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Copyright by R. S. Pradhan All rights reserved.

WELCOME TO

CHAPTER 1: INTRODUCTION

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Copyright by R. S. Pradhan All rights reserved.
CHAPTER 1: INTRODUCTION
Importance
1. Finance: an exciting subject, a way of life,
financial news.
2. Dramatic developments in financial markets.
3. Financial problems faced by firms are similar.
The Finance Function
Key finance functions are concerned with
investment, financing, & dividend decisions.
Major job of financial manager is to plan for,
obtain, & use funds.
Earlier emphasis was on obtaining funds.
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Several activities:
1) Planning & forecasting
2) Raising & utilization of funds
3) Interaction with other functional managers
(coordination & control)
4) Linking the firm to the money & capital
markets (relations with the financial markets)
5) Managing risks.

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Copyright by R. S. Pradhan All rights reserved.
Finance in organization structure
Board of Director
Chairman Board/ Chief Executive Officer (CEO)
President / Chief Operations Officer (COO)
Vice President
Production
Vice President
Finance
Vice President
Marketing
Treasurer Controller
Tax
Manag
er
Cost
Accounti
ng
Cash
Manager
Financial
Planning
Capital
Expenditur
e
Credit
Manage
r
Fin.
Actg.
Manag
er
Data
processi
ng
manager
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Copyright by R. S. Pradhan All rights reserved.
Finance in organization structure
CFO is assisted by treasurer & controller.
Treasurer's functions:
- Acquisition & use of fund
- Working capital (cash, receivables, & inventory)
mgmt.
- Capital expenditure
- Financial planning & control
- Preparation of cash budgets
- Pension fund
- Relation with bankers.
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Controller's functions:
- Financial accounting
- Cost accounting
- Reporting & control - Data processing
- Preparation of financial statements, budgets &
pay roll
- Taxes
- Auditing
Whether fin. mgmt. is more concerned with
treasurers or controllers functions?
Large firms use Finance Committees/ Budget
committee/ Capital Appropriation Committee.
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Goal of Financial Management
To make money, to add value for the owners.
To avoid financial distress & bankruptcy
To beat the competition
To maximize sales or market share
To minimize cost
The above goals are not appropriate goals.
To maximize profits
Profit maximization:
- most commonly cited goal
- real test of financial criteria over the long run.
- formal purpose for which companies are
established.
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- pursuit of maximum profits creates greatest
economic welfare
- ensures natural selection
Problems with profit maximization
1. Not a clear goal. It is vague. Ambiguous.
Profit before tax? After tax? or EPS?
2. Profit in the short-run or in the long-run?
3. Ignores time value of money
4. Ignores risk or uncertainty
Shareholders' wealth maximization
Goal of the firm is shareholders' wealth
maximization.
Maximizing current market value per share of
the existing stock.
No ambiguity
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No short-run versus long-run issue.
One dimensional goal (If stockholders are
winning, everybody else will be winning.
Stockholders are residual owners).
How to apply SWM in the case of non-traded
stock? Proprietorship? Partnership?
Corporation? Not-for-profit organization?
How to apply SWM in choosing projects?
Main challenge lies in obtaining information &
assess the likely impact of decision on firms
market value of share. Change style of thinking.
Discipline of the financial markets is maintained
(If MPS is high, the firm can raise capital easily).
Also considers the goal of social responsibility:
(SWM requires well managed operation,
efficiency, innovation, new products, better
technology, quality products at a lower cost).
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Contractual theory of nature of the firm has now
become widely held.
It views the firm as a network of contracts.
The contracts specify roles & responsibilities of
the various participants/stakeholders (workers,
managers, owners, & creditors/lenders).
Still potential conflict of interest exists between
different stakeholders because they have
personal goals as well.
Agency problem in business mainly refers to:
a) stockholders & managers
b) stockholders & bondholders
The Agency Problem (Theory)
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Stockholders & managers:
In theory, managers are the agents of the
owners.
But managers exercise control over the firm -
major agency problem in business.
Agency problem is more acute in large firms.
A separation of ownership & control gives rise
to agency problem.
Agency problem refers to divergence of interest
between stockholders & managers: principal &
his agent.
J ensen & Meckling: 'Theory of the Firm:
Managerial Behavior, Agency Costs, and
Ownership Structure', J ournal of Financial
Economics, 3, (October 1976), pp. 350-360.
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They described how agency problem arises
when managers have fractional/ no ownership.
Fractional/ no ownership leads them to work
less actively & demand more perquisites.
Managers demand more perquisites, which
would not have been there if they own all
shares.
Stockholders want managers to maximize the
market value of share but managers pursue
some other goals, e.g., greater firm size.
This is so because quite often managers
compensation is related to sales or total assets.
How to solve agency problem? Agency costs:
1) Changes in organization system.
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2) Setting up monitoring unit, etc.
3) Bonding assurances
4) Limit managerial autonomy
5) Provide incentives: profit sharing, stock
options, bonuses & perquisites.
Managerial control or compensation plans?
Stock prices also serve as a performance
monitor.
Stock prices are affected by the general
economic trend or industrywide factors.
Managerial labor market, which prices the
human capital of managers.
It refers to managerialism, which means self-
serving behavior by managers.
The shareholders may exercise ultimate power
to replace management.
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Stockholders & bondholders
Divergence of interest between stockholders
& bondholders.
Bondholders provide a good portion of
capital but receive a fixed interest in return.
Shareholders undertake risky investments
from the borrowed capital & increase their
wealth.
Shareholders take advantage at the cost of
bondholders.
Quiz - next class.
Thanking you