73650644 role of financial management

8/2/2019 73650644 Role of Financial Management

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Introduction

When financial management emerged as a separate field of study in the early 1900s, the

emphasis was on the legal aspects of mergers, the formation of new firms, and the various

types of securities firms could issue to raise capital. During the Depression of the 1930s,the emphasis shifted to bankruptcy and reorganization,corporate liquidity, and the

regulation of security markets. During the 1940s and early 1950s, finance continued to be

taught as a descriptive, institutional subject, viewed more from the standpoint of an

outsider rather than that of a manager. However, a movement toward theoretical analysisbegan during the late 1950s, and the focus shifted to managerial decisions designed to

maximize the value of the firm. The focus on value maximization continues as we begin

the 21st century.

However, two other trends are becoming increasingly important: (1) the globalization

of business and (2) the increased use of information technology. Both of these trendsprovide companies with exciting new opportunities to increase profitability and reduce

risks. However, these trends are also leading to increased competition and new risks. Toemphasize these points throughout the book, we regularly profile how companies or

industries have been affected by increased globalization and changing technology. Theseprofiles are found in the boxes labeled Global Perspectives and Technology Matters.

Financial Management can be defined as the management of the finances of a business /organisation in order to achieve financial objectives taking a commercial business as the

most common organisational structure destinations.The financial management should beregarded as a component of the companys general management.

From this perspective, the financial management can be defined as an under-system of the

companys general management, having as purpose insuring the necessary financialresources, their profitable assignment and usage, improving the value and the safety of its

patrimony, by fulfilling an active role, starting with the financial resources meant for the

establishment of the companys strategic and tactical objectives and for the control andevolution of their fulfillment.

Beginning with this definition, it can be stated that the financial management hasat least the following tasks:

to evaluate the effort, from the financial point of view, of all the actionsthat

are about to be made in a given administration period; to provide, at the right moment, in the structure and the quality

conditions claimed by necessities, the capital, at the lowest possiblecost;

to follow how the capital is used;

to influence the decision factors in each performance centre in order toinsure an efficient usage of all funds attracted in the circuit;

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to insure and maintain the financial balance according to thecompanys needs;

to try to obtain the anticipated financial result and to distribute it on

key objectives of financial management

The key objectives of financial management would be to:

Create wealth for the business

Generate cash, and

Provide an adequate return on investment bearing in mind the risks that the business istaking and the resources invested

There are three key elements to the process of financial management:

(1) Financial Planning

Management need to ensure that enough funding is available at the right time to meet the needs ofthe business. In the short term, funding may be needed to invest in equipment and stocks, payemployees and fund sales made on credit.

In the medium and long term, funding may be required for significant additions to the productivecapacity of the business or to make acquisitions.

(2) Financial Control

Financial control is a critically important activity to help the business ensure that the business ismeeting its objectives. Financial control addresses questions such as:

Are assets being used efficiently?

Are the businesses assets secure?

Do management act in the best interest of shareholders and in accordance with business rules?

(3) Financial Decision-making

The key aspects of financial decision-making relate to investment, financing and dividends:

Investments must be financed in some way however there are always financing alternatives thatcan be considered. For example it is possible to raise finance from selling new shares, borrowingfrom banks or taking credit from suppliers

A key financing decision is whether profits earned by the business should be retained rather thandistributed to shareholders via dividends. If dividends are too high, the business may be starved offunding to reinvest in growing revenues and profits further.

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The Goal of the Firm

A firm cannot survive with mere profit maximisation, but must increase long-term securitythrough investment and meeting shareholder expectations. This will increase their productivecapacity for the furture as well as encourage the risky capital investment of the shareholders.Maximization of Shareholder Wealth and Value creation occurs when we maximize the shareprice for current shareholders or by profit maximaization or maximizing the EPS.

1) Shortcomings of Alternative Perspectives:

a. Profit Maximization:Maximizing a firms earnings after taxes,but someitmesthe firm faces some problems like increasing current profits while harming firm(e.g., defer maintenance, issue common stock to buy T-bills, etc.). or Ignoreschanges in the risk level of the firm.

b. Earnings per Share Maximization:Maximizing earnings after taxes dividedby shares outstanding but we need to know if it does not specify timing orduration of expected returns or sometimes calls for a zero payout dividendpolicy.

2) Strengths of Shareholder Wealth Maximization:

When business managers try to maximize the wealth of their firm, they are actually trying toincrease their stock price. As the stock price increases, the individual who holds the stock wealthincreases. As the stock price goes up, the value of the firm increases and the net worth of theindividual who owns the stock increases.Takes account of: current and future profits and EPS;the timing, duration, and risk of profits and EPS; dividend policy; and all other relevant

factors.Thus, share price serves as a barometer for business performance

Cadbury Schweppes : governing objective is growth in shareowner value

Credit Suisse Group : achieve high customer satisfaction, maximize shareholder

value and be an employer of choice

Dow Chemical Company : maximize long-term shareholder value

ExxonMobil : long-term, sustainable shareholder value

Stockholders own the firm and elect the board of directors, which then selects the management

team. Management, in turn, is supposed to operate in the bestinterests of the stockholders. We know, however, that because the stock of mostlarge firms is widely held, managers of large corporations have a great deal of

autonomy.

This being the case, might not managers pursue goals other than stock price maximization? Forexample, some have argued that the managers of large, well-entrenched corporations couldwork just hard enough to keep stockholder returns at a reasonable level and then devote theremainder of their effort and resources to public service activities, to employee benefits, tohigher executive salaries, or to golf.It is almost impossible to determine whether a particularmanagement team is trying to maximize shareholder wealth or is merely attempting to

keepstockholders satisfied while managers pursue other goals.

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For example, how can we tell whether employee or community benefit programs are in thelong-run best interests of the stockholders? Similarly, are huge executive salaries reallynecessary to attract and retain excellent managers, or are they just another example ofmanagers taking advantage of stockholders?It is impossible to give definitive answers to thesequestions. However, we doknow that the managers of a firm operating in a competitive marketwill be forced to undertake actions that are reasonably consistent with shareholder wealthmaximization. If they depart from that goal, they run the risk of being removed from their jobs,

either by the firms board of directors or by outside forces. We will have more to say about thisin a later section.

3) The Modern Corporation:

The modern concept of corporate power holds that the rights of the participants as well as the

conduct of the enterprise must be the subject of managerial discretion. The salient characteristic

of the modern corporation is the separation of management from ownership. Management of

industrial corporations now requires executive managers and a corporate bureacracy to oversee

its complex and interlacing activities.

The large business corporation has strongly influenced the control of property in the modern

world. The large corporations are typically controlled by a small minority of the stockholders.

There are several methods employed by small groups of stockholders to gain control of large

corporations. These include pooling of the majority of stock in the hands of trustees having the

power to vote it and the use of proxies (agents for the actual stockholders pledged to vote for

particular candidates for managerial positions). Proxies are generally successfully used because

stockholders rarely attend meetings or name proxies other than those suggested to them by

management.

A more recent type of corporation is the holding company, organized to buy a controlling interest

in other corporations; this type of corporation typically possesses no physical assets. The

amount of cash needed to control a concern is lessened by pyramiding holding companies. This

is done by creating a company to hold a voting control of one or more operating companies. A

third company is created to hold a controlling interest in the second, and so on. The control of

the last holding company is sufficient to control all; and such control, because of the scattering of

stock among many small holders, may need the ownership of only 10% or 20% of the stock

available

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4) Role of Management :

Management acts as an agentfor the owners (shareholders) of the firm.An agentis an

individual authorized by another person, called the principal, to act in the latters

behalf.

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5) Agency Theory

Jensen and Meckling developed a theory of the firm based on agency theory.

Agency Theory is a branch of economics relating to the behavior of

principals and their agents. Principals must provide incentives so that management acts in the principals

best interests and then monitorresults

Incentives include, stock options, perquisites, and bonuses.

6) Social Responsibility

Wealth maximization does notpreclude the firm from being socially responsible.

Assume we view the firm as producing both private and social goods.

Then shareholder wealth maximization remains the appropriate goal in governing the

firm.

Another issue that deserves consideration is social responsibility: Should businesses operate

strictly in their stockholders best interests, or are firms also responsible for the welfare of their

employees, customers, and the communities in which they operate? Certainly firms have anethical responsibility to provide a safe working environment, to avoid polluting the air or water,

and to produce safe products. However, socially responsible actions have costs, and not all

businesses would voluntarily incur all such costs. If some firms act in a socially responsible

manner while others do not, then the socially responsiblefirms will be at a disadvantage in

attracting capital.

To illustrate, suppose all firms in a given industry have close to normal profits and rates of return

on investment, that is, close to the average for all firms and just sufficient to attract capital. If one

company attempts to exercise social responsibility, it will have to raise prices to cover the added

costs. If other firms in its industry do not follow suit, their costs and prices will be lower. The

socially responsible firm will not be able to compete, and it will be forced to abandon its efforts.

Thus, any voluntary socially responsible acts that raise costs will be difficult, if not impossible, in

industries that are subject to keen competition.

What about oligopolistic firms with profits above normal levelscannot such firms devote

resources to social projects? Undoubtedly they can, and many large, successful firms do engage

in community projects, employee benefit programs, and the like to a greater degree than would

appear to be called for by pure profit or wealth maximization goals.4 Furthermore, many such

firms contribute large sums to charities. Still, publicly owned firms are constrained by capital

market forces. To illustrate, suppose a saver who has funds to invest is considering two

alternative firms. One devotes a substantial part of its resources to social actions, while the other

concentrates on profits and stock prices. Many investors would shun the socially oriented firm,

thus putting it at a disadvantage in the capital market. After all, why should thestockholders ofone corporation subsidize society to a greater extent than those of other businesses?

For this reason, even highly profitable firms (unless they are closely held rather than publicly

owned) are generally constrained against taking unilateral cost-increasing social actions.

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Does all this mean that firms should not exercise social responsibility? Not at all. But it does

mean that most significant cost-increasing actions will have to be put on a mandatory rather than

a voluntary basis to ensure that the burden falls uniformly on all businesses. Thus, such social

benefit programs as fair hiring practices, minority training, product safety, pollution abatement,

and antitrust actions are most likely to be effective if realistic rules are established initially and

then enforced by government agencies.

Of course, it is critical that industry and government cooperate in establishing the rules of

corporate behavior, and that the costs as well as the benefits of such actions be estimated

accurately and then taken into account. In spite of the fact that many socially responsible actions

must be mandated by government, in recent years numerous firms have voluntarily taken

such actions, especially in the area of environmental protection, because they helped sales. For

example, many detergent manufacturers now use recycled paper for their containers, and food

companies are packaging more and more products in materials that consumers can recycle or

that are biodegradable.

To illustrate, McDonalds replaced its styrofoam boxes, which take years mto break down in

landfills, with paper wrappers that are less bulky and decompose rapidly. Some companies, such

as The Body Shop and Ben & Jerrys Ice Cream, go to great lengths to be socially responsible.

According to the president of The Body Shop, the role of business is to promote the public good,

not just the good of the firms shareholders. Furthermore, she argues that it is impossible to

separate business from social responsibility. For some firms, socially responsible actions may not

de facto be costlythe companies heavily advertise their actions, and many consumers prefer to

buy from socially responsible companies rather than from those that shun social responsibility.

Corporate Governance:

The essence of the corporate governance debate is the effects of the particular relationship

between directors and shareholders. The greater the separation between the two, the greater the

potential for abuse and also the greater the possibility of suboptimal behaviour by managers as

viewed by shareholders. At present in the UK there is a voluntary system of governance in place.

The framework has evolved through, or been impacted upon, by six key ,reports starting with the

Cadbury report in 1992. The various recommendations of these reports have been incorporated

into the combined code which is included in the Listing Rules of the London .Stock Exchange as

an appendix. The rules require a company to Corporate Governance represents the system bywhich corporations are managed and controlled. Includes shareholders, board of directors, and

senior management. Then shareholder wealth maximization remains the appropriate goal in

governing the firm.

Board of Directors

u Typical responsibilities:u Set company-wide policy;

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u Advise the CEO and other senior executives;u Hire, fire, and set the compensation of the CEO;u Review and approve strategy, significant investments, and acquisitions; andu Oversee operating plans, capital budgets, and financial reports to common

shareholders.

u CEO/Chairman roles commonly same person in US, but separate in Britain (US

moving this direction).

Financial management and risk

Since financial management is concerned with making decisions, and decision making is

concerned with the future and the future is uncertain, risk must be a major factor in all aspects of

financial management. Risk may be defined as the extent to which what we estimate will happen

in the future may or may not happen. If there is only one single possible outcome, there is no risk.

If there are many possible outcomes and many of them are very different from our estimate of the

outcome, then there is a lot of risk.

Broadly speaking, both theory and practice show us that risk and return are correlated. We seekhigher expected returns for investing in riskier projects. Where we perceive little risk (e.g. an

investment in government securities), we are prepared to accept relatively small returns.

Organization of the Financial Management Function:

Organizational structures vary from firm to firm, but Figure 1-1 presents a fairly typicalpicture of the role of finance within a corporation. The chief financial officer (CFO)generally has the title of vice-president: finance, and he or she reports to thepresident. The financial vice-presidents key subordinates are the treasurer and thecontroller.

In most firms the treasurer has direct responsibility for managing the firms cash and

marketable securities, for planning its capital structure, for selling stocks and bonds toraise capital, for overseeing the corporate pension plan, and for managing risk. Thetreasurer also supervises the credit manager, the inventory manager, and the directorof capital budgeting (who analyzes decisions related to investments in fixed assets).

The controller is typically responsible for the activities of the accounting and taxdepartments.

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Conclusion

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Knowledge through financial management will not restrict only tonumericaldata. For a complete image of the cause and effect type of relations, it isnecessary tocombine the structured information data with the non-structuredinformation text.Consequently, in a society of latest generation information technologyknowledge, a Web environment at the level of the whole company allowstheinteraction, the distribution of results and achievement of theorganizations personality.

The financial management offers the possibility to plan the way toachieve theproposed objectives, to cover a well-defined path and to take advantageof the newopportunities which come along. At the same time, it offers an image of

thecompatibility between the companys internal processes, the existingfinancial sources,their cost and way of appropriation, offering strategic recommendationsto avoidunpleasant events that may occur.

The most decisive matter regarding the financial management isrepresented bythe managing teams level of involvement into the necessary changes.Without a strong

involvement, the financial management can not be implemented.

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73650644 role of financial management

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