to improve the value or wealth of the shareholders.

- Wealth maximization considers the comparison of the value to cost associated with the business
concern. Total value detected from the total cost incurred for the business operation. It provides
extract value of the business concern.

- Wealth maximization considers both time and risk of the business concern.

- Wealth maximization provides efficient allocation of resources.

- It ensures the economic interest of the society

Wealth Maximization: Unfavorable Arguments

- Wealth maximization leads to prescriptive idea of the business concern but it may not be suitable to
present day business activities.

- Wealth maximization creates ownership-management controversy.

- Management alone enjoy certain benefits.

- The ultimate aim of the wealth maximization objectives is to maximize the profit.

- Wealth maximization can be activated only with the help of the profitable position of the business
concern.
Functions of Finance Manager
1. Forecasting Financial Requirements

It is the primary function of the Finance Manager. He is responsible to estimate the financial
requirement of the business concern. He should estimate, how much finances required to acquire
fixed assets and forecast the amount needed to meet the working capital requirements in future.
2. Acquiring Necessary Capital

After deciding the financial requirement, the finance manager should concentrate how the finance
is mobilized and where it will be available. It is also highly critical in nature. Functions of
Finance Manager

3. Investment Decisions

The finance manager must carefully select best investment alternatives and consider the
reasonable and stable return from the investment. He must be well versed in the field of capital
budgeting techniques to determine the effective utilization of investment. The finance manager
must concentrate to principles of safety, liquidity and profitability while investing capital.
Functions of Finance Manager

4. Cash Management

Present day’s cash management plays a major role in the area of finance because proper cash
management is not only essential for effective utilization of cash but it also helps to meet the
short-term liquidity position of the concern. Functions of Finance Manager

5. Interrelation with Other Departments

Finance manager deals with various functional departments such as marketing, production,
personnel, system, research, development, etc. Finance manager should have sound knowledge
not only in finance related area but also well versed in other areas. He must maintain a good
relationship with all the functional departments of the business organization.

Importance of Financial Mgt.

Financial Planning Financial management helps to determine the financial requirement of the
business concern and leads to take financial planning of the concern. Financial planning is an
important part of the business concern, which helps to promotion of an enterprise.

Acquisition of Funds

Financial management involves the acquisition of required finance to the business concern. Acquiring
needed funds play a major part of the financial management, which involve possible source of finance
at minimum cost.
Proper Use of Funds

Proper use and allocation of funds leads to improve the operational efficiency of the business
concern. When the finance manager uses the funds properly, they can reduce the cost of capital and
increase the value of the firm.

Financial Decision

Financial management helps to take sound financial decision in the business concern. Financial
decision will affect the entire business operation of the concern. Because there is a direct relationship
with various department functions such as marketing, production personnel, etc.

Improve Profitability

Profitability of the concern purely depends on the effectiveness and proper utilization of funds by the
business concern. Financial management helps to improve the profitability position of the concern
with the help of strong financial control devices such as budgetary control, ratio analysis and cost
volume profit analysis.

Increase the Value of the Firm

Profitability of the concern purely depends on the effectiveness and proper utilization of funds by the
business concern. Financial management helps to improve the profitability position of the concern
with the help of strong financial control devices such as budgetary control, ratio analysis and cost
volume profit analysis.

Promoting Savings

Savings are possible only when the business concern earns higher profitability and maximizing
wealth. Effective financial management helps to promoting and mobilizing individual and corporate
savings. Nowadays financial management is also popularly known as business finance or corporate
finances. The business concern or corporate sectors cannot function without the importance of the
financial management.
 Finance within an Organization

Three

Areas of Finance
I. Financial Management
II. Capital Markets
III. Investments

Financial Management
Financial management, also called corporate finance, focuses on decisions relating to how much and
what types of assets to acquire, how to raise the capital needed to buy assets, and how to run the firm
so as to maximize its value. The same principles apply to both for-profit and not-for-profit
organizations; and as the title suggests, much of this book is concerned with financial management.
Capital Markets
Capital markets relate to the markets where interest rates, along with stock and bond prices, are
determined. Also studied here are the financial institutions that supply capital to businesses. Banks,
investment banks, stockbrokers, mutual funds, insurance companies, and the like bring together
“savers” who have money to invest and businesses, individuals, and other entities that need capital for
various purposes. Governmental organizations such as the Federal Reserve System, which regulates
banks and controls the supply of money, and the SEC, which regulates the trading of stocks and bonds
in public markets, are also studied as part of capital markets.
Investments
Investments relate to decisions concerning stocks and bonds and include a number of activities:
1. Security Analysis
2. Portfolio Theory
3. Market Analysis

(1) Security analysis deals with finding the proper values of individual securities (i.e., stocks and
bonds).
(2) Portfolio theory deals with the best way to structure portfolios, or “baskets,” of stocks and
bonds. Ratio- nal investors want to hold diversified portfolios in order to limit risks, so choosing a
properly balanced portfolio is an important issue for any investor. III. Investments (3) Market
analysis deals with the issue of whether stock and bond markets at any given time are “too high,”
“too low,” or “about right.” Behavioral finance, where investor psychology is examined in an effort
to determine if stock prices have been bid up to unreasonable heights in a speculative bubble or
driven down to unreasonable lows in a fit of irrational pessimism, is a part of market analysis

Forms of Business Organization

There are four main forms of business organizations:

(1) sole proprietorships,

(2) partnerships,
(3) corporations, and
(4) limited liability companies (LLCs) and limited liability partnerships (LLPs)

I. Sole Proprietorships

- A proprietorship is an unincorporated business owned by one individual. Going into business as a

sole proprietor is easy—a person begins business operations.

- Proprietorships have three important advantages:

(1) They are easily and inexpensively formed,
(2) they are subject to few government regulations, and
(3) they are subject to lower income taxes than are corporations.

- However, proprietorships also have three important limitations:

(1) Proprietors have unlimited personal liability for the business’s debts, so they can lose more than
the amount of money they invested in the company
(2) The life of the business is limited to the life of the individual who created it; and to bring in new
equity, investors require a change in the structure of the business.
 (3) Because of the first two points, proprietorships have difficulty obtaining large sums of capital;
hence, proprietorships are used primarily for small businesses.

II. Partnerships

- A partnership is a legal arrangement between two or more people who decide to do business
together. II. Partnerships

- Partnerships are similar to proprietorships in that they can be established relatively easily and
inexpensively.

- Moreover, the firm’s income is allocated on a pro rata basis to the partners and is taxed on an
individual basis. This allows the firm to avoid the corporate income tax.

- However, all of the partners are generally subject to unlimited personal liability, which means that if
a partnership goes bankrupt and any partner is unable to meet his or her pro rata share of the firm’s
liabilities, the remaining partners will be responsible for making good on the unsatisfied claims.

- Unlimited liability makes it difficult for partnerships to raise large amounts of capital.

III. Corporations

- A corporation is a legal entity created by a state, and it is separate and distinct from its owners and
managers. III. Corporations

- It is this separation that limits stockholders’ losses to the amount they invested in the firm—the
corporation can lose all of its money, but its owners can lose only the funds that they invested in the
company.

- Corporations also have unlimited lives, and it is easier to transfer shares of stock in a corporation
than one’s interest in an unincorporated business.

- A major drawback to corporations is taxes. Most corporations’ earnings are subject to double
taxation—the corporation’s earnings are taxed; and then when its after-tax earnings are paid out as
dividends, those earnings are taxed again as personal income to the stockholders.

- However, as an aid to small businesses, Congress created S corporations, which are taxed as if they
were partnerships; thus, they are exempt from the corporate income tax. To qualify for S
corporation status, a firm can have no more than 75 stockholders, which limits their use to relatively
small, privately owned firms.

- Larger corporations are known as C corporations. The vast majority of small corporations elect S
status and retain that status until they decide to sell stock to the public, at which time they become C
corporations.

IV. Limited Liability Company (LLC)

- A limited liability company (LLC) is a relatively new type of organization that is a hybrid between a
partnership and a corporation. A limited liability partnership (LLP) is similar to an LLC; but LLPs
are used for professional firms in the fields of accounting, law, and architecture, while LLCs are
used by other businesses.

- Both LLCs and LLPs have limited liability like corporations but are taxed like partnerships. Further,
unlike limited partnerships, where the general partner has full control of the business, the investors
in an LLC or LLP have votes in proportion to their ownership interest.

Which is the best form of organization?

- When deciding on its form of organization, a firm must trade off the advantages of incorporation
against a possibly higher tax burden. However, for the following reasons, the value of any business
other than a relatively small one will probably be maximized if it is organized as a corporation:
Which is the best form of organization?

- Limited liability reduces the risks borne by investors; and other things held constant, the lower the
firm’s risk, the higher its value.

- A firm’s value is dependent on its growth opportunities, which are dependent on its ability to attract
capital. Because corporations can attract capital more easily than other types of businesses, they are
better able to take advantage of growth opportunities.

- The value of an asset also depends on its liquidity, which means the time and effort it takes to sell
the asset for cash at a fair market value. Because the stock of a corporation is easier to transfer to a
potential buyer than is an interest in a proprietorship or partnership and because more investors are
willing to invest in stocks than in partnerships (with their potential unlimited liability), a corporate
investment is relatively liquid. This too enhances the value of a corporation.

Managerial Actions, the Economic Environment, Taxes, and the Political

Climate
 Market Equilibrium: Intrinsic Value = Stock Price

Intrinsic Value: An estimate of a stock’s “true” value based on accurate risk and return data. The
intrinsic value can be estimated but not measured precisely.
Market Price: The stock value based on perceived but possibly incorrect information as seen by
the marginal investor.
Marginal Investor: An investor whose views determine the actual stock price.
Equilibrium: The situation in which the actual market price equals the intrinsic value, so investors
are indifferent between buying or selling a stock.

Notes:
- Indeed, estimating intrinsic values is what security analysis is all about and is what distinguishes
successful from un- successful investors.

- Management’s goal should be to take actions designed to maximize the firm’s intrinsic value, not its
current market price.

Important Business Trends

I. Focus on Business Ethics

II. Globalization
III. Ever-improving information technology
IV. The changes in corporate governance.

I. Focus on Business Ethics

- Executives at Enron, WorldCom, and other companies lied when they reported financial results,
leading to huge stockholder losses. These companies’ CEOs later claimed not to have been aware of
what was happening, and their knowledge (or lack thereof) was a central issue in their trials. As a
result, Congress passed the Sarbanes-Oxley bill, which requires the CEO and CFO of a firm to
certify that the firm’s financial statements are accurate.

- These executives can be sent to jail if it later turns out that the statements did not meet the required
standards. Consequently, businesses beefed up their internal and external auditing procedures, and
the accuracy of published statements has improved.

II. Globalization

- Developments in communications technology have made it possible for WalMart, for example, to
obtain real-time data on the sales of hundreds of thousands of items in stores from China to Chicago
and to manage all of its stores from Bentonville, Arkansas. IBM, Microsoft, and other high-tech
companies now have research labs and help desks in China, India, and Romania;
- and customers of Home Depot and other retailers have their telephone and email questions answered
by call center operators in countries around the globe. Coca-Cola, Exxon Mobil, GE, and IBM,
among others, generate more than half of their sales and income overseas. The trend toward
globalization is likely to continue, and companies that resist will have difficulty competing in the
21st century.

III. Ever-improving Information

- Technology Improvements in IT are spurring globalization, and they are changing financial
management as it is practiced in the United States and elsewhere. Firms are collecting massive
amounts of data and using it to take much of the guesswork out of financial decisions. For example,
when Wal-Mart is considering a potential site for a new store, it can draw on historical results from
thousands of other stores to predict results at the proposed site. This lowers the risk of investing in
new stores.

IV. Corporate Governance

- Some years ago the chairperson of the board of directors was almost always also the CEO, and this
individual decided who would be elected to the board. That made it almost impossible for
stockholders to replace a poor management team. Today, though, active investors who control huge
pools of capital (hedge funds and private equity groups) are constantly looking for underperforming
firms; and they will quickly pounce on laggards, take control, and replace managers

- At the same time, the SEC, which has jurisdiction over the way stockholders vote and the
information they must be given, has been making it easier for activist stockholders to change the
way things are done within firms. For example, the SEC is forcing companies to provide more
transparent information on CEO compensation, which is affecting managers’ actions.

FINANCE WITHIN THE ORGANIZATION

            In an organization, a structure is very important so as to provide a skeleton to understand how
functions relate to each other. We will be zooming in on the function of finance in a corporation and
how it connects to and with other functions in the firm.
            A typical corporation would at least contain the following organizational chart:
Board of Directors (BOD)– is the top governing body of the organization. The board's key purpose
is to ensure the company's prosperity by collectively directing the company's affairs while meeting
the appropriate interests of its shareholders and relevant stakeholders. They are elected from the
shareholders and the board is normally headed by the chairperson who is the highest-ranking official.
 
Chief Executive Officer (CEO) - A chief executive officer (CEO) is the highest-ranking executive in
a company, whose primary responsibilities include making major corporate decisions, managing the
overall operations and resources of a company, acting as the main point of communication between
the board of directors (the board) and corporate operations and being the public face of the company.
A CEO is elected by the board and its shareholders. However, in most cases, the CEO of the company
is also the chairperson of the board.
 
Chief Operating Officer (COO) – Directly under the CEO, the COO is often designated as the
President of the company. The COO directs the operations of the firm, which include marketing,
manufacturing, sales, and other operating departments.
 
Chief Financial Officer (CFO) – Generally a Senior Vice President, the CFO is normally the third
highest-ranking official of the corporation. The Chief Financial Officer (CFO) of a company has
primary responsibility for the planning, implementation, managing, and running of all the finance
activities of a company, including business planning, budgeting, forecasting, and negotiations.
For a corporation that is publicly listed, meaning its stocks are traded in a stock exchange, both the
CEO and CFO must certify the veracity of the reports submitted to stakeholders, such as the financial
statements, and other annual reports.

FORMS OF BUSINESS ORGANIZATIONS

 A sole proprietorship is an unincorporated business with only one owner who pays personal
income tax on profits earned. Sole proprietorships are easy to establish and dismantle, due to a
lack of government involvement, making them popular with small business owners and
contractors
 A partnership is a form of business organization formed by two or more parties to manage and
operate a business and share its profits. There are several types of partnership arrangements. In
particular, in a partnership business, all partners share liabilities and profits equally, while in
others, partners have limited liability
 A corporation is a business entity that is owned by its shareholder(s), who elect a board of
directors to oversee the organization’s activities. The corporation is liable for the actions and
finances of the business – the shareholders are not. Corporations can be for-profit, as
businesses are, or not-for-profit, as charitable organizations typically are.

PROPRIETORSHIPS AND PARTNERSHIPS

Advantages over a Corporation

 Ease of formation
 Subject to few regulations
 No corporate income taxes

Disadvantages over a Corporation

 Difficult to raise capital

 Unlimited liability
 Limited life
CORPORATION
Advantages over proprietorship and partnerships

 Unlimited life
 Easy transfer of ownership
 Limited liability
 Ease of raising capital

Disadvantages over proprietorship and partnerships

 Double taxation
 Cost of setup and report filing

THE OVERALL FINANCIAL GOAL: Creating Value for Investors

            The corporation is owned by the shareholders who contribute resources and get shares of
stocks in exchange. Their claim over the corporation, therefore, is the stocks that they own. It
follows that creating value for the investor means maximining the value of their share, their stock.
Earning profit is just one of the goals but the main focus is to satisfy the investors by increasing the
value of their claim over the corporation.

            The measure of “value” should be understood in different contexts. Talking about the value
of a share of stock, two terms must be kept in mind: the Intrinsic Value and the Market Value.
Market value is simply a measure of how much the market values the company, or how much it
would cost to buy it. This can be directly observed in the stock market, particularly when a
company is publicly traded. Intrinsic value on the other hand is an estimate of the actual value of a
company, separate from how the market values it. Intrinsic value cannot be directly observable.
Calculations are needed to be able to estimate it. Is it be possible that the market value is different
from the stock’s intrinsic value? DEFINITELY YES!!!
The market price of the stock represents the market’s perception of the company. Intrinsic value is
the theoretical “true” value of the company. When the market price is equal to the stock’s intrinsic
value, it is called an equilibrium. When the stock price is less than the intrinsic value, the stock is
said to be under-priced and thus, a regular investor would want to buy a share. A stock on the other
hand is overpriced when its market price is higher than its intrinsic value, thus an investor should
sell it to realize a profit.

STOCKHOLDER-MANAGER CONFLICTS
 Managers are naturally inclined to act in their own best interests (which are not always the
same as the interest of stockholders).
 But the following factors affect managerial behaviour:
o Managerial compensation packages
o Direct intervention by shareholders
o The threat of firing
o The threat of takeover
 
STOCKHOLDER-DEBTHOLDER CONFLICTS
 Stockholders are more likely to prefer riskier projects because they receive more of the
upside if the project succeeds. By contrast, bondholders receive fixed payments and are
more interested in limiting risk.
 Bondholders are particularly concerned about the use of additional debt.
o Bondholders attempt to protect themselves by including covenants in bond
agreements that limit the use of additional debt and constrain managers’ actions.
 
BALANCING SHAREHOLDER INTERESTS AND SOCIETY INTERESTS
 The primary financial goal of management is shareholder wealth maximization, which
translates to maximizing stock price.
o The value of any asset is the present value of the cash flow stream to owners.
o Most significant decisions are evaluated in terms of their financial consequences.
o Stock prices change over time as conditions change and as investors obtain new
information about a company’s prospects.
  Managers recognize that being socially responsible is not inconsistent with maximizing
shareholder value.
 
The following texts are Excerpts from the CFA Institute, Standards of Practice Guidance, 2017,
updated in 2017, https://www.cfainstitute.org/ethics-standards/codes/standards-of-practice-
guidance/ethics-and-investement-industryLinks to an external site.) 
 
WHY ETHICS MATTER

            Ethics can be defined as a set of moral principles or rules of conduct that provide guidance
for our behaviour when it affects others. Widely acknowledged fundamental ethical principles
include honesty, fairness, diligence, and care and respect for others. Ethical conduct follows those
principles and balances self-interest with both the direct and the indirect consequences of that
behaviour for other people.
             Not only does unethical behaviour by individuals have serious personal consequences—
ranging from job loss and reputational damage to fines and even jail—but unethical conduct from
market participants, investment professionals, and those who service investors can damage
investor trust and thereby impair the sustainability of the global capital markets as a whole.
Unfortunately, there seems to be an unending parade of stories bringing to light accounting frauds
and manipulations, Ponzi schemes, insider-trading scandals, and other misdeeds. Not surprisingly,
this has led to erosion in public confidence in investment professionals. Empirical evidence from
numerous surveys documents the low standing in the eyes of the investing public of banks and
financial services firms—the very institutions that are entrusted with the economic well-being and
retirement security of society.
           Governments and regulators have historically tried to combat misconduct in the industry
through regulatory reform, with various levels of success. Global capital markets are highly
regulated to protect investors and other market participants. However, compliance with regulation
alone is insufficient to fully earn investor trust. Individuals and firms must develop a “culture of
integrity” that permeates all levels of operations and promotes the ethical principles of stewardship
of investor assets and working in the best interests of clients, above and beyond strict compliance
with the law. A strong ethical culture that helps honest, ethical people engage in ethical behavior
will foster the trust of investors, lead to robust global capital markets, and ultimately benefit
society. That is why ethics matters.
              Society ultimately benefits from efficient markets where capital can freely flow to the
most productive or innovative destination. Well-functioning capital markets efficiently match
those needing capital with those seeking to invest their assets in revenue-generating ventures. In
order for capital markets to be efficient, investors must be able to trust that the markets are fair and
transparent and offer them the opportunity to be rewarded for the risk they choose to take. Laws,
regulations, and enforcement play a vital role but are insufficient alone to guarantee fair and
transparent markets. The markets depend on an ethical foundation to guide participants’ judgment
and behavior.
 
THE RELATIONSHIP BETWEEN ETHICS AND REGULATIONS
             Some equate ethical behavior with legal behavior: If you are following the law, you must
be acting appropriately. Ethical principles, like laws and regulations, prescribe appropriate
constraints on our natural tendency to pursue self-interest that could harm the interests of others.
Laws and regulations often attempt to guide people toward ethical behavior, but they do not cover
all unethical behavior. Ethical behavior is often distinguished from legal conduct by describing
legal behavior as what is required and ethical behavior as conduct that is morally correct. Ethical
principles go beyond that which is legally sufficient and encompass what is the right thing to do.
          Given many regulators’ lack of sufficient resources to enforce well-conceived rules and
regulations, relying on a regulatory framework to lead the charge in establishing ethical behavior
has its challenges. Therefore, reliance on compliance with laws and regulations alone is
insufficient to ensure the ethical behavior of investment professionals or to create a truly ethical
culture in the industry.
          The recent past has shown us that some individuals will succeed at circumventing the
regulatory rules for their personal gain. Only the application of strong ethical principles, at both
the individual level and the firm level, will limit abuses. Knowing the rules or regulations to apply
in a particular situation, although important, may not be sufficient to ensure ethical conduct.
Individuals must be able both to recognize areas that are prone to ethical pitfalls and to identify
and process those circumstances and influences that can impair ethical judgment.

1. If management operates in a manner designed to maximize the firm's expected profits for the current
year, this will also maximize the stockholders' wealth as of the current year.
- FALSE  
 
2. If a stock's market price is above its intrinsic value, then the stock can be thought of as being
undervalued, and it would be a good buy.
- FALSE  
 
3. Managers always attempt to maximize the long-run value of their firms' stocks, or the stocks' intrinsic
values. This is exactly what stockholders desire. Thus, conflicts between stockholders and managers are
not possible.
- FALSE 
 
4. If a lower level person in a firm does something illegal, like "cooking the books," to understate costs and
thereby increase profits above the correct profits because he or she was told to do so by a superior, the
lower level person cannot be prosecuted but the superior can be prosecuted.
- FALSE 

5. Relaxant Inc. operates as a partnership. Now the partners have decided to convert the business into a corporation. Which of the
following statements is CORRECT?

  
The company will probably be subject to fewer regulations and required disclosures.
 

  
Relaxant's shareholders (the ex-partners) will now be exposed to less liability.
 

  
The firm will find it more difficult to raise additional capital to support its growth.
 

  
Assuming the firm is profitable, none of its income will be subject to federal income taxes.
 

 
6. Which of the following statements is CORRECT?

  
In most corporations, the CFO ranks above the CEO.
 

  
The board of directors is the highest ranking body in a corporation, and the chairman of the board is the highest ranking individual.
The CEO generally works under the board and its chairman, and the board generally has the authority to remove the CEO under
certain conditions. The CEO, however, cannot remove the board, but he or she can endeavor to have the board voted out and a new
board voted in should a conflict arise. It is possible for a person to simultaneously serve as CEO and chairman of the board, though
many corporate control experts believe it is bad to vest both offices in the same person.
 

  
By law in most states, the chairman of the board must also be the CEO.
 

  
The CFO is responsible for raising capital and for making sure that capital expenditures are desirable, but he or she is not
responsible for the validity of the financial statements, as the controller and the auditors have that responsibility.
 

 
7. Which of the following actions would be most likely to reduce potential conflicts of interest between stockholders and
managers?

  
Beef up the restrictive covenants in the firm's debt agreements.
 
   
Change the corporation's formal documents to make it easier for outside investors to acquire a controlling interest in the firm
through a hostile takeover.
 

  
For a firm that compensates managers with stock options, reduce the time before options are vested, i.e., the time before options can
be exercised and the shares that are received can be sold.
 

  
Pay managers large cash salaries and give them no stock options.
 

 
8. Which of the following mechanisms would be most likely to help motivate managers to act in the best interests of
shareholders?

  
Elect a board of directors that allows managers greater freedom of action.
 

  
Take actions that reduce the possibility of a hostile takeover.
 

  
Decrease the use of restrictive covenants in bond agreements.
 

  
Increase the proportion of executive compensation that comes from stock options and reduce the proportion that is paid as cash
salaries.
 

9. Which of the following statements is CORRECT?

  

If someone deliberately understates costs and thereby causes reported profits to increase, this can cause the stock price to rise
above its intrinsic value. The stock will probably fall in the future. Both those who participated in the fraud and the firm itself can be
prosecuted.
 

  
If a lower level person in a firm does something illegal, like "cooking the books," to understate costs and thereby artificially increase
profits because he or she was ordered to do so by a superior, the lower level person cannot be prosecuted but the superior can be
prosecuted.
 

  
Ethical behavior is not influenced by training and auditing procedures. People are either ethical or they are not, and this is what
determines ethical behavior in business.
 

  
There are many types of unethical business behavior. One example is where executives provide information that they know is
incorrect to outsiders. It is illegal to provide such information to federally regulated banks, but it is not illegal to provide it to
stockholders because they are the owners of the firm.
 

 
Question 10
2 / 2 pts
Which of the following statements is CORRECT?

  
Reducing the threat of corporate takeover increases the likelihood that managers will act in shareholders' interests.
 

  
Corporations are taxed more favorably than proprietorships.
 

  
Bond covenants are designed to protect bondholders and to reduce potential conflicts between stockholders and bondholders.
 

  
Because of their size, large corporations face fewer regulations than smaller corporations and proprietorships.
 

 
Question 11
2 / 2 pts
Which of the following statements is CORRECT?

  
There is no good reason to expect a firm's stockholders and bondholders to react differently to the types of assets in which it invests.
 

  
One disadvantage of operating as a corporation rather than as a partnership is that corporate shareholders are exposed to more
personal liability than are partners.
 

  
Relative to proprietorships, corporations generally face fewer regulations, and they also find it easier to raise capital.
 

  
Stockholders should generally be happier than bondholders to have managers invest in risky projects with high potential returns as
opposed to safe projects with lower expected returns.
 

 
Question 12
2 / 2 pts
Which of the following statements is CORRECT?

  
One disadvantage of operating a business as a proprietor is that the firm is subject to double taxation, because taxes are levied at
both the firm level and the owner level.
 

  
One advantage of forming a corporation is that equity investors are usually exposed to less liability than they would be in a
partnership.
 

  
It is generally less expensive to form a corporation than a proprietorship because, with a proprietorship, extensive legal documents
are required.
 
   
Corporations face fewer regulations than proprietorships.
 

 
Question 13
2 / 2 pts
The following are the three areas of finance, except

  
Investments
 

  
All of the above are areas of finance
 

  
Management Accounting
 

  
Capital Markets
 

 
Question 14
2 / 2 pts
This deals with finding the proper values of individual securities.

  
Portfolio theory
 

  
Market Theory
 

  
Security Analysis
 

  
Market Analysis
 

 
Question 15
2 / 2 pts
This deals with the best way to structure portfolios, or “baskets,” of stocks and bonds.

  
Market Theory
 

  
Portfolio Theory
 

  
Market Analysis
 

  
Security Analysis
 

 
Question 16
2 / 2 pts
It is calculated by a competent analyst who has the best available risk and return data.

  
Market Price
 

  
Intrinsic Value
 

  
Equilibrium
 

  
Marginal Investor
 

 
Question 17
2 / 2 pts
It is the value based on perceived information as seen by the marginal investor.

  
Intrinsic Value
 

  
Equilibrium
 

  
Market Price
 

  
Marginal Investor

CASH FLOWS

THE ANNUAL REPORTS

 Balance sheet – provides a snapshot of a firm’s financial position at one point in time.
 Income statement – summarizes a firm’s revenues and expenses over a given period of
time.
  Statement of cash flows – reports the impact of a firm’s activities on cash flows over a
given period of time.
 Statement of stockholders’ equity – shows how much of the firm’s earnings were retained,
rather than paid out as dividends.

The Cash Flow Statement

https://youtu.be/Xy-yDw0gsgc - intro

https://youtu.be/KOR10VPsyO8 - prepare cf direct method

https://youtu.be/8CH-6wdfz0Y - indirect

Treatment for Interest Expense  

            An issue is can be raised with respect to interest expense. In the previous discussions, the
interest expense is ignored. But looking into the nature of the interest expense, this item is really a
result of long term borrowing, which is classified as a financing activity. As such, an alternative to
the treatment for interest expense (or paid) is for it to be added back to the net income in
determining the operating cash flow. As this is done, the same amount shall be treated as part of
the financing activity (as a deduction) as this normally represent cash outflow.

OTHER PERFORMANCE MEASURES

            The textbook has discussed exhaustively other performance measures that the company can use.
Some of these are:
 Free Cash Flow – The amount of cash that could be withdrawn without harming the a firm’s ability
to operate and produce future cash flows.
 Net operating profit after tax – The profit a company could generate if it had no debt and held only
operating profit
 Market Value Added – The excess of the market value of the equity over its book value
 Economic Value Added – Excess of NOPAT over capital costs.
These measures along with other important figures and their formula are given on the below:

FINANCIAL STATEMENTS ANALYSIS

OVERVIEW OF STATEMENT OF THE
FINANCIAL POSITION

TOTAL ASSETS TOTAL LIABILITIES

AND EQUITY
Current Assets Current Liabilities
Noncurrent Liabilities
Noncurrent Assets Common Stock
Preferred Stock
Retained Earnings

ASSETS LIABILITIES EQUITY

Resources controlled by Present obligations of the It is the residual interest in the
the entity as a result of entity arising from past assets of the entity after subtracting
past events. events. all its liabilities.

They represent probable Their settlement is expected

future economic benefits to result in an outflow of
to the entity. economic benefits from the
entity.

Classified as current if its realization/settlement The following are the major items
Is within operating cycle or 1 year, whichever is of the equity:
longer.
Capital contributions by owners
NOTE: Current Liabilities do not include short- term debt (common/preferred stock)
if an entity

- Intends to refinance them on a Retained Earnings are the

noncurrent basis accumulated net income not yet
- Demonstrates an ability to do so distributed to owners.

Treasury stock is the firm’s own

stock repurchased, presented as a
contra account.

Accumulated Other
Comprehensive Income are
items of not income not
Included in profit or loss.
OVERVIEW OF THE INCOME STATEMENT / STATEMENT
OF COMPREHENSIVE INCOME

Single-Step
Total Revenues
Less: Total Expenses Income from Continuing
Ope. before tax Less: Income Tax Expense
(Current/Deferred) Income from Continuing
Operations Discontinued Operations (net of
tax) Net Income
Add/Less: Other Comprehensive
Income (net of tax) Comprehensive Income
Multiple-Step
Net Sales
Less: Cost of Goods Sold Gross Margin
Less: Operating Expenses Operating Income
Add: Other Revenues and Gains
Less: Other Expenses and Losses Income from
Continuing Ope. before tax Less: Income Tax
Expense
(Current/Deferred) Income from Continuing
Operations Discontinued Operations (net of
tax) Net Income
Add/Less: Other Comprehensive
Income (net of tax) Comprehensive Income

COMPARATIVE FINANCIAL STATEMENT ANALYSIS

One of the main difficulties in the comparison of financial statements between

companies/periods of time for the same company is the difference in size.

 When comparing two companies, one company may have a higher net income simply
because it is bigger and not because it is more efficient, effective or sells a better
product.
 When comparing financial statements for the same company over several
accounting periods, the income statements may report significant sales growth
during one of the periods, making comparison difficult.

One of the ways to deal with these size differences is through comparative financial
statement analysis. Comparative financial statements state each item of the financial
statement not as a numerical amount, but rather as a percentage of a relevant base amount.

 Vertical analysis, also called common-size financial statements, makes it

possible to compare the performance of companies of different sizes during the
same period of time.
  Horizontal or trend analysis, also called common-base year statements,
enables comparison of data for a single company or a single industry over a period
of time.

VERTICAL COMMON-SIZE FINANCIAL STATEMENTS

A simple vertical common-size financial statement covers one year’s operating results
and expresses each component as a percentage of a total.

 Line items on the income statement and statement of cash flows are
Presented as a percentage of
Net sales
 Line items on the balance sheet
revenue
total assets
are presented as a percentage of

However, common-size financial statements do not need to relate each balance sheet item
to total assets only.

A vertical common-size income statement might state each classification of sales revenue or
expenses as a percentage of total revenues. Alternatively, it might state general and
administrative expenses and selling expenses each as a percentage of total operating expenses.

HORIZONTAL TREND ANALYSIS

Horizontal trend analysis is used to evaluate trends for a single business over a period of
several years. In analyzing the income statement, changes in revenues or expenses over time
can indicate, for example, the effectiveness of a company’s change in pricing strategy or its
efforts to improve operations.

Horizontal trend analysis can be in the form of common-base year financial statements or
as a variation analysis, a presentation of the annual growth rates of line items.

A. Common-base year financial statements use the first year as the base year. Financial
statement amounts for subsequent years are presented not as dollar amounts but as percentages
of the base year amount, with the base year assigned a value of 100% or 100.

Common Base Year Statements = New Line Item Amount x 100

Base Year Line Item Amount

B. Horizontal analysis can also be done in the form of a variation analysis by calculating
the annual growth rate of each individual line item. Each year’s value is compared with that
of the previous year.

Annual Growth Rate of Line Items = New Line Item Amount -1

Old Line Item Amount

The percentage of change year-over-year can also be calculated as follows:

Annual Growth % = New Line Item Amount – Old Line Item Amount

Old Line Item Amount