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Financial Decisions

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These factors are divided into two parts

1. Micro economic factors

Nature and Size of the Firm Level of Stability in Risk and Earnings

Liquidity Position

Asset Structure and Pattern of Ownership

Attitude of Management

2. Macro economic factors

The state of the Economy Government Policies

Factors Influencing Financial Decision

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1. ProfitabilityIs the ability to earn a profit.

Many start-ups are not profitable during their first one to three years, however a firm must become profitable to remain viableand provide a return to its owners.

2. Liquidity

Is acompany’s

 ability to meet its short-term financial obligations. Even if a firm is profitable, it is often a challenge to keep enoughmoney in the bank to meet its routine obligations.

3. EfficiencyHow productively a firm utilizes its assets relative to its revenue & itsprofits.4. StabilityIs the strength and vigor of the firm’s overall financial posture. For a firm to be stable, it must not only earn a profit and remain

liquid but also keep its debt in check.

Financial Objectives of a Firm

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1. Funds Raising2. Funds Allocation

3. Profit Planning4. Understanding Capital Markets

•All the management decisions should help to accomplish the goalof the firm

• What should be the goal of a firm?

 – Maximize profit?

 – Minimize costs? – Maximize Earning per share?

 – Maximize the current value of the company’s stock? 

Financial Manager Role

Fundamental Objective

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M E P Sh

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EPS is the total earning divided by total number of shares.

Ignores timing and risk of the expected benefit.

Market value is not a function of EPS. Hence maximizing EPS will

not result in highest price for company's shares.

Maximizing EPS implies that the firm should make no dividend

payment so long as funds can be invested at positive rate ofreturn — such a policy may not always work.

Maximizing Earning Per Share

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Wealth Maximization criterion is based on the concept of cashflows generated by the decision rather than accounting profit.

It incorporates the time value of money. Two important issues related to value/price maximization

 – Economic value added is

= after tax profits - cost of funds used to finance investments.

 – Stakeholders include group such as employees, customers,suppliers, creditors, owners and others who have a direct link tothe firm.

Principal hires an agent to represent their interest.

Stockholders (principals) hire managers (agents) to run thecompany.

Shareholder’s Wealth Maximization 

Agency Relationship

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Agency Problem is the likelihood that managers may placepersonal goals ahead of corporate goals.

Agency Problem can be minimized in two ways1. Market Forces

1. Behavior of Security Market Participants

2. Hostile Takeovers

2. Agency Costs

Cost borne by shareholders to prevent agency problem.

i. Monitoring Expenditures

ii. Bonding Expenditures: Re-imburse for financial loss caused bydishonest act of managers.

iii. Stock option: Purchase share at concessional price.

iv. Incentive Plans: Tie management compensation to share price.

v. Performance Shares: Given for meeting the stated performance goals.

Agency Problem

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• Wealth maximization does t  preclude the firm from being

socially responsible. 

Social Responsibility

Corporate Governance

• Corporate governance: represents the system by which

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.

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How would the stockholder of a small business react if they were

told that their manager canceled all casualty and liability insurance

policies so the money spent of premium could go to profit instead. Even though the expected profits increased by this action, it is

likely that stockholders would be dissatisfied because of the

increase risk they would bear.

When the stockholders are dissatisfied they will simply sell the

stock of the company.

Why is Market Value more important than Book Value?

Book value are often based on dated values. They consist of theoriginal cost of the asset from the past time minus the

accumulated depreciation ( Which may not represent the actual

decline of the asset).

What About Risk