Financial Management PDF

# UNIT I ## Overview of Financial Management | Chapter | Topic | |---|---| | 1 | Nature, Purpose and Scope of Financial Management | | 2 | Relationship of Financial Objectives to Organizational Strategy and Other Organizational Objectives | | 3 | Functions of Financial Management | | 4 | Business...

# UNIT I ## Overview of Financial Management | Chapter | Topic | |---|---| | 1 | Nature, Purpose and Scope of Financial Management | | 2 | Relationship of Financial Objectives to Organizational Strategy and Other Organizational Objectives | | 3 | Functions of Financial Management | | 4 | Business Organization and Trends | ## CHAPTER 1 ### Nature, Purpose and Scope of Financial Management #### Expected Learning Outcomes: After studying Chapter 1, you should be able to: 1. Describe the nature, goal and basic scope of financial management. 2. Explain briefly the three major types of decisions that the Finance Manager makes. 3. Discuss the importance or significance of financial management. 4. Describe the relationship between Financial Management and Accounting. 5. Describe the relationship between Financial Management and Economics. #### Nature of Financial Management Financial Management, also referred to as managerial finance, corporate finance, and business finance, is a decision-making process concerned with planning, acquiring, and utilizing funds in a manner that achieves the firm’s desired goals. It is also described as the process for and the analysis of making financial decisions in the business context. Financial management is part of a larger discipline called FINANCE, which is a body of facts, principles, and theories relating to raising and using money by individuals, businesses, and governments. This concerns both financial management of profit-oriented business organizations, particularly the corporate form of business, as well as concepts and techniques that are applicable to individuals and to governments. #### The Goal of Financial Management Assuming that we confine ourselves to for-profit businesses, the goal of financial management is to make money and add value for the owners. This goal, however, is a little vague and a more precise definition is needed in order to have an objective basis for making and evaluating financial decisions. The financial manager in a business enterprise must make decisions for the owners of the firm. He must act in the owners’ or shareholders’ best interest by making decisions that increase the value of the firm or the value of the stock. The appropriate goal for the financial manager can thus be stated as follows: The goal of financial management is to maximize the current value per share of the existing stock or ownership in a business firm. The stated goal considers the fact that the shareholders in a firm are the residual owners. By this, we mean that they are entitled only to what is left after employees, suppliers, creditors and anyone else with a legitimate claim are paid their due. If any of these groups go unpaid, the shareholders or owners get nothing. So, if the shareholders are benefiting in the sense that the residual portion is growing, it must be true that everyone else is being benefited too. Because the goal of financial management is to maximize the value of the share(s), there is a need to learn how to identify investments, arrangements, and distribute satisfactory amounts of dividends or share in the profits that favorably impact the value of the share(s). Finally, our goal does not imply that the financial manager should take illegal or unethical actions in the hope of increasing the value of the equity in the firm. The financial manager should best serve the owners of the business by identifying goods and services that add value to the firm because they are desired and valued in the free market place. #### Scope of Financial Management Traditionally, financial management is primarily concerned with acquisition, financing, and management of assets of business concern in order to maximize the wealth of the firm for its owners. The basic responsibility of the Finance Manager is to acquire funds needed by the firm and investing those funds in profitable ventures that will maximize the firm’s wealth, as well as, generating returns to the business concern. Briefly, the traditional view of Financial Management looks into the following functions that a financial manager of a business firm will perform: 1. Procurement of short-term as well as long-term funds from financial institutions 2. Mobilization of funds through financial instruments such as equity shares, preference shares, debentures, bonds, notes, and so forth 3. Compliance with legal and regulatory provisions relating to funds procurement, use, and distribution, as well as the coordination of the finance function with the accounting function With modern business situations increasing in complexity, the role of Finance Manager, which initially is just confined to acquisition of funds, expanded to judicious and efficient use of funds available to the firm, keeping in view the objectives of the firm and expectations of the providers of funds. More recently though, with the globalization and liberalization of world economy, tremendous reforms in the financial sector evolved in order to promote more diversified, efficient and competitive financial system in the country. The financial reforms coupled with the diffusion of information technology have brought intense competition, mergers, takeovers, cost management, quality improvement, financial discipline, and so forth. Globalization has caused to integrate the national economy with the global economy and has created a new financial environment which brings new opportunities and challenges to the business enterprises. This development has also led to total reformation of the finance function and its responsibilities in the organization. Financial management has assumed a much greater significance and the role of the finance managers has been given a fresh perspective. In view of modern approaches, the Finance Manager is expected to analyze the business firm and determine the following: a. The total funds requirements of the firm b. The assets or resources to be acquired c. The best pattern of financing the assets #### Types of Financial Decisions The three major types of decisions that the Finance Manager of a modern business firm will be involved in are: 1. Investment decisions 2. Financing decisions 3. Dividend decisions All these decisions aim to maximize the shareholders’ wealth through maximization of the firm’s wealth. #### Investment Decisions The investment decisions are those which determine how scarce or limited resources in terms of funds of the business firms are committed to projects. Generally, the firm should select only those capital investment proposals whose net present value is positive and the rate of return exceeding the marginal cost of capital. It should also consider the profitability of each individual project proposal that will contribute to the overall profitability of the firm and lead to the creation of wealth. #### Financing Decisions Financing decisions assert that the mix of debt and equity chosen to finance investments should maximize the value of investments made. The finance decisions should consider the cost of finance available in different forms and the risks attached to it. The principle of financial leverage or trading on the equity should 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. #### Significance of Financial Management The importance of financial management is known for the following aspects: #### Broad Applicability Any organization, whether motivated with earning profit or not having cash flow, requires to be viewed from the angle of financial discipline. The principles of finance are applicable wherever there is cash flow. The concept of cash flow is one of the central elements of financial analysis, planning, control, and resource allocation decisions. Cash flow is important because the financial health of the firm depends on its ability to generate sufficient amounts of cash to pay its employees, suppliers, creditors, and owners. Financial management is equally applicable to all forms of business like sole traders, partnerships, and corporations. It is also applicable to nonprofit organizations, like trust, societies, government organizations, public sectors, and so forth. #### Reduction of Chances of Failure A firm having latest technology, sophisticated machinery, high caliber marketing and technical experts, and so forth may still fail unless its finances are managed on sound principles of financial management. The strength of business lies in its financial discipline. Therefore, finance function is treated as primordial, which enables the other functions like production, marketing, purchase, and personnel to be effective in the achievement of organizational goals and objectives. #### Measurement of Return on Investment Anybody who invests his money will expect to earn a reasonable return on his investment. The owners of businesses try to maximize their wealth. Financial management studies the risk-return perception of the owners and the time value of money. It considers the amount of cash flows expected to be generated for the benefit of owners, the timing of these cash flows, and the risk attached to these cash flows. The greater the time and risk associated with the expected cash flow, the greater is the rate of return required by the owners. #### 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. Financial statements help managers to make business decisions involving the best use of cash, the attainment of efficient operations, the optimal allocation of funds among assets, and the effective financing of investment and operations. The interpretation of financial statements is achieved partly by using financial ratios, pro forma and 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 wealth. In view of the above, finance function is considered a distinct and separate function rather than simply an extension of accounting function. It should be pointed out that the managers of a firm are supplied with more detailed statistical information than what appears in published financial statements. These data are especially important in developing cash flow concepts for evaluating the relative merits of different investment projects. This information permits managers to determine incremental cash flows (an approach that looks at the net returns a given project generates in comparison with alternative investments), thus enabling them to make more accurate assessments of the profitabilities of specific investments. It is the responsibility of managers to direct their accountants to prepare internal statements that include this information so that they can make the best investment decisions possible. 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 to 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 Financial managers can make better decisions if they apply these basic economic principles. For example, economic theory teaches us to seek the best allocation of resources. To this end, financial managers are given the responsibility to find the best and least expensive sources of funds and to invest these funds into the best and most efficient mix of assets. In doing so, they try to find the mix of available resources that will achieve the highest return at the least risk within the confines of an expected change in the economic climate. Good financial management has a sound grasp of the way economic and financial principles impact the profitability of the firm. Financial managers do a better job when they understand how to respond effectively to changes in supply, demand, and prices (firm-related micro factors), as well as to more general and overall economic factors (macro factors). Learning to deal with these factors provides important tools for effective financial planning. The finance manager must be familiar with the microeconomic and macroeconomic environment aspects of business. When making investment decisions, financial managers consider the effects of changing supply, demand, and price conditions on the firm’s performance. Understanding the nature of these factors helps managers make the most advantageous operating decisions. Also, managers should determine when it is best to issue equity shares, bonds, or other financial instruments. The sale of products at a profit depends heavily on how well managers are able to analyze and interpret supply and demand conditions. Supply considerations relate specifically to the control of production costs, where the key element is to hold costs down so that prices can be set at competitive levels. The best machinery must be bought; and the most qualified product workers available must be hired. The goal is to squeeze out the biggest possible profit under given supply conditions. Maintaining a low-cost operation will enable the firm to charge competitive prices for its products and maintain its market share while still obtaining a reasonable return. Knowledge of economic principles can be useful in generating the highest sales possible. Understanding and appropriately responding to changes in demand allows financial managers to take full advantage of market conditions. To accomplish this, the best managers develop and adopt reliable, workable statistical techniques that forecast demand and pinpoint when directional changes in sales take place. #### Microeconomics 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 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. #### Financial Management and Public Responsibility Finance is a very challenging and rewarding field. Financial managers are given the responsibility to plan the future growth and direction of a firm which can greatly affect the community in which it is based. The decisions reached by a financial manager ultimately represent a blend of theoretical, technical, and judgmental matters that must reflect the concerns of society. The primary goal for managers of publicly owned companies implies that decisions should be made to maximize the long-run value of the firm’s equity shares. At the same time, managers know that this does not mean maximize shareholder value “at all costs”. Managers have the obligation to behave ethically, and they must follow the law and other society imposed constraints. Financial managers have certain obligations to those who entrust them with the running of the firm. They must have a clear sense of ethics, and must avoid pay offs or other forms of personal gain. Managers should not engage in practices that can damage the image of the firm, but should articulate as much as possible in social activities to demonstrate that they are cognizant of the importance of the community and those who buy their products or services. In short, financial managers must reconcile social and environmental requirements with profit-making motive. Adherence to social values may not produce the most efficient use of assets or the lowest costs, but it will enhance the image of the firm. Looking after the interest in community, setting up of training facilities, casing for the safely and the welfare of the workers, providing free college education for the dependents of the employees can produce long-term benefits in the form of higher productivity and more harmonious relationships between labor and management. Although there may be conflict between promoting socially responsible programs and the profit motive, maintaining some concern for social needs when pursuing the goal of maximizing the wealth of the firm is a primary responsibility of a firm. ## CHAPTER 2 ### Relationship of Financial Objectives to Organizational Strategy and Other Organizational Objectives #### Introduction At one time or another, most people have had occasion to hire agents to take care of a specific matter. In doing so, responsibility is delegated to another person. For example, when suing for damages, individuals may represent themselves, or may hire a lawyer to plead their case in court. As an agent, the lawyer is given the assignment to get the highest possible award. And so, it is with shareholders when they delegate the task of running a firm to a financial manager who acts as an agent of the company. Obviously, the goal is to achieve the highest value of an equity share for the firm’s owners. But there are no standard rules that indicate which course of action should be followed by managers to achieve this. The ultimate guideline is how investors perceive the actions of managers. A good way to motivate managers is to offer them lucrative share options linked to performance. Finance permeates the entire business organization by providing guidance for the firm’s strategic (long-term) and day-to-day decisions. For long-range planning and management control, a business firm establishes its overall objectives. Such objectives are developed by the top management and they usually consist of general statements, or a series of statements in general terms stating what the company expects to achieve. Objective setting is thus, an important phase in the business enterprise since upon correct objectives setting will the entire structure of the strategies, policies, and plans of a company rest. Firms have numerous goals but not every goal can be attained without causing conflict in reaching other goals. Conflicts often arise because of the firm's many constituents, who include shareholders, managers, employees, labor unions, customers, creditors, and suppliers. There are those who claim that the firm’s goal is to maximize sales, or market share; others believe the role of business is to provide quality products and services; still others feel that the firm has a responsibility for the welfare of society at large. For example, the objective may be stated in such broad terms as: It is the goal of the company to be a leader in technology in the industry, or To achieve profits through a high-level manufacturing efficiency, or To achieve a high degree of customer satisfaction. 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 of 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 holds 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 decisions 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 shareholder(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 shareholder'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 mix 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: * Evaluation and selection of capital investment proposal * Determination of the total amount of funds that a firm can commit for investment * Prioritization of investment alternatives * Funds allocation and its rationing * Determination of the levels of investments in working capital (i.e. inventory, receivables, cash, marketable securities and its management) * Determination of fixed assets to be acquired * Asset replacement decisions * Purchase or lease decisions * Restructuring, reorganization, mergers, and acquisition * 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: * Determination of the financing pattern of short-term, medium-term, and long-term funds requirements * Determination of the best capital structure or mixture of debt and equity financing * Procurement of funds through the issuance of financial instruments, such as equity shares, preference shares, bonds, long-term notes, and so forth. * Arrangement with bankers, suppliers, and creditors for its working capital, medium-term, and other long-term funds requirement * 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's short-term asset (i.e., inventory, receivables, cash, and short-term investments) and its short-term liabilities (i.e., accounts payable, 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: * The level of cash, securities, and inventory that should be kept on hand * The credit policy (i.e., should the firm sell on credit? If so, what terms should be extended?) * Source of short-term financing (i.e., if the firm would borrow in the short-term, how and where should it borrow?) * 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 warning 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 ne: 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 opinion 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. ## CHAPTER 3 ### Functions of Financial Management #### Expected Learning Outcomes After studying Chapter 3, you should be able to: 1. Describe the role of Finance Manager in achieving the primary goal of the firm. 2. Understand how finance fits in the organizational structure of the firm. 3. Enumerate the fundamental activities of the Treasurer, and the Controller. 4. Explain how the finance function relates to the other functional areas of a business. 5. Learn the importance of corporate governance in achieving the goals of a business organization. 6. Appreciate the importance of ethics in finance. #### 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 of the firm: Financial Manager Makes Decisions Involving Acquisition of Funds, Impact on Risk and Return, Affect the Market Price of Common Stock, and Lead to Shareholder’s Wealth Maximization. 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 | | | |----------------------------|---------------------------------| | **Board of Directors** | Chairman of the Board and Chief Executive Officer (CEO) | | **President and Chief Operations Officer (COO)** | | | **Vice President Marketing** | | | **Vice President Finance (CFO)** | | | **Vice President Production** | | | **Treasurer** | Cash Manager, Credit Manager, Capital Expenditure, Financial Planning | | **Controller** | Tax Manger, Cost Accounting Manager, Financial Accounting Manager, Data Processing Manager | #### 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