Module #01: An Overview of Financial Management

Finance Within the Organization

Definition of Finance
– is the study of how individuals, institutions, governments and businesses acquire, spend
and manage money and other financial resources
– Procurement or gathering of funds, effective and efficient utilization of financial
resources, allocation of financial assets or resource

Sarbanes-Oxley Act - Sox Act

– Designed primarily to regulate corporate conduct in an attempt to promote ethical
behavior and prevent fraudulent financial reporting
– 301 - responsibilities of BOD and audit committee, appointment and compensation
– 302 - CEO and CFO to sign and certify that the financial statements are accurate
– 303, 304, 306 - ethical conduct by BOD, Executives and key employees
– 406 - public corporation to have code of ethics for senior executive

Introduction To Financial Management

– Engaging in business is like gambling, it is too risky.
– Shareholders: managers who govern the business on behalf of the owners
– Financial Management: the process of planning, directing, organizing, controlling, and
monitoring (PDOCM) of the monetary resources in order to achieve the objectives and
goals of the business.
o Objectives and goals: Maximize profit, minimize losses
o Financial Managers are responsible for the management of these monetary
resources. (Example: CFO, Treasurer, Controller)

Forms/Kinds of Business Organization

– Sole Proprietorship
o Simplest form of business organization.
o Owned by an individual known as the sole proprietor (1).
o It is subject to fewer government regulations.
o Registered through the Department of Trade and Industry (DTI).
• Business Name Registration System (BNRS)
• Business Permit ➔ BIR
o Business income is not subject to separate taxation.
o Taxation = Professional Income (Ex. Professor) + Business Income (Ex.
Barbershop, Accounting Firm), with this you will become a mixed income
earner and will be taxed as one.
 Disadvantages:
• Unlimited Liability - Debts and losses of the business shall be borne by
the personal assets of the owner in time of bankruptcy.
• Limited Life - The death of the business owner leads to the termination
of the proprietorship.
• Amount of capital raised is significantly limited.
– Partnership
o Article 1767, New Civil Code (NCC) - a contract of two or more persons who
bind themselves to contribute money, property, or industry to a common fund,
with the intention of dividing the profits among themselves.
o Has a juridical personality separate and distinct from that of each partner and is
created by contract.
o Separate Taxation like Corporation = 25% corporate income tax, amended by
the CREATE law.
• Tax of the partnership is different from that of the partners.
o Unlimited liability (General Rule but subject to exemptions)
• General Partnership - All the partners have unlimited liability, wherein
creditors may claim their separate assets in case of bankruptcy.
• Limited Partnership - Limited partners that have liability to the creditors
only up to the extent of their capital contribution, thus, their separate
assets are safe from the claims of creditors.
o Limited Life - the death of one of the partners will result in the dissolution of the
partnership.
• Retirement
• Admission
• Incorporation
• Death
o May be constituted in any form, whether oral or written.
o The contract of the partnership having a capital of 3,000 or more, in money or
property is required to be:
• In public instrument
• Recorded in the Office of the Securities and Exchange Commission
(SEC).
• Failure to comply shall not affect the liability of the partnership and the
members thereof to third persons (Article 1771-1772 of NCC)
o Capital raised is usually more compared to Sole Proprietorship because of the
larger number of sources of capital.

– Corporation
o Corporation Code of the Philippines (CCP) - an artificial being created by the
operation of the law, having the right of succession and powers, attributes and
properties expressly authorized by law or incident to its existence (Section 2 of
CCP).
• Juridical Personality; Can sue and be sued.
o Composed of five to fifteen incorporators and must also be registered with the
Securities and Exchange Commission (SEC).
• Unless you are going to put up a One Person Corporation (OPC).
o Separate Taxation = 25% corporate income tax amended by the CREATE law.
• Dividends are also subject to tax.
 • Dual Taxation wherein the income of the corporation is subject to
corporate income tax while the earnings of the owners/shareholders are
subject to separate individual income tax.
o Unlimited life/ Perpetual life but subject to stricter government regulations.
o Limited liability for stockholders - the claim of the creditors is only up to the
amount of capital investments of these shareholders and the personal assets are
not subject to appropriations.
• Except if there is fraud. The concept of Piercing Veil of Corporate
Fiction (PVCF) will come in.

Kinds of Business Sole Proprietorship Partnership Corporation

Organization
Owner(s) are called Manager Partners Shareholders
Owner and Managers
are Separate No No Yes
Owner’s Liability Unlimited Unlimited Limited**
Separate Taxation No Yes* Yes
Life of the Business Limited Limited Unlimited

*Except in General Professional Partnership (GPP), this partnership will not be taxed like a
corporation.
– Section 22(B) of NIRC, general partnerships are those formed by a person for the sole
purpose of exercising their common profession, no part of the income of which is
derived from engaging in any trade or business.
– For tax purposes, the term corporation shall include partnership no matter how created or
organized, joint-stock companies, joint-venture accounts (Cuentas en participación),
association, or insurance companies but does not include general professional
partnerships and joint venture or consortium formed for the purpose of engaging in
petroleum, coal, geothermal or other energy operations pursuant to an operating
consortium agreement under a service contract with the Government.
– As an exception, GPP’s income is not taxed separately using the 25% corporate income
tax

**Except when the doctrine of Piercing the Veil of Corporate Fiction applies.
– Shall disregard the separate personality of the corporation because the veil of corporate
fiction was used as a shield to perpetuate fraud, justify wrong, defeat public
inconvenience, or defend crime.
– The effect is to make the directors, officers, and shareholders, involved in fraud or crime,
liable for the obligation of the corporation.

Proprietorships and Partnerships

– Advantages
o Ease of formation
o Subject to few regulations
o No corporate income taxesπ
– Disadvantages
o Difficult to raise capital
o Unlimited liability
o Limited life
– Often set up through LLCs/LLPs.
Corporation
– Advantages
o Unlimited life
o Easy transfer of ownership
o Limited liability
o Ease of raising capital
– Disadvantages
o Double taxation
o Cost of setup and report filing

Types of Corporation
A. As To Legal Status
– De Jure Corporation
o organized in accordance with the law.
o Strict or substantial compliance with the statutory requirements for its
incorporation.
o It exists in fact and in law.
o Articles of Incorporation + By Laws = SEC
– De Facto Corporation
o exists only in fact but not in law because there is a flaw in its
incorporation.
o Has no legal right to corporate existence as against the state.

B. As To Functions And Governing Law

– Public Corporation
– organized by the state for the government to promote the general welfare of the
public.
o Governed by special laws and the Local Government Code of the
Philippines.
o EX. SSS, GSIS, PhilHealth
– Private Corporation
o organized by private individuals for the purpose of generating profit.
o Governed by the Law on Private Corporation
o EX. Jollibee, San Miguel, SM, PLDT
C. As To The Existence Of Stocks
– Stock Corporation
o capital stock is divided into shares and is authorized to distribute to the
holders thereof of such shares dividends or allotments of the surplus
profits. (Sec. 3 of the Corporate Code of the Philippines)
o Owners are called shareholders or stockholders.
o Profit = Share Dividends
– Non-stock Corporation
o has no stock issuances and no distribution of dividends to its members.
o A corporation is not automatically considered a stock corporation if
there is a statement of capital stock.
o are called members not stockholders
o E.g. Academic institutions
 o Supreme Court: If the dividends are not supposed to be declared or
there is no distribution of retained earnings, the corporation is still a
non-stock corporation. Moreover, the owners are called members.
o Profit = Reinvested in the Company
D. As To Shares Being Traded In The Stock Exchange
– Publicly listed Company
o Shares are offered to the public or traded in the Philippine stock
exchange.
o Undergoes initial public offering (IPO).
– Privately owned Company
o Shares are not traded in the stock market.
o A corporation “going private” because it restricts the stockholders to a
certain group, usually family members.
o Sometimes called a close or closely held corporation or privately held
corporation.
o does not undergo IPO

Corporations That Are Not Acceptable In Philippine Law

– Limited liability Company
o A business structure that combines the tax advantage (10%) of a partnership
(GPP) and the limited liability advantage of a corporation.
– Professional Corporation
o Composed of persons with the same professions such as Doctors, Lawyers, or
Certified Public Accountants

Goals of The Corporation

– All forms of business organizations whether sole proprietorship, partnership, or
corporation has the goal of maximizing earnings or profit.
– For a sole proprietorship or the partners, profit maximization may be the end goal.
– However, for corporations, profit maximization is just a means to the ultimate goal of the
corporation.
– Stock price maximization/Shareholder’s wealth maximization - the increase in the value
of stock price resulting in capital gains that shareholders will yield on their investments.
– Market value maximization - is given more emphasis than of profit maximization for
the following reasons:
o Maximizing the market value of the corporation, a discount rate which reflects
the risks of capitalization and the time value of money is taken into
consideration.
o In maximizing future profits, the company may opt to decrease and postpone its
dividend declaration, and instead, it will reinvest the freed-up cash.
– In Summary, the goal of sole proprietorship and partnership is to gain profit; while,
corporations are shareholder’s wealth maximization, stock price maximization, and
market value maximization.

Inappropriate Ways On How Management Maximizes The Profit Of The Corporation

– Management wants to accelerate sales by materially increasing the swelling prices of the
goods offered to the consumers, or
 – Management wants to reduce expenses by cutting wage rates of the laborers or buying
cheapest material for production

Financial Managers Of The Corporation

– Financial Managers are responsible for managing the monetary resources of the
corporation in order to maximize the firm’s value.
o They are also responsible for dealing with the different financial markets.
o These managers are the agents who act on behalf of the principals
(owners/shareholders) to perform investment, financing, and operation
decisions.

Financial Managers Are:

1. Board Of Directors
o they are direct owners and are elected by the shareholders to manage the
corporation. They are charged with ultimate governance of the corporation.
Thus, they have the ultimate responsibility for decking on highly important
financial matters of the corporation. Moreover, BOD decides on when to declare
and how much dividends per share to distribute.
 Can vote unless they are ratified
 Dual personality involved (both an owner and manager)
 decides on high risk investments, expansion, buying of PPEs, issuance
of bonds, and loans.
2. Chief Financial Officer
o also known as the Vice President for Finance (VP Finance), who has
responsibility over financial planning and formulation of financial corporate
strategies.
 Under his supervision are the Treasurer and the Controller
 Oversees the company’s financial statements
3. Treasurer
o focuses on the financial aspect of the corporation; has the responsibility of
raising and managing the capital or funds of the company; transaction and
maintaining good relationships with various banks; and the formulation of the
company’s credit policies collection (inflow of funds).
 Fundraising activities
 Cash balance
 Bank loans, issuance of bonds
4. Controller
o focuses on the accounting and budgeting aspect of the corporation; he is
responsible for the custody of financial records, preparation of the financial
statements, and interpretation of financial statements
 Bookkeeping, auditing, recording, budgeting

General Role Of Financial Manager

– Investing Decision
o also known as capital budgeting, answers the question: “what assets should the
corporation acquire in order to provide better returns in the future.”
o Investing activities - outflows of cash to acquire Non-Current Assets (land,
building, equipment - will prompt faster production) - to generate cash (if they
are used for operations).
– Financing Decision
 o applies in the event that the cash available is insufficient from the retained
earnings; answers the question on “how much funds can be raised and how to
raise such funds” or “how to raise funds in order to finance the investment and
operating activities of the firm.”
o Inflow through fundraising activities such as loans, stocks, or bonds.
o The financial managers accumulate funds through the following means:
 performing long term financing through bank loans if the prevailing
interest rate is not high
 issuance of financial assets such as share of stocks (equity security) or
bonds (debt security) ○ EX. if stock price is high, sell it otherwise, don’t
sell it
– Operating Decision
o should decide on how much funds should be allocated to each operating unit. It
answers the question: “how much funds will be allocated to support the day-to-
day transactions of the firm.”
o Outflow/Inflow of Current Assets
Outflow Inflow
Raw Materials Sales
Direct Labor COGS
Overhead Gross Profit
Net Income

Resolution Of Agency Problem

– Agency conflicts are problems between the principal and agent of the company.
o shareholders (principal)
o financial managers (agents)

Solutions To Mitigate
1. Compensation Plans
o these incentives are provided in order to motivate these managers to perform
better so that the goal of maximizing the value of the firm may be achieved. the
companies would offer incentives to their managers such as:
 additional bonuses
 percentage interest in the net income
 stock options
2. Threats As To Change In Board Of Directors
o the shareholders have the power to elect a new set of BOD if they are not
satisfied with the performance of the board.
3. Threats As To Management Takeovers
o management takeover indicates that the old management team is replaced by the
new management.
4. Legal And Regulatory Requirements
o these requirements imposed upon the corporation, especially those publicly
listed companies, aim to provide security on the part of the shareholders or
investors.
5. Specialist Monitoring
o it is assumed that employees will perform their functions well if they are
monitored by their superior.
Conflicts Between Stockholders And Bondholders
– The stockholders, as owners of the firm, want the financial managers to invest in risky
investments (high risk/risk takers).
– The bondholders, as the lenders of the firm, oppose risky investments (low risk).

Retained Earnings (Financial Managers’ Decision)

– Appropriated
o Plowback or reinvest (EX. for expansion)
o Market value rises
– Unappropriated
o Dividends will be available for the stockholders

Ethical Considerations
– Maximizing the firm’s market value or the maximization of the shareholder’s wealth is
achieved through an ethical manner of doing business.
– The company should maintain its Corporation Social Responsibility (CSR) at all times.
– Ethics and the goal of maximizing shareholder wealth generally lean towards similar
ends because ethical behavior builds good reputation that will benefit the organization.
– Between ethics and profit goals, ethics will prevail.

Balancing Shareholder Value and Society Interests

– The primary financial goal of management is shareholder wealth maximization, which
translates to maximizing stock price.
o Value of any asset is present value of 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.

Stock Prices and Intrinsic Value

– In equilibrium, a stock’s price should equal its “true” or intrinsic value.
– Intrinsic value is a long-run concept.
– To the extent that investor perceptions are incorrect, a stock’s price in the short run may
deviate from its intrinsic value.
– Ideally, managers should avoid actions that reduce intrinsic value, even if those
decisions increase the stock price in the short run.

When is a stock said to be in equilibrium? At any given time, would you guess that most
stocks are in equilibrium as you defined it?
– Equilibrium is the situation where the actual market price equals the intrinsic value, so
investors are indifferent between buying or selling a stock. If a stock is in equilibrium,
then there is no fundamental imbalance, hence no pressure for a change in the stock's
price. At any given time, most stocks are reasonably close to their intrinsic values and
thus are at or close to equilibrium. However, at times stock prices and equilibrium values
are different, so stocks can be temporarily undervalued or overvalued.

What is the firm’s intrinsic value? Current stock price? Is the stock’s “true” long-run
value more closely related to intrinsic value or current price?
– A firm’s intrinsic value is an estimate of a stock’s “true” value based on accurate risk
and return data. It can be estimated but not measured precisely. A stock’s current price
 is its market price—the value based on perceived but possibly incorrect information as
seen by the marginal investor. From these definitions, you can see that a stock’s “true”
long-run value is more closely related to its intrinsic value rather than its current price.

When is a stock said to be in equilibrium? At any given time, would you guess that most
stocks are in equilibrium as you defined it?
– Equilibrium is the situation where the actual market price equals the intrinsic value, so
investors are indifferent between buying or selling a stock. If a stock is in equilibrium,
then there is no fundamental imbalance, hence no pressure for a change in the stock’s
price. At any given time, most stocks are reasonably close to their intrinsic values and
thus are at or close to equilibrium. However, at times stock prices and equilibrium
values are different, so stocks can be temporarily undervalued or overvalued.

Suppose 3 honest individuals gave you estimates of stock x's intrinsic value (roommate,
professional security analyst and company x's cfo) the 3 differed in estimation, in which one
would you have confidence
– If the three intrinsic value estimates for Stock X were different, you would have the most
confidence in Company X's CFO's estimate. Intrinsic values are strictly estimates, and
different analysts with different data and different views of the future will form different
estimates of the intrinsic value for any given stock. However, a firm's managers have the
best information about the company's future prospects, so managers' estimates of
intrinsic value are generally better than the estimates of outside investors.

Is it better for a firm’s actual stock price in the market to be under, over or equal to its
intrinsic value?
– If a stock’s market price and intrinsic value are equal, then the stock is in equilibrium
and there is no pressure (buying/selling) to change the stock’s price. So, theoretically, it
is better that the two be equal; however, intrinsic value is a long-run concept.
Management’s goal should be to maximize the firm’s intrinsic value, not its current
price.
– So, stockholders in general would probably expect the firm’s market price to be under
the intrinsic value—realizing that if management is doing its job that current price at any
point in time would not necessarily be maximized.
– However, the CEO would prefer that the market price be high—since it is the current
price that he will receive when exercising his stock options. In addition, he will be
retiring after exercising those options, so there will be no repercussions to him (with
respect to his job) if the market price drops—unless he did something illegal during his
tenure as CEO.

If a company's bod wants to maximize shareholder wealth, should the ceo's compensation
be set as a fixed dollar amount or depend on how well the firm performs
– The board of directors should set CEO compensation dependent on how well the firm
performs. The compensation package should be sufficient to attract and retain the CEO
but not go beyond what is needed. Compensation should be structured so that the CEO
is rewarded on the basis of the stock's performance over the long run, not the stock's
price on an option exercise date.
– This means that options (or direct stock awards) should be phased in over a number of
years so the CEO will have an incentive to keep the stock price high over time. If the
intrinsic value could be measured in an objective and verifiable manner, then
performance pay could be based on changes in intrinsic value.
 – However, it is easier to measure the growth rate in reported profits than the intrinsic
value, although reported profits can be manipulated through aggressive accounting
procedures and intrinsic value cannot be manipulated. Since intrinsic value is not
observable, compensation must be based on the stock’s market price—but the price used
should be an average over time rather than on a specific date

Determinants of Intrinsic Values and Stock Prices

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

– Stockholder wealth maximization is a long-run goal. Companies, and consequently the
stockholders, prosper by management making decisions that will produce long-term
earnings increases. Actions that are continually shortsighted often “catch up” with a
firm and, as a result, it may find itself unable to compete effectively against its
competitors.
– There has been much criticism in recent years that U.S. firms are too short-run profit-
oriented. A prime example is the U.S. auto industry, which has been accused of
continuing to build large “gas guzzler” automobiles because they had higher profit
margins rather than retooling for smaller, more fuel-efficient models.

What are some actions that stockholders can take to ensure the management’s and
stockholders are aligned
– Useful motivational tools that will aid in aligning stockholders’ and management’s
interests include:
1) reasonable compensation packages,
2) direct intervention by shareholders, including firing managers who don’t
perform well, and
3) the threat of takeover
– The compensation package should be sufficient to attract and retain able managers but
not go beyond what is needed. Also, compensation packages should be structured so
that managers are rewarded on the basis of the stock’s performance over the long run,
not the stock’s price on an option exercise date.
– This means that options (or direct stock awards) should be phased in over a number of
years so managers will have an incentive to keep the stock price high over time. Since
intrinsic value is not observable, compensation must be based on the stock’s market
price—but the price used should be an average over time rather than on a specific date.
– In effect, these institutional investors act as lobbyists for the body of stockholders.
Second, any shareholder who has owned $2,000 of a company’s stock for one year can
sponsor a proposal that must be voted on at the annual stockholders’ meeting, even if
management opposes the proposal. Although shareholder-sponsored proposals are non-
binding, the results of such votes are clearly heard by top management
 – If a firm’s stock is undervalued, then corporate raiders will see it to be a bargain and will
attempt to capture the firm in a hostile takeover. If the raid is successful, the target’s
executives will almost certainly be fired. This situation gives managers a strong
incentive to take actions to maximize their stock’s price.

SSC’s primary goal is to increase value of stockholder’s equity: contributed 1.5m in

symphony orchestra’s headquarters
– Corporate philanthropy is always a sticky issue, but it can be justified in terms of helping
to create a more attractive community that will make it easier to hire a productive work
force. This corporate philanthropy could be received by stockholders negatively,
especially those stockholders not living in its headquarters city. Stockholders are
interested in actions that maximize share price, and if competing firms are not making
similar contributions, the “cost” of this philanthropy has to be borne by someone--the
stockholders. Thus, stock price could decrease.

SSC’s primary goal is to increase value of stockholder’s equity: spending 500 million to
open a new plant and expand operations
– Companies must make investments in the current period in order to generate future cash
flows. Stockholders should be aware of this, and assuming a correct analysis has been
performed, they should react positively to the decision. The Chinese plant is in this
category. Capital budgeting is covered in depth in Part 4 of the text. Assuming that the
correct capital budgeting analysis has been made, the stock price should increase in the
future.

SSC’s primary goal is to increase value of stockholder’s equity: shifting emergency funds
from treasury bond to common stock
– U.S. Treasury bonds are considered safe investments, while common stocks are far more
risky. If the company were to switch the emergency funds from Treasury bonds to
stocks, stockholders should see this as increasing the firm’s risk because stock returns
are not guaranteed—sometimes they increase and sometimes they decline. The firm
might need the funds when the prices of their investments were low and not have the
needed emergency funds. Consequently, the firm’s stock price would probably fall.
Some Important Business Trends
– Corporate scandals have reinforced the importance of business ethics and have spurred
additional regulations and corporate oversight.
– Increased globalization of business.
– The effects of ever-improving information technology have had a profound effect on all
aspects of business finance.
– Stockholders now have more control of corporate governance.

Conflicts Between Managers and Stockholders

– 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 behavior:
o Managerial compensation packages
o Direct intervention by shareholders
o The threat of firing
o The threat of takeover

Conflicts Between Stockholders and Bondholders

– 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.
– Bondholders attempt to protect themselves by including covenants in bond agreements
that limit the use of additional debt and constrain managers’ actions.