Block, Hirt, and Danielsen

Foundations of Financial Management

17th edition

Chapter 01

– The Goals and Activities of Financial

Management

©2019 McGraw-Hill Education. All rights reserved. Authorized only for instructor use in the classroom.  No reproduction or further distribution permitted without the prior written consent of McGraw-Hill Education.
 Learning Objectives
The field of finance integrates concepts from economics,
accounting, and a number of other areas.
A firm can have many different forms of organization.
The relationship of risk to return is a central focus of finance.
The primary goal of financial managers is to maximize the wealth
of the shareholders.
Financial managers attempt to achieve wealth maximization
through daily activities such as credit and inventory management
and through longer-term decisions related to raising funds.
The financial turmoil that roiled the markets between 2001 and
2012 resulted in more regulatory oversight of the financial
markets.
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 The Field of Finance
Economics provides broad pictures of economic
environments for decision making
Accounting provides financial data through:
• Income statements
• Balance sheets
• Statement of cash flows
Finance links economic theory with accounting
numbers

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 Evolution of the Field of Finance 1

1900s—Finance emerges as separate field from

economics
1930s—Financial practices revolve around such
topics as
• Capital preservation
• Maintenance of liquidity
• Reorganization of financially troubled corporations
• Bankruptcy process

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 Evolution of the Field of Finance 2

1950s—Finance becomes more analytical

• Financial capital (money) used to purchase real
capital (long-term plant and equipment)
• Cash and inventory management
• Capital structure theory
• Dividend policy
• Financial manager making day-to-day decisions

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 Modern Issues in Finance 1

Focus has been on

• Risk-return relationships
• Maximizing return for given risk level
• Portfolio management
• Capital structure theory
New financial products focusing on hedging are
now widely used
• Reducing risk by changing interest rates

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 Modern Issues in Finance 2

Inflation (increase of prices)—key variable in

financial decisions
Disinflation (a slowing down of price increases)
Significant factors during decision making
• Effects of inflation/deflation on financial forecast
• Required rates of return for capital budgeting
decisions
• Cost of capital

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 Risk Management and a
Review of the Financial Crisis
Reasons for recent financial crisis
• Extension of credit to high-risk borrowers
• Creation/sale of mortgage-backed securities
• Losses from credit defaults in excess of banks’ capital in
many cases
Creation of complicated, unregulated financial products
like credit default swaps (CDS)
Government action and bail-outs
• Federal Reserve money
New regulations for financial institutions
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 The Dodd-Frank Act 1

Wall Street Reform and Consumer Protection

Act of 2010
• Passed in response to financial crisis
• Improve accountability and transparency
• Protected taxpayers through financial institutions
• Protected consumers from abusive practices in the
financial industry
• First major financial regulatory change since the
Great Depression
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 The Dodd-Frank Act 2

Created the Financial Stability Oversight Council

Created the Office of Financial Research within
Treasury Department
• Identify systematic risks
• Reduce moral hazard
• Maintain stability of U.S. financial system

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 The Dodd-Frank Act 3

Provides for orderly liquidation/bankruptcy of

non-bank financial companies
Consolidates regulators
Hedge funds and investment advisors must
register with Securities Exchange Commission
Established Federal Insurance Office
Volcker Rule
• Limits speculative investing by regulated institutions

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 The Dodd-Frank Act Concluded
Bureau of Consumer Financial Protection
• Dictates fees that banks charge and products they
offer
• Power widely criticized; attack on free markets
Issues
• Rulemaking, implementation left to agencies
charged with enforcement
• Rulemaking delayed by different regulators
• Gray area in many financial activities
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 The Impact of the Internet 1

Internet accelerates e-commerce solutions for

“old economy” companies
E-commerce solutions for existing companies
• Business to consumer (B2C)
• Business to business (B2B)
Creation of new business models and companies
• Amazon.com and eBay (retail)
• Facebook and Twitter (social media)
• Netflix and Google (entertainment & information)
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 The Impact of the Internet 2

E-commerce affects pattern and speed with

which cash flows through firms
• B2C model
• Orders placed with credit cards
• Selling firms get cash flow faster
• New ways to reach customers
• B2B model
• Lower cost of managing inventory, accounts receivable,
cash
• Efficient way to interact with suppliers
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 Activities of Financial Management 1

Financial management concerned with managing

entity’s money
Functions
• Allocate funds to current and fixed assets
• Obtain best mix of financing alternatives
• Develop appropriate dividend policy within context
of firm’s objectives
• Day-to-day credit management, inventory control,
and receipt and disbursement of funds
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 Activities of Financial Management 2

Financial management concerned with managing

entity’s money
Functions
• Allocate funds to current and fixed assets
• Obtain best mix of financing alternatives
• Develop appropriate dividend policy within context
of firm’s objectives
• Day-to-day credit management, inventory control,
and receipt and disbursement of funds
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 Figure 1-1 Functions of the
Financial Manager

Access the text alternative for these images

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 Forms of Organization 1

2017 Tax Cuts and Jobs Act

• Significantly modified taxation for all forms or
organizations
• Corporate tax rate went down from as high as 35 percent
to flat rate of 21 percent
• Established 20 percent deduction of qualified business
income from pass through businesses
• Sole proprietorships, partnerships, and limited liability
partnerships are considered pass through organizations

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 Forms of Organization 2

• Represents single-person ownership

• Advantages
• Simplicity of decision making
• Low organizational and operational costs
• Drawback
• Unlimited liability to owner
• Profits and losses taxed as though they belong to
individual owner
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 Forms of Organization 3

Partnership
• Similar to sole proprietorship except with two or
more owners
• Articles of partnership specify:
• Ownership interest
• Methods for distributing profits
• Means of withdrawing from the partnership

• Carries unlimited liability for the owners

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 Forms of Organization 4

Partnership (cont’d)
• Limited liability partnership
• One or more partners designated general partners and
have unlimited liability for debts of firm
• Other partners designated limited partners and liable only
for initial contribution
• Not all financial institutions extend funds to limited
partnership firms

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 Forms of Organization 5

Corporation
• Unique; legal entity unto itself
• May sue or be sued, engage in contracts, and acquire
property
• Formed through articles of incorporation, which
specify rights and limitations of entity
• Owned by shareholders who enjoy limited liability
• Has continual life
• Key feature—easy divisibility of ownership interest by
issuing shares of stock
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 Forms of Organization Concluded
Corporation (cont’d)
• Disadvantage
• Potential of double taxation of earnings
• S corporation
• Income taxed as direct income to stockholders, thus
taxed only once as normal income
• Limited liability company (LLC)
• Provides limited liability for the owners
• Can be taxed as sole proprietorship, partnership,
corporation, or S corporation, depending upon
elections made by owners
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 Corporate Governance
Agency theory
• Examines relationship between owners and
managers of firm
• Identify and reduce potential conflicts of interest
Institutional investors
• Have more to say about how publicly owned
companies are managed
• Able to vote large blocks of shares for election of
board of directors
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 The Sarbanes-Oxley Act
Set up five-member Public Company Accounting
Oversight Board (PCAOB) with responsibility for
• Auditing standards within companies
• Controlling quality of audits
• Setting rules and standards for independence of the auditors
Major focus is to make sure publicly traded
corporations accurately present
• Assets
• Liabilities
• Equity and income on financial statements
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 Goals of Financial Management
Primary goal—maximization of profit
• Drawbacks
• Change in profit may also represent change in risk
• Fails to consider timing of benefits
• Impossible task of accurately measuring key variable
“profit”
• Problems with inflation and international currency
transactions further complicate the issue

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 Valuation Approach
Ultimate measure of performance – how earnings are
valued by investor
Investor will consider
• Risk inherent in firm’s operation
• Time pattern of firm’s earnings increase or decrease
• Quality and reliability of reported earnings
Question impact of each decision on firm’s overall
valuation
• If it maintains or increases the firm’s overall value, it is
acceptable
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 Maximizing Shareholder Wealth
Shareholder wealth maximization is the broad
goal of the firm
• Achieved through high value for the firm
Long-term wealth is difficult with changing
investor expectations
Financial problems following 2012 led investors to
remain conservative
• Causing valuations to be depressed from formal highs
• 2014 investors questioning Dow Jones Industrial
Average highs
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 Management and Stockholder
Wealth
Only way to retain power in long run is by
becoming sensitive to shareholder concerns
Sufficient stock option incentives to motivate
achievement of market value maximization
Powerful institutional investors making
management more responsive to shareholders

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 Social Responsibility and Ethical
Behavior 1

Adopting policies that maximize values in market

• Attract capital
• Provide employment
• Offer benefits to society
Certain cost-increasing activities may initially
have to be mandatory rather than voluntary, to
ensure burden falls equally over all business
firms

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 Social Responsibility and Ethical
Behavior 2

Insider trading
• Using information not available to public, making
undue profit from trading in company’s publicly
traded securities
• Unethical and illegal practice protected against by
Securities Exchange Commission (SEC)
• Has a negative impact on shareholder’s interest
Ethical behavior creates invaluable reputation

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 Role of the Financial Markets
Financial markets—meeting place for people,
corporations, and institutions
• Have either a need to lend, borrow, or invest money
Participants can be national, state, and local
governments
• Their markets are public financial markets
Corporate participants raise funds in corporate
financial markets

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 Structure and Functions of the
Financial Markets 1

Distinct parts of financial markets

• Domestic and international markets
• Corporate and government markets
• Money and capital markets

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 Structure and Functions of the
Financial Markets 2

Money markets
• Deal with short-term securities with life of one year
or less
• Securities include
• Commercial paper sold by corporations to finance daily
operations
• Certificates of deposit with maturities of less than one
year sold by banks

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 Structure and Functions of the
Financial Markets Concluded
Capital markets
• Deal with securities that have life of more than one
year
• Long-term markets
• Defined as either 1 to 10 years (intermediate markets) or
greater than 10 years (long-term markets)
• Securities include
• Common stock
• Preferred stock
• Corporate and government bonds
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 Allocation of Capital 1

Primary market
• When corporation uses financial markets to raise
new funds, sale of securities made through new
issue is called initial public offering (IPO)
Secondary market
• Securities bought/sold amongst investors
• Prices of securities keep changing continually
• Financial managers given feedback about firms’
performance
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 Allocation of Capital 2

Return maximization and risk minimization

• Investors can choose risk level that meets objective,
maximizes return for given risk level
• Companies rewarded with high-priced securities can
raise new funds in money and capital markets at
lower cost than competitors
• Firms pay penalty for failing to perform
competitively

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 Institutional Pressure on Public
Companies to Restructure
Restructuring can result in:
• Changes in capital structure (liabilities and equity on
balance sheet)
• Sale of low-profit-margin divisions with proceeds
from sale reinvested in better investment
opportunities
• Removal of current management team or large
reductions in workforce
Also includes mergers and acquisitions
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 Internationalization
of Financial Markets
Allocation of capital and search for lower-cost
sources of financing in global market
Impact of international affairs and technology
has resulted in need for managers to understand
• International capital flows
• Computerized electronic funds transfer systems
• Foreign currency hedging strategies

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 Information Technology and Changes
in the Capital Markets 1

Cost reduction in trading securities driven down

Many stock markets and brokerage firms have
merged with domestic and international partners
Creation of electronic communication networks
(ECNs)
• Has speed and cost advantages over traditional
markets
Electronic markets like NASDAQ have gained
popularity against traditional organized exchanges
such as NYSE 40
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 Information Technology and Changes
in the Capital Markets 2

Retail stock trading allow customers to directly

compete with full-service brokers
• Charles Schwab
• E*TRADE
• TD Ameritrade
Change to price quotes in decimals
• From the traditional 1/16, 1/8 , 1/4, and 1/2 price
quotes
• Lower-cost environment for customers and a profit
squeeze on markets and brokers 41
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