CHAPTER 1 following functions that a financial manager of a business firm

NATURE, PURPOSE AND SCOPE OF FINANCIAL will perform:

1. Procurement of short-term as well as long-term funds from
MANAGEMENT
financial institutions
NATURE OF FINANCIAL MANAGEMENT
2. Mobilization of funds through financial instruments such as
Financial Management, also referred to as managerial
equity shares, preference shares, debentures, bonds, notes,
finance, corporate finance, and business finance, is a decision
and so forth
making process concerned with planning, acquiring and
3. Compliance with legal and regulatory provisions relating to
utilizing funds in a manner that achieves the firm's desired
funds procurement, use and distribution as well as
goals. It is also described as the process for and the analysis
coordination of the finance function with the accounting
of making financial decisions in the business context. Financial
function
management is part of a larger discipline called FINANCE
With modern business situation increasing in complexity, the
which is a body of facts. principles, and theories relating to
role of Finance Manager which initially is just confined to
raising and using money by individuals, businesses, and
acquisition of funds, expanded to judicious and efficient use of
governments. This concerns both financial management of
funds available to the firm, keeping in view the objectives of
profit-oriented business organizations particularly the corporate
the firms and expectations of the providers of funds.
form of business, as well as, concepts and techniques that are
More recently though, with the globalization und liberalization
applicable to individuals and to governments.
of world economy, tremendous reforms in financial sector
THE GOAL OF FINANCIAL MANAGEMENT
evolved in order to promote more diversified, efficient and
Assuming that we confine ourselves to for-profit businesses,
competitive financial system in the country. The financial
the goal of financial management is to make money and add
reforms coupled with the diffusion of information technology
value for the owners. This goal, however, is a little vague and a
have brought intense competition, mergers, takeovers, cost
more precise definition is needed in order to have an objective
management, quality improvement, financial discipline and so
basis for making and evaluating financial decisions. The
forth.
financial manager in a business enterprise must make decision
Globalization has caused to integrate the national economy
for the owners of the firm.
with the global economy and has created a new financial
He must act in the owners' or shareholders best interest by
environment which brings new opportunities and challenges to
making decisions that increase the value of the firm or the
the business enterprises. This development has also led to
value of the stock.
total reformation of the finance function and its responsibilities
in the organization. Financial management has assumed a
The appropriate goal for the financial manager can thus be
much greater significance and the role of the finance
stated as follows:
managers has been given a fresh perspective.

The goal of financial management is to maximize the current In view of modern approach, the Finance Manager is
value per share of the existing stock or ownership in a expected to analyze the business firm and determine the
business firm. following:
a. The total funds requirements of the firm
b. The assets or resources to be acquired and
The stated goal considers the fact that the shareholders in a
c. The best pattern of financing the assets
firm are the residual owners. By this, we mean that they are
TYPES OF FINANCIAL DECISIONS
entitled only to what is left after employees, supplier, creditors
The three major types of decisions that the Finance Manager
and anyone else with a legitimate claim are paid their due. If
of a modern business firm will be involved in are:
any of these groups go unpaid, the shareholders or owners get
1. Investment decisions
nothing. So, if the shareholders are benefiting in the sense that
2. Financing decisions
the residual portion is growing, it must be true that everyone
3. Dividend decisions
else is being benefited too. Because the goal of financial
All these decisions aim to maximize the shareholders' wealth
management is to maximize the value of the share(s), there is
through maximization of the firm's wealth.
a need to learn how to identify investments, arrangements and
distribute satisfactory amount of dividends or share in the
INVESTMENT DECISIONS
profits that favorably impact the value of the share(s).
The investment decisions are those which determine how
scarce or limited resources in terms of funds of the business
Finally, our goal does not imply that the financial manager
firms are committed to projects.
should take illegal or unethical actions in the hope of
Generally, the firm should select only those capital investment
increasing the value of the equity in the firm. The financial
proposals whose net present value is positive and the rate of
manager should best serve the owners of the business by
return exceeding the marginal cost of capital. It should also
identifying goods and services that add value to the firm
consider the profitability of each individual project proposal that
because they are desired and valued in the free market place.
will contribute to the overall profitability of the firm and lead to
SCOPE OF FINANCIAL MANAGEMENT
the creation of wealth.
Traditionally, financial management is primarily concerned
FINANCING DECISIONS
with acquisition, financing and management of assets of
Financing decisions assert that the mix of debt and equity
business concern in order to maximize the wealth of the firm
chosen to finance investments should maximize the value of
for its owners. The basic responsibility of the Finance Manager
investments made.
is to acquire funds needed by the firm and investing those
The finance decisions should consider the cost of finance
funds in profitable ventures that will maximize the firm's wealth,
available in different forms and the risks attached to it. The
as well as, generating returns to the business concern. Briefly,
principle of financial leverage or trading on the equity should
the traditional view of Financial Management looks into the
be considered when selecting the debt-equity mix or capital
structure decision. If the cost of capital of each component is
reduced, the overall weighted average cost of capital and
minimization of risks in financing will lead to the profitability of
the organization and create wealth to the owner.
DIVIDEND DECISIONS
The dividend decision is concerned with the determination of
quantum of profits to be distributed to the owners, the
frequency of such payments and the amounts to be retained
by the firm.
The dividend distribution policies and retention of profits will
have ultimate effect on the firm's wealth. The business firm
should retain its profits in the form of appropriations or
reserves for financing its future growth and expansion
schemes. If the firm, however, adopts a very conservative
dividend payments policy, the firm's share prices in the market
could be adversely affected. An optimal dividend distribution
policy therefore will lead to the maximization of shareholders'
wealth.
To summarize, the basic objective of the investment,
financing and dividend decisions is to maximize the firm's
wealth. If the firm enjoys the stability and growth, its share
prices in the market will improve and will lead to capital
appreciation of shareholders’ investment and ultimately
maximize the shareholders' wealth.
RELATIONSHIP BETWEEN FINANCIAL MANAGEMENT,
ACCOUNTING AND ECONOMICS
FINANCIAL MANAGEMENT AND ACCOUNTING
Just as marketing and production are major functions in an
enterprise, finance too is an independent specialized function
and is well knit with other functions.
Financial management is a separate management area. In
many organizations, accounting and finance functions are
intertwined and the finance function is often considered as part
of the functions of the accountant. Financial management is
however, something more than an art of accounting and
bookkeeping.
Accounting function discharges the function of systematic
recording of transactions relating to the firm's activities in the
books of accounts and summarizing the same for presentation
in the financial statements such as the Statement of
Comprehensive Income, the Statement of Financial Position,
the Statement of Changes in Shareholders' Equity and the
Cash flow Statement.
The finance manager will make use of the accounting
information in the analysis and review of the firm's business
position in decision making. In addition to the analysis of
financial information available from the books of accounts and
records of the firm, a finance manager uses the other methods
and techniques like capital budgeting techniques, statistical
and mathematical models, and computer applications in
decision making to maximize the value of the firm's wealth and
value of the owner's sealth. In view of the above, finance
function is considered a distinct and separate function rather
than simply an extension of accounting function.
Financial management is the key function and many firms
prefer to centralize the function to keep constant control on the
finances of the firm. Any inefficiency in financial management
will be concluded with a disastrous situation. But, as far as the
routine matters are concerned, the finance function could be
decentralized with adoption of responsibility accounting
concept. It is advantageous 10 decentralize accounting
function to speedup the processing of information. But since
the accounting information is used in making financial
decisions, proper controls should be exercised in processing of
accurate and reliable information to the needs of the firm. The
centralization or decentralization of accounting and finance
functions mainly depends on the attitude of the top level
management.
FINANCIAL MANAGEMENT AND ECONOMICS
The finance manager must be familiar with the
microeconomic and macroeconomic environment aspects of
business.
Microeconomics deals with the economic decisions of
individuals and firms. It focuses on the optimal operating
strategies based on the economic data of individuals and firms.
The concept of microeconomics helps the finance manager in
decisions like pricing, taxation, determination of capacity and
operating levels, break-even analysis, volume-cost-profit
analysis, capital structure decisions, dividend distribution
decisions, profitable product-mix decisions, fixation of levels of
inventory, setting the optimum cash balance, pricing of
warrants and options, interest rate structure, present value of
cash flows, and so forth.
Macroeconomics looks at the economy as a whole in which a
particular business concern is operating. Macroeconomics
provides insight into policies by which economic activity is
controlled. The success of the business firm is influenced by
the overall performance of the economy and is dependent
upon the money and capital markets, since the investible funds
are to be procured from the financial markets. A firm is
operating within the institutional framework, which operates on
the macroeconomic theories. The government's fiscal and
monetary policies will influence the strategic financial planning
of the enterprise. The finance manager should also look into
the other macroeconomic factors like rate of inflation, real
interest rates, level of economic activity, trade cycles, market
competition both from new entrants and substitutes,
international business conditions, foreign exchange rates.
bargaining power of buyers. unionization of labor, domestic
savings rate, depth of financial markets, availability of funds in
capital markets, growth rate of economy, government's foreign
policy, financial intermediation, banking system, and so forth.
REVIEW QUESTIONS AND PROBLEMS
Questions
1. What is the purpose of financial management? Describe the
kinds of activities that financial management deals with.
2. What is the difference in perspective between finance and
accounting?
3. Explain the shareholder wealth maximization goal of the firm
and how it can be measured. Make an argument for why it is a
better goal than maximizing profit.
4. Name and describe as many corporate stakeholders as you
can.
5. What conflicts of interest can arise between managers and
stockholders?
6. What are the three types of financial management
decisions? For each type of decision, give an example of a
business transaction that would be relevant.
7. What goal should always motivate the action of a firm's
financial manager?
II. Multiple Choice Questions
1. What is the primary goal of financial management?
a. Increase earnings
b. Maximizing cash flow
c. Maximizing shareholders’ wealth
d. Minimizing risk of the firm
2. Proper-risk return management means that
a. the firm should take as few risks as possible.
 b. consistent with the objectives of the firm, an
appropriate trade-off between risk and return should
be determined.
c. the firm should earn highest return possible.
d. the firm should value future profits more highly than
current profits.
3. Which of the following is not a major area of concern
and emphasis in modern financial management?
a. Inflation and its effect on profits
b. Stable short-term interest rates
c. Changing international environment
d. Increased reliance on debt
4. Which of the following is not a major area of concern
and emphasis in modern financial management?
a. Marginal analysis
b. Risk-return trade-off
c. Commodity trading
d. Changing financial institutions
5. A financial manager's goal of maximizing current or
short-term earnings may not be appropriate because
a. it fails to consider the timing of the benefits.
b. increased earnings may be accompanied by
unacceptably higher levels of risk.
c. earnings are subjective; they can be defined in
various ways such as accounting or economic
carings.
d. All of the given choices.
CHAPTER 2
RELATIONSHIP OF FINANCIAL
OBJECTIVES TO ORGANIZATIONAL
STRATEGY AND OBJECTIVES
For the purpose though of measuring performance and degree
of control, it is necessary to set objectives or goal in more
precise terms. The objectives are usually in quantitative terms
and are set within a time frame. The setting or
physical targets to be accomplished within a set time period
would provide the basis of conversion of the targets into
financial objectives.
STRATEGIC FINANCIAL MANAGEMENT
Strategic planning is long-range in scope and has its focus
on the organization as a whole. The concept is based on an
objective and comprehensive assessment of the present
situation of the organization and the setting up of targets to be
achieved in the context of an intelligent and knowledgeable
anticipation of changes in the environment. The strategic
financial planning involves financial planning, financial
forecasting, provision of finance and formulation of finance
policies which should lead the firm's survival and success.
The responsibility of a finance manager is to provide a basis
and information for strategic positioning of the firm in the
industry. The firm's strategic financial planning should be able
to meet the challenges and competition, and it would
lead to firm's failure or success.
The strategic financial planning should enable the firm to
judicious allocation of funds, capitalization of relative strengths,
mitigation of weaknesses, early identification of shifts in
environment, counter possible actions of competitor, reduction
in financing costs, effective use of funds deployed, timely
estimation of funds requirement, identification of business and
financial risk, and so forth.
The strategic financial planning is likewise needed to counter
the uncertain and imperfect market conditions and highly
competitive business environment. While framing financial
strategy, shareholders should be considered as one of the
constituents of a group of stakeholders, debenture holders,
banks, financial institutions, government, managers,
employees, suppliers and customers. The strategic planning
should concentrate on multidimensional objectives like
profitability, expansion growth, survival, leadership, business
success, positioning of the firm, reaching global markets and
brand positioning. The financial policy requires the deployment
of firm's resources for achieving the corporate strategic
objectives. The financial policy should align with the company's
strategic planning. It allows the firm in overcoming its
weaknesses, enables the firm to maximize the utilization of its
competencies and to direct the prospective business
opportunities and threats to its advantage. Therefore, the
finance manager should take the investment and finance
decisions in consonance with the corporate strategy.
A company's strategic or business plan reflects how it plans
to achieve its goals and objectives. A plan's success depends
on an effective analysis of market demand and supply.
Specifically, a company must assess demand for its products
and services, and assess the supply of its inputs (both labor
and capital). The plan must also include competitive analyses,
opportunity assessments and consideration of business
threats.
Historical financial statements provide insight into the
success of a company's strategic plan and are an important
input of the planning process. These statements highlight
portions of the strategic plan that proved profitable and, thus,
warrant additional capital investment. They also reveal areas
that are less effective and provide information to help
managers develop remedial action.
Once strategic adjustments are planned and implemented,
the resulting financial statements provide input into the
planning process for the following year, and this process
begins again. Understanding a company's strategic plan helps
focus our analysis of the company's short-term and long-term
financial objectives by placing them in proper context.
SHORT-TERM AND LONG-TERM FINANCIAL OBJECTIVES
OF A BUSINESS ORGANIZATION
Among are the primary financial objectives of a firm are the
following:
SHORT AND MEDIUM-TERM
• Maximization of return on capital employed or return on
investment
• Growth in earnings per share and price/earnings ratio
through maximization of net income or profit and adoption of
optimum level of leverage
• Minimization of finance charges
• Efficient procurement and utilization of short-term,
medium-term, and long-term funds
LONG-TERM
• Growth in the market value of the equity shares through
maximization of the firm's market share and sustained growth
in dividend to shareholders
• Survival and sustained growth of the firm
There have been a number of different, well-developed
viewpoints concerning what the primary financial objectives of
the business firm should be. The competing viewpoints are:
• The owner's perspective which hold that the only appropriate
goal is to maximize shareholder or owner's wealth, and;
• The stakeholders perspective which emphasizes social
responsibility over profitability (stakeholders include not only
the owners and shareholders, but also include the business's
customers, employees and local commitments).
While strong arguments speak in favor of both perspectives,
financial practitioners and academics now tend to believe that
the manager's primary responsibility should be to maximize
shareholder's wealth and give only secondary consideration to
other stakeholders' welfare.
Adam Smith, an 18th century economist was one of the first
and well known proponent of this viewpoint. He argued that, in
capitalism, an individual pursuing his own interest tends also to
promote the good of his community. He also pointed out that
acting through competition and the free price system, only
those activities most efficient and beneficial to society as a
whole would survive in the long run. Thus, those same
activities would also profit the individual most. Owners of the
firm hire managers to work on their behalf, so the manager is
morally, ethically, and legally required to act in the owners’ best
interests. Any relationships between the manager and other
firm stakeholders are necessarily secondary to the objective
that shareholders give to their hired managers.
The financial manager must have some goals or objectives
to guide decision involving the management of the firm's
assets, liabilities and equity. Hence, priorities must be set to
resolve conflicting goals.
To reiterate, the primary financial goal of the firm is to
maximize the wealth of its existing shareholders or owners.
Therefore, the overriding premise of financial management is
that the firm should be managed to enhance owner(s)
well-being. Shareholder's wealth depends on both the
dividends paid and the market price of the equity shares.
Wealth is maximized by providing the shareholders with the
target attainable combination of dividends per share and share
price appreciation.
While this may not be a perfect measure of shareholders’
wealth, it is considered one of the best available measures.
The wealth maximization goal is advocated on the following
grounds:
• It considers the risk and time value of money
It considers all future cash flow, dividends and earnings per
share
• It suggests the regular and consistent dividend payments to
the shareholders
• The financial decisions are taken with a view to improve the
capital appreciation of the share price
• Maximization of firm's value is reflected in the market price of
share since it depends on sharcholder's expectations
regarding profitability. long-run prospects, timing difference of
returns, risk distribution of returns of the firm
Critics of the wealth maximization objective however say that,
this objective is narrow and ignores the concept of wealth
maximization of society since society's resources are used to
the advantage only of a particular firm. The optimal allocation
of the society's resources should result in capital formation and
growth of the economy which should ultimately lead to
maximization of economic welfare of the society.
RESPONSIBILITIES TO ACHIEVE THE FINANCIAL
OBJECTIVES
INVESTING
The finance manager is responsible for determining how
scarce resources or funds are committed to projects. The
investing function deals with managing the firm's assets.
Because the firm has numerous alternative uses of funds, the
financial manager strives to allocate funds wisely within the
firm. This task requires both the mix and type of assets to hold.
The asset mit refers to the amount of pesos invested in current
and fixed assets.
The investment decisions should aim at investments in assets
only when they are expected to earn a return greater than a
minimum acceptable return which is also called as hurdle rate.
This minimum return should consider whether the money
raised from debt or equity meets the returns on investments
made elsewhere on similar investments.
The following areas are examples of investing decisions of a
finance manager:
a. Evaluation and selection of capital investment proposal
b. Determination of the total amount of funds that a firm can
commit for investment
c. Prioritization of investment alternatives
d. Funds allocation and its rationing
c. Determination of the levels of investments in working capital
(i.e. inventory, receivables, cash, marketable securities and its
management)
f. Determination of fixed assets to be acquired
g. Asset replacement decisions
h. Purchase or lease decisions
i. Restructuring reorganization mergers and acquisition
j.Securities analysis and portfolio management
FINANCING
The finance manager is concerned with the ways in which the
firm obtains and manages the financing it needs to support its
investments. The financing objective asserts that the mix of
debt and equity chosen to finance investments should
maximize the value of investments made. Financing decisions
call for good knowledge of costs of raising funds, procedures in
hedging risk, different financial instruments and obligation
attached to them. In fund raising decisions, the finance
manager should keep in view how and where to raise the
money, determination of the debt-equity mix, impact of interest,
and inflation rates on the firm, and so forth.
The finance manager will be involved in the following finance
decisions:
a. Determination of the financing pattern of short-term,
medium-term and long-term funds requirements
b. Determination of the best capital structure or mixture of debt
and equity
financing
c. Procurement of funds through the issuance of financial
instruments such as equity shares, preference shares, bonds,
long-term notes, and so forth
d. Arrangement with bankers, suppliers, and creditors for its
working capital, medium-term and other long-term funds
requirement
e. Evaluation of alternative sources of funds
OPERATING
This third responsibility area of the finance manager
concerns working capital management. The term working
capital refers to a firm short-term asset (i.e., inventory,
receivables, cash, and short-term investments) and its
short-term liabilities (i.e.. accouts pavable, short-term loans).
Managing the firm's working capital is a day-to-day
responsibility that ensures that the firm has sufficient resources
to continue its operations and avoid costly interruptions. This
also involves a number of activities related to the firm's
receipts and disbursements of cash.
Some issues that may have to be resolved in relation to
managing a firm's working capital are:
a. The level of cash, securities and inventory that should be
kept on hand
b. The credit policy (i.e., should the firm sell on credit? If so,
what terms should be extended?)
c. Source of short-term financing (i.e., if the firm would borrow
in the short-term, how and where should it borrow?)
d. Financing purchases of goods (i.e., should the firm purchase
its raw materials or merchandise on credit or should it borrow
in the short-term and pay cash?)
ENVIRONMENTAL “GREEN” POLICIES AND THEIR
IMPLICATIONS FOR THE MANAGEMENT OF THE
ECONOMY AND FIRM
Private property rights can promote prosperity and
cooperation and at the same time protect the environment, but
do they protect the environment sufficiently? In recent years,
people have increasingly turned to the government to achieve
additional environmental improvements. Sometimes, people
turned to government because property rights failed to hold
polluters accountable for the costs they were imposing on
others. In these "external cost cases", government may be
able to improve accountability and protect rights more
efficiently by regulation. In other instances, people with strong
desires for various environmental amenities (for example,
green spaces, hiking trails and wilderness lands) want the
government to force others to help pay for them.
Courts help owners protect their property against invasions
by others, including polluters. In some cases however, it is
difficult - if not impossible - to define, establish and fully protect
property rights. This is particularly true when there is either a
large number of polluters or a large number of people harmed
by the emissions, or both. In these large numbers of cases,
high transaction costs undermine the effectiveness of the
property rights - market exchange approach. For example,
consider the air quality in a large city such as Manila or
Quezon City. Millions of people are harmed when pollutants
are put into the air. But millions of people also contribute to the
pollution as they drive their cars. Property rights alone will be
unable to handle large-number cases like this efficiently. More
direct regulations may generate a better outcome.
Although government regulation is an alternative method of
protecting the environment, the regulatory approach also has a
number of deficiencies. First, government regulation is often
sought precisely because the harms are uncertain and the
source of the problem cannot be demonstrated, so relief from
the courts is difficult to obtain. But when the harms are
uncertain, so are the benefits of reducing them. Second, by its
very nature, regulation overrides or ignores the information and
incentives provided by market signals. Accountability of
regulators for the costs they impose is lacking, just as
accountability for polluters is missing in the market sector
when secure and tradable property rights are not in place. The
tunnel vision of regulators, each assigned to oversee a small
part of the economy, is not properly constrained by readily
observable costs. Third, regulation allows special interests to
use political power to achieve objectives that may be quite
different from the environmental goals originally announced.
The global warming issue illustrates all of these problems and
the uncertainties that they generate.
People turn to government to get what they cannot get in
markets. In many cases, they are seeking to get what they
want with a subsidy from others. Government can provide
protection from harms, as in regulation that reduces pollution,
or production of goods and services, as in the provision of
national parks. Government can indeed shift the cost of
services from some citizens to others, and can do the same
with benefits from its programs. There is little reason, however,
to expect a net increase in efficiency when the government
steps in.
That is true in environmental matters, as well as in many other
areas of citizen
concern.
When it is difficult to assign and enforce private property
rights, markets often result in outcomes that are inefficient.
This is often the case when large numbers of people engage in
actions that impose harm on others. Government regulation
has some premise but also poses some problems of its own.
Global warming could exert a sizeable adverse impact on
human welfare, but there is considerable uncertainty about
both its cause and the potential gains that might be derived
from regulations such as those of the Kyoto treaty. Global
temperature changes have been observed previously. We do
not know that the current warming is the result of human
activity. We do not even know whether on balance, a warming
would exert an adverse impact. These uncertainties increase
the attractiveness of adaptation as an option to regulation.
Market-like schemes can reduce the costs of reaching a
chosen environment goal, but the programs provide little help
in choosing the right goal.
Government ownership of national parks, as with other
lands, has brought troublesome results along with benefits, but
there seems to be progress in moving closer to market
solutions that provide better information and incentives for
government managers.
Given that stock market investors emphasize financial results
and the maximization of shareholder value, one can wonder if
it makes sense for a company to be socially responsible. Can
companies be socially responsible and oriented toward
shareholder wealth at the same time? Many businessmen
think so and so do most big business establishments that they
have adopted well-laid environmental-saving strategies that
can observe such as recycling programs, pollution control,
tree-planting activities and so forth. The benefits come a little
at a time but one can be sure they will add up. If an investor
wants wealth maximization, management that minimizes
wastes might do the other little things right that make a
company well-run and profitable.
REVIEW QUESTIONS AND PROBLEMS
I. Questions
1. Suppose you were the financial manager of a not-for-profit
business (a not-for-profit hospital). What kinds of goals do you
think would be appropriate?
2. Evaluate the following statement: Managers should not
focus on the current stock value because doing so will lead to
an overemphasis on short-term profits at the expense of
long-term profits.
3. If a company's board of directors wants management to
maximize shareholders’ wealth, should the CEO's
compensation be set as a fixed amount, or should the
compensation depend on how well the firm performs? If it is to
be based on performance, how should performance be
measured? Would it be easier to measure performance by the
growth rate in reported profits or the growth rate in the stock's
intrinsic value?
Which would be the better performance measure? Why?
4. Should stockholder wealth maximization be thought of as a
long-term or short-term goal? For example, if one action
increases a firm's stock price from a current level of P1,000 to
P2,000 in 6 months and then to P3.000 in 5 years but another
action keeps the stock at P1000 for several years but then
increases it to P4,000 in 5 years, which action would be
better? Think of some specific corporate actions that have
these general tendencies.
5. What are some actions that stockholders can take to ensure
that management's and stockholders' interests are aligned?
6. The president of Southern Tagalog Corporation (STC) made
this statement in the company's annual report: "STC's primary
goal is to increase the value of our common stockholder's
equity". Later in the report, the following announcements were
made:
a. The company contributed P1.5 million to the symphony
orchestra.
b. The company is spending P500 million to open a new plant
and expand operations. No profits will be produced by the
operation for 4 years, so earnings will be depressed during this
period versus what they would have been had the decision
been made not to expand.
c. The company holds about half of its assets in the form of
government treasury bonds, and it keeps these funds available
for use in emergencies. In the future, though. STC plans to
shift its emergency funds from treasury bonds to common
stocks.
Discuss how STC's stockholders might view each of these
actions and how the actions might affect the stock price.
7. Miguel Enterprises recently made a large investment to
upgrade its technology. While these improvements won't have
much effect on performance in the short run, they are expected
to reduce future costs significantly. What effect will this
investment have on Miguel Enterprises' earnings per share this
year? What effect might this investment have on the
company's intrinsic value and stock price?
Multiple Choice Questions
1. Which of the following statements is true?
a. The higher the profit of a firm, the higher the value of the
firm is assured of receiving in the market.
b. Social responsibility and profit maximization are
synonymous.
c. Maximizing the earnings of the firm is the primary goal of
financial management.
d. There are some serious problems with the financial goal of
maximizing the earnings of the firm.
2. Corporate social responsibility is
a. effectively enforced through the controls envisioned by
classical economics.
b. the obligation to shareholders to earn a profit.
c. the duty to embrace service to the public interest.
d. the obligation to serve long-term organizational interests.
3. A common argument against corporate involvement in
socially responsible behavior is that
a. It encourages government intrusion in decision making.
b. as a legal person, a corporation is accountable for its
conduct.
c. It creates goodwill.
d. in a competitive market, such behavior incurs costs that
place the company at a disadvantage.
4. Which of the following statements is false?
a. Because socially desirable goals can impede profitability in
many instances, managers should not try to operate under the
assumption of wealth maximization.
b. As finance emerged as a new field, much emphasis was
placed on mergers and acquisitions.
c. Timing is a particularly important consideration in financial
decisions.
d. During the 1930s, the government assumed a much greater
role in regulating the securities industry.
5. Which of the following statements is false?
a. In the mid 1950s, finance began to change to a more
analytical, decision oriented approach.
b. Recently, the emphasis of financial management has been
on the relationships between risk and returns.
c. Inflation has led to phantom profits and undervalued assets.
d. For as long as satisfactory level of profit is earned, the
financial manager need not be concerned with unethical
behavior.
CHAPTER 3
FUNCTIONS OF FINANCIAL MANAGEMENT
ROLE OF FINANCE MANAGER
Having examined the field of finance and some of its more
recent developments, let us turn our attention to the
functions of the financial manager.
Figure 3-1 shows the financial manager's role in achieving
the primary goal or the firm.
Figure 3-1. The financial manager’s role in achieving the
goal of the firm
In striving to maximize owners' or shareholders' wealth, the
financial manager makes decisions involving planning,
acquiring, and utilizing funds which involve a set of risk-return
trade-offs. These financial decisions affect the market value of
the firm's stock which leads to wealth maximization.
In the short run, many factors affect the market price of a
firm's shares which are beyond management's control. Some
of the changes in market price do not reflect a fundamental
change in the value of the firm. In the long run, increased
prices of the firm's stock reflect an increase in the value of the
firm. Hence, financial decision making should take a
longer-term perspective.
It is the responsibility of financial management to allocate
funds to current and fixed assets, to obtain the best mix of
financing alternatives, and to develop an appropriate dividend
policy within the context of the firm's objectives. The daily
activities of financial management include credit management,
inventory control, and the receipt and disbursement of funds.
Less routine functions encompass the sale of stocks and
bonds and the establishment of capital budgeting and dividend
plans.
The appropriate risk-return trade-off must be determined to
maximize the market value of the firm for its shareholders. The
risk-return decision will influence not only the operational side
of the business (capital versus labor) but also the financing mix
(stocks versus bonds versus retained earnings).
THE FINANCE ORGANIZATION
The financial management function is usually associated
with a top officer of the firm such as a Vice President of
Finance or some other Chief Financial Officer (CFO). Figure
3-2 is a simplified organizational chart that highlights the
finance activity in a large firm. As shown, the Vice President of
finance coordinates the activities of the treasurer and the
controller. The Controller's office handles cost and financial
accounting, tax payments, and management information
systems. The Treasurer's office is responsible for managing
the firm's cash and credit, its financial planning, and its capital
expenditures.
Figure 3-2. A Sample of Simplified Organizational Chart
RELATIONSHIP WITH OTHER KEY FUNCTIONAL
MANAGERS IN THE ORGANIZATION
Finance is one of the major functional areas of a business.
For example, the functional areas of business operations for a
typical manufacturing firm are manufacturing, marketing, and
finance. Manufacturing deals with the design and production of
a product. Marketing involves the selling, promotion, and
distribution of a product. Manufacturing and marketing are
critical for the survival of a firm because these areas determine
what will be produced and how these products will be sold.
However, these other functional areas could not operate
without funds. Since finance is concerned with all of the
monetary aspects of a business, the financial manager must
interact with other managers to ascertain the goals that must
be met, when and how to meet them. Thus, finance is an
integral part of total management and cuts across functional
boundaries.
CORPORATE GOVERNANCE
Corporate governance is the process of monitoring managers
and aligning their incentives with shareholders goals. In reality,
because shareholders are usually inactive, the firm actually
seems to belong to management. Generally speaking, the
investing public does not know what goes on at the firm's
operational level. Managers handle day-to-day operations, and
they know that their work is mostly unknown to investors. This
lack of supervision demonstrates the need for monitors. Figure
3-3 shows the people and organizations that help monitor
corporate activities.
Figure 3-3. Corporate Governance Monitors
The monitors inside a public firm are the board of directors,
who are appointed to represent shareholders' interest. The
board hires the CEO, evaluates management, and can also
design compensation contracts to tie management's salaries to
firm performance.
The monitors outside the firm include auditors, analysts,
investment banks, and credit rating agencies. External auditors
examine the firm’s accounting systems. and comment on
whether financial statements fairly represent the firm's financial
position. Investment analysts keep tract of the firm's
performance, conduct their own evaluations of the company's
business activities, and report to the investment community.
Investment banks, which help firms access capital markets,
also monitor firm performance. Credit analysts examine a
firm’s financial strength for its debt holders. The Government
also monitors business activities through the Securities and
Exchange Commission (SEC), Bureau of internal Revenue
(BIR), Bangko Sentratng Pilipinas (BSP), and so forth.
ETHICAL BEHAVIOR
Ethics are of primary importance in any practice of finance.
Finance professionals commonly manage other people's
money. For instance, corporate managers control the
stockholders' firm, bank employees perform cash receipts and
disbursements functions and investment advisors manage
people’s investment portfolios.
These fiduciary relationships oftentimes create tempting
opportunities for finance professionals to make decisions that
either benefit the client or benefit the advisors themselves.
Strong emphasis on ethical behavior and ethics training and
standards are provided by professional associations such as
the Finance Executives of the Philippines (FINEX), Bankers
Association of the Philippines, Investment Professionals, and
so forth. Nevertheless, as with any profession with millions of
practitioners, a few are bound to act unethically. In a number of
instances, the corporate governance system has created
ethical dilemmas and has failed to prevent unethical managers
from stealing from firms which ultimately means stealing from
owners or stockholders.
Governments all over the world have passed laws and
regulations meant to ensure compliance with ethical codes of
behavior. And if professionals do not act appropriately,
governments have set up strong punishment for financial fraud
and abuse. Ultimately, financial manager must realize that they
owe the owners/shareholders the very best decisions to
protect and further shareholder interests, but they also have a
broader obligation to society as a whole.
REVIEW QUESTIONS AND PROBLEMS
Questions
1. In a large corporation, what are the two distinct groups that
report to the chief financial officer? Which group is the focus of
corporate finance?
2. Can our goal of maximizing the value of the equity shares
conflict with other goals, such as avoiding unethical or illegal
behavior? In particular, do you think subjects like customer and
employee safety, environment and general good of society fit
in this framework, or are they essentially ignored? Think of
some specific scenarios to illustrate your answer.
3. Would our goal of maximizing the value of the equity shares
be different if we were thinking about financial management in
a foreign country?
Why or why not?
4. Critics have charge that compensation to top managers in
the United States is simply too high and should be cut back.
For example, focusing on large corporations, Ray Irani of
Occidental Petroleum has been one of the best-compensated
CEOs in the United States, earning about $54.4 million in 2007
alone and SS50 million over the 2003-2007 period. Are such
amounts excessive? In answering, it might be helpful to
recognize that superstar athletes such as Roger Federer, top
entertainers such as Justin Bieber and Manny Pacquiao and
many others at the top of their respective fields earn at least as
much, if not a great deal more.
5. Why should effective corporate governance be in place?
6. Distinguish the role of an external auditor from the role of an
internal auditor.
7. Distinguish the functions of a controller from the functions of
the treasurer.
Multiple Choice Questions
1. All of the following are functions of the financial manager
except
a. Analyzing and planning the company's performance.
b. Anticipating the company's financial needs.
c. Assigning the market price of the company's stock
d. Allocating funds to the most profitable asset.
2. Which of the following statements is false?
a. The financing decision involves the process of
allocating funds for investment in competing assets.
b. The treasurer would be responsible for activities such
as managing cash balances, granting credit to
customers and managing the process of issuing new
securities.
c. The optimal capital structure is the best combination
of long-term debt and equity.
d. It is necessary to determine the appropriate
risk-return trade-off to maximize the market value of
the firm for its shareholders.
3. Regine is a financial manager who has discovered that her
company is violating environmental regulations. If her
immediate superior is involved, her appropriate action is to
a. do nothing since she has a duty of loyalty to the
organization.
b. consult the audit committee.
c. present the matter to the next higher managerial
level.
d. confront her immediate superior.
4. If a financial manager discovers unethical conduct in his/her
organization and fails to act, he/she will be in violation of which
ethical standard(s)?
a. "Actively or passively subvert the attainment of the
organization's legitimate and ethical objectives."
b. "Communicate unfavorable as well as favorable
information."
c. "Condone the commission of such acts by others
within their organizations."
d. All of the answers are correct.
5. Integrity is an ethical requirement for all financial managers.
One aspect of integrity requires
a. performance of professional duties in accordance with
applicable laws.
b. avoidance of conflict of interest.
c. refraining from improper use of inside information.
d. maintenance of an appropriate level of professional
competence.
6. A financial manager discovers a problem that could mislead
users of the firm's financial data and has informed his/her
immediate superior. He/she should report the circumstances to
the audit committee and/or the board of directors only if
a. the immediate superior, who reports to the chief
executive officer, knows about the situation but
refuses to correct it.
b. the immediate superior assures the financial manager
that the problem will be resolved.
c. the immediate superior reports the situation to his/her
superior.
d. the immediate superior, the firm's chief executive
officer, knows about the situation but refuses to
correct it.
CHAPTER 4
FORMS OF BUSINESS ORGANIZATION
THE ORGANIZATION OF THE BUSINESS FIRM
The business firm is an entity designed to organize raw
materials, labor, and machines with the goal of producing
goods and/or services. Firms
1. purchase productive resources from households and
other firms,
2. transform them into a different commodity, and
3. sell the transformed product or service to consumers
For business firms engaged in retail or trading activities,
transforming purchased goods into a different commodity does
not necessarily take place.
Every society, no matter what type of economy it has, relies
on business firms to organize resources and transform them
into products. In market economies, most firms choose their
own price, output level, and methods of production. They get
the benefits of sales revenues, but they also must pay the
costs of the resources they use.
Business firms can be organized in one of three ways: as a
proprietorship, a partnership, or a corporation. The structure
chosen determines how the owners share the risks and
liabilities of the firm and how they participate in making
decisions.
LEGAL FORMS OF BUSINESS ORGANIZATION
PROPRIETORSHIP
A sole proprietorship is a business owned by a single person
who has complete control over business decisions. This
individual owns all the firm's assets and is responsible for all its
liabilities. More businesses are sole proprietorship than any
form of business organization. From a legal point of view, the
owner of a proprietorship is not separable from the business
and is personally liable for alL debts of the business. From an
accounting prospective, however, the business is an entity
separate from the owner (proprietor). Therefore, the financial
statements of the business present only those assets and
liabilities pertaining to the business.
The owner cannot be paid salary or wages from the
business. Instead, the owner may withdraw funds or other
property from the business. These withdrawals are treated as
reduction of owner's equity or financial interest of the owner in
the business. The business itself does not pay any income
taxes. The income or loss of the business is reported on the
owner's personal income tax return on a supporting schedule.
Among the advantages of a sole proprietorship are:
1. Ease of entry and exit
- A sole proprietorship requires no formal charter and is
inexpensive to form and dissolve.
2. Full ownership and control
- The owner has full control, reaps all profits and bears
all losses.
3. Tax savings
- The entire income generated by the proprietorship
passes directly to the owner. This may result in a tax
advantage if the owner's tax rate is less than the tax
rate of a corporation.
4. Few government regulations
- A sole proprietorship has the greatest freedom as
compared with any form of business organization.
Major disadvantages of the proprietorship form include:
1. Unlimited liability
- The owner is personally liable or responsible for any
and all business debts. Thus, the owner's personal
assets can be claimed by the creditors if the firm
defaults on its obligations.
2. Limitations in raising capital
- Fund-rising ability is limited. Resources may be
limited to the assets of the owner and growth may
depend on his or her ability to borrow money.
3. Lack of continuity
- Upon death or retirement of the owner, the
proprietorship ceases to exist.
Therefore, the proprietorship may be an ideal form of
business organization when the following conditions exist:
● The anticipated risk is minimum and adequately
covered by insurance.
● The owner is either unable or unwilling to maintain the
necessary organizational documents and tax returns
of more complicated business entities.
• The business does not require extensive borrowing.
PARTNERSHIP
A partnership is a legal arrangement in which two or more
persons agree to contribute capital or services to the business
and divide the profits or losses that may be derived therefrom.
Partnership may operate under varying degrees of formality.
For example, a formal partnership may be established using a
written contract known as the partnership agreement which is
filed with the Securities and Exchange Commission.
Partnership may be either general or limited.
A general partnership is one in which each partner has
unlimited liability for the debts incurred by the business.
General partners usually manage the firm and may enter into
contractual obligations on the firm's behalf. Profits and asset
ownership may be divided in any way agreed upon by the
partners.
A limited partnership is one containing one or more general
partners and one or more limited partners. The personal
liability of a general partner for the firm's debt is unlimited while
the personal liability of limited partners is limited to their
investment. Limited partners cannot be active in management.
Advantages of a partnership include among others the
following:
1. Ease of formation
- Forming a partnership may require relatively little
effort and low startup costs.
2. Additional sources of capital
- A partnership has the financial resources of several
individuals.
3. Management base
- A partnership has a broader management base or
expertise than a sole proprietorship.
4. Tax Implication
- A partnership like a proprietorship does not pay any
income taxes. The income or loss of the business is
distributed among the partners in accordance with the
partnership and each partner reports his or her
portion whether distributed or not on personal income
tax return
Disadvantages of partnership are:
1. Unlimited liability
- General partners have unlimited liability for the debts
and litigations of the business.
2. Lack of continuity
- A partnership may dissolve upon the withdrawal or
death of a general partner, depending on the
provisions of the partnership.
3. Difficulty of transferring ownership
- It is difficult for a partner to liquidate or transfer
ownership. It varies with conditions set forth in the
partnership agreement.
4. Limitatioris in raising capital
- A partnership may have problems raising large
amounts of capital because many sources of funds
are available only to corporations.
CORPORATION
A corporation is an artificial being created by law and is a
legal entity separate and distinct from its owners. This legal
entity may own assets, borrow money and engage in other
business entities without directly involving the owners. In many
corporations, owners who are also called shareholders do not
directly manage the firm. Instead they select managers
designated as the Board of Directors to run the firm for them.
The Board of Directors is authorized to act in the corporation's
behalf.
The incorporation process is initiated by filing the articles of
incorporation and other requirements with the Securities and
Exchange Commission (SEC). The articles of incorporation
includes among others the following:
● Incorporators
● Name of the corporation
● Purpose of the corporation
● Capital stock
● Authorized shares
After the corporation is legally formed, it will then issue its
capital stock. Ownership of this stock is evidenced by a stock
certificate. The corporate bylaws which are rules that govern
the internal management of the company are established by
the board of directors and approved by the shareholders.
These bylaws may be amended or extended from time to time
by shareholder.
Advantages of a corporation are:
1. Limited liability
- Shareholders are liable only to the extent of their
investment in the corporation. Thus, shareholders can
only lease what they have invested in the firm's
shares, not any other personal assets. However,
 limited liability is not all-encompassing. Government
may pass through the corporate shield to collect
unpaid taxes. Also, it is not uncommon for creditors to
require that major shareholders personally co-sign for
credit extended to the corporation. Thus, upon default
by the business, the creditors may sue both the
corporation and shareholders who have co-signed.
2. Unlimited life
- Corporations continue to exist even after death of the
owners.
3. Ease in transferring ownership
- Shareholders can easily sell their ownership interest
in most corporations by selling their stock without
affecting the legal form of business organizations.
The ability to sell stock provides corporations with a
stronger financial base and the capital needed for
expansion
4. Ability to raise capital
- Corporations can raise capital through the sale of
securities such a bonds to investors who are lending
money to the corporations and equity securities such
as common stock to investors who are the owners.
Disadvantages of a corporation include:
1. Time and cost of formation
- Registration of public companies with the SEC may
be time-consuming and costly.
2. Regulation
- Corporations are subject to greater government
regulations than other forms of business
organizations. Shareholders can not just withdraw
assets from the business. They can only receive
corporate assets when dividends are declared and
these amounts may be subject to limits imposed by
law.
3. Taxes
- Corporations pay taxes on income they have earned.
The complexity of the subject of taxation demands the
advice of a qualified tax accountant.
The need of large businesses for outside investors and
creditors is such that, the corporate form will generally be the
best for such firms. We focus on corporations in the chapters
ahead because of the importance of the corporate form not
only locally but also in world economies. Also, a few financial
management issues, such as dividend policy are unique to
corporations. However, businesses of all types and sizes need
financial management, so the majority of the subjects we
discuss bear on any form of business.
REVIEW QUESTIONS AND PROBLEMS
Questions
1. What are the three basic forms of business ownership?
What are the advantages and disadvantages to each?
2. Between the three basic forms of business ownership,
describe the ability of each form to access capital.
3. Explain how the founder of a business can eventually lose
control of the firm. How can the founder ensure this will not
happen?
4. Who owns a corporation? Describe the process whereby the
owners control the firm's management. What is the main
reason that an agency relationship exists in the corporate form
of organization? In this context, what kinds of problems can
arise?
Multiple Choice Ouestions
1. One of the major disadvantages of a sole proprietorship is
a. that there is unlimited liability to the owner.
b. the simplicity of decision making.
c. low organizational costs.
d. low operating costs.
2. The partnership form of organization
a. avoids the double taxation of earnings and dividends
found in the corporate form of organization.
b. usually provides limited liability to the partners.
c. has unlimited life.
d. simplifies decision making.
3. A corporation is
a. owned by stockholders who enjoy the privilege of
limited liability.
b. easily divisible between owners.
c. separate legal entity with perpetual life.
d. all of the above.
Case
In early 2008, Dee and Lyn Royes formed the Super
Delicious Cake Company. The company produced a full line
ableakes and its specialties included cheese cake, lemon
pound cake, double-iced cake and double-chocolate cake. The
couple formed the company as an outside interest and both
continued to work at their current jobs. Dee did all the baking
and Lyn handled the marketing and distribution. With good
product quality and a sound marketing plan, the company grew
rapidly. In early 2013, the company was featured in a widely
distributed entrepreneurial magazine. Later that year, the
company was featured in Best Desserts, a leading specialty
food magazine. After the article appeared in Best Desserts,
sales exploded and the company began receiving orders from
all over the world
Because of the increased sales, Dee left his other job,
followed shortly by Lyn. The company hired additional workers
to meet demand. Unfortunately, the fast growth experienced by
the company led to cash flow and capacity problems. The
company is currently producing as many cakes as possible
with the assets it owns, but demand for its cakes is still
growing. Further, the company has been approached by a
national supermarket chain with a proposal to put four of its
cakes in all of the chain's stores, and a national restaurant
chain has connected the company about selling Super
Delicious cakes without a brand name.
Dee and Lyn have operated the company as a sole
proprietorship. They have approached you to help manage and
direct the company's growth. Specifically, they have asked you
to answer the following questions.
1. What are the advantages and disadvantages of changing
the company organization from a sole proprietorship to a
limited partnership?
2. What are the advantages and disadvantages of changing
the company organization from a sole proprietorship to a
corporation?
3. Ultimately, what action would you recommend the company
undertake? Why?