Chapter 1: The Financial Manager and the
Firm
Learning Objectives
1. IDENTIFY THE KEY FINANCIAL DECISIONS
FACING THE FINANCIAL MANAGER OF ANY
BUSINESS FIRM.
2. IDENTIFY THE BASIC FORMS OF BUSINESS
ORGANIZATION IN THE UNITED STATES AND
THEIR RESPECTIVE STRENGTHS AND
WEAKNESSES.
Learning Objectives
3. DESCRIBE THE TYPICAL ORGANIZATION OF THE
FINANCIAL FUNCTION IN A LARGE
CORPORATION.
4. EXPLAIN WHY MAXIMIZING THE CURRENT
VALUE OF THE FIRM’S STOCK IS THE
APPROPRIATE GOAL FOR MANAGEMENT.
5. DISCUSS HOW AGENCY CONFLICTS AFFECT THE
GOAL OF MAXIMIZING SHAREHOLDER VALUE.
Learning Objectives
6. EXPLAIN WHY ETHICS IS AN APPROPRIATE
TOPIC IN THE STUDY OF CORPORATE
FINANCE.
The Role of the Financial Manager
o THREE KEY FINANCIAL DECISIONS
• Capital Budgeting: decide which long-term
assets to acquire
• Financing: decide how to pay for short-term
and long-term assets
• Working Capital: decide how to manage short-
term resources and obligations
The Role of the Financial Manager
o THREE KEY FINANCIAL DECISIONS
• Capital Budgeting
Choose the long-term assets that will yield the greatest
net benefits for the firm.
The Role of the Financial Manager
o THREE KEY FINANCIAL DECISIONS
• Financing
Finance assets with the optimal combination of short-
term debt, long-term debt, and equity.
The Role of the Financial Manager
o THREE KEY FINANCIAL DECISIONS
• Working Capital Management
Adjust current assets and current liabilities as needed
to promote growth in cash flow.
Cash Flows Between the Firm and Its
Stakeholders and Owners
How the Financial Manager’s Decisions Affect
the Balance Sheet
The Role of the Financial Manager
o THREE KEY FINANCIAL DECISIONS
• Poor decisions about capital budgeting,
financing, or working capital may lead to
bankruptcy or business failure
Basic Forms of Business Organization
o BUSINESS STRUCTURE
• Sole Proprietorship
• Partnership
• Corporation
Basic Forms of Business Organization
o SOLE PROPRIETORSHIP
• Owned by a single person who is financially
responsible for the actions and obligations of
the business
Basic Forms of Business Organization
o SOLE PROPRIETORSHIP
• Advantages
easiest to create
easiest to control
easiest to dissolve
right to all profit
Basic Forms of Business Organization
o SOLE PROPRIETORSHIP
• Disadvantages
owner’s personal assets at risk
owner’s unlimited liability for firm obligations
equity only from owner or business profit
business income taxed as personal income
difficult to transfer ownership
Basic Forms of Business Organization
o PARTNERSHIP
• A business owned by more than one person; one
or more of them financially responsible for the
actions and obligations of the business
Basic Forms of Business Organization
o PARTNERSHIP
• Advantages vs. sole proprietorship
limited protection of owners’ personal assets
owners’ limited liability for firm obligations
more sources of equity
more sources of expertise
Basic Forms of Business Organization
o PARTNERSHIP
• Disadvantages vs. proprietorship
shared control
shared profit
harder to dissolve
Basic Forms of Business Organization
o CORPORATION
• A business owned by more than one person;
none of them financially responsible for the
actions and obligations of the business. The
corporation is responsible for its obligations
and actions.
Basic Forms of Business Organization
o CORPORATION
• Advantages
protects personal assets
no shareholder liability for business
easiest to change ownership
greatest access to sources of funds
Basic Forms of Business Organization
o CORPORATION
• Disadvantages
most difficult and expensive to establish
dilutes individual control over the firm
overall higher taxes on income for shareholders
Organization of the Financial Function
o CHIEF EXECUTIVE OFFICER (CEO)
• Chief manager in the firm
• Ultimate power to make decisions and ultimate
responsibility for decisions
• Reports directly to the board-of-directors who
protect shareholder’s interests
Simplified Corporate Organization Chart
Organization of the Financial Function
o CHIEF FINANCIAL OFFICER (CFO)
• The V.P. of Finance/CFO is responsible for the
quality of the financial reports received by the
CEO
Organization of the Financial Function
o KEY FINANCIAL REPORTS
• The Treasurer manages and reports on the
collection and disbursement of cash
• The Risk Manager manages and reports on
activities to limit the firm’s risks in financial
and commodity markets
Organization of the Financial Function
o KEY FINANCIAL REPORTS
• The Controller is the firm’s accountant and
prepares its financial reports
• The Internal Auditor controls and reports on
activities to limit the firm’s exposure to internal
threats such as fraud and inefficient use of
resources
Organization of the Financial Function
o EXTERNAL AUDITOR
• Conducts an independent audit of a firm’s
financial activities
• Provides an opinion about whether the financial
reports the firm prepared are reasonably
accurate and conform to generally accepted
accounting principles
The Goal of the Firm
o DO NOT MAXIMIZE MARKET SHARE
• Giving away goods or services for free will
maximize a firm’s market share for a while, but
the firm will not be able to pay its bills and stay
in business
The Goal of the Firm
o DO NOT MAXIMIZE PROFIT
• Accounting profit differs from economic profit
• Profit earned may not equal cash received
Cash not received can’t be used to pay bills
• The strategy ignores the timing of future cash
flows
• The strategy ignores the risks associated with
having to wait for cash flows
The Goal of the Firm
o MAXIMIZE SHAREHOLDERS’ WEALTH!
• Future cash flows are considered
• The timing of future cash flows is considered
• The risks associated with having to wait to for
cash flows are considered
The Goal of the Firm
o MAXIMIZE SHAREHOLDERS’ WEALTH!
• Maximizing the price of a firm’s stock will
maximize the value of a firm and the wealth of
its shareholders (owners)
The Goal of the Firm
o ITS ALL ABOUT CASH FLOW!
• Positive residual cash flow may be paid to firm
owners as dividends or invested in the firm
• The larger the positive residual cash flow, the
greater the value of a firm
• Negative residual cash flow – over the long run
- leads to bankruptcy or closing a business
Agency Conflicts
o AGENCY RELATIONSHIP
• An agency relationship is created when the
owner (a principal) of a business hires an
employee (an agent)
• The owner surrenders some control over the
enterprise and its resources to the employee
• Separating ownership from control creates the
potential for agency conflicts
Agency Conflicts
o AGENCY RELATIONSHIP
• An agency relationship exists between
stockholders (principals) and the firm’s hired
management (agents)
• In large corporations, shared ownership among
many shareholders may result in relatively little
control over management
Agency Conflicts
o OWNERSHIP AND CONTROL
• Shareholders own the corporation, but
managers control the firm’s assets and may use
them for their own benefit
Major Factors Affecting Stock Prices
Agency Conflicts
o AGENCY COSTS
• Arise from (incurring and preventing) conflicts-
of-interests between a firm’s owners and its
managers
• May reduce positive residual cash flow, stock
price, and shareholder wealth
Agency Conflicts
o GIVING AGENTS THE RIGHT INCENTIVE
• Managers tend to focus on wealth maximization
when their compensation depends on stock
price
Agency Conflicts
o GIVING AGENTS THE RIGHT INCENTIVE
• Today, the firm’s stock trades at $0.95 per
share. The CEO has an option to buy 2.5
million shares from the firm for $1.15 per share
at any time, beginning one year from today. If
the stock price rises to $3.15, the option will be
worth $5 million.
Agency Conflicts
o GIVING AGENTS THE RIGHT INCENTIVE
• Want to keep their jobs
• Oversight by the board of directors
• Oversight by large blockholders
• Potential takeover of the firm
• The legal and regulatory environment.
Agency Conflicts
o SARBANES-OXLEY AND REGULATORY REFORM
• Better corporate governance reduces agency
costs by requiring
more effective monitoring of managers’ activities
programs that promote appropriate behavior by
managers
penalties for executives who do not fulfill their fiduciary
responsibilities
Corporate Governance Regulations Designed
to Reduce Agency Costs
Ethics in Corporate Finance
o WHAT ARE ETHICS?
• Ethics
society’s standards for judging whether an action is
right or wrong
• Business Ethics
society’s standards for acceptable behavior applied to
business and financial markets
Ethics in Corporate Finance
o EXAMPLES OF ETHICAL CONFLICT IN BUSINESS
• Agency Cost
employee’s unacceptable use of employer’s computer
• Conflict of Interest
mortgage contract which a home-buyer is unlikely to
fulfill but earns a mortgage broker more money
• Information Asymmetry
seller knows about prior damage to the vehicle but the
potential buyer does not
Ethics in Corporate Finance
o BUSINESS BEHAVIOR
• Regulation and market forces are not enough to
maintain integrity in the marketplace
• Business norms must be based on ethical
beliefs, customs, and practices
Ethics in Corporate Finance
o CONSEQUENCES OF UNETHICAL BEHAVIOR
• Inefficiency in the economy and costs to society
• High legal and social costs
• Problems such as the recent financial crisis in
the U.S.
Ethics in Corporate Finance
o ETHICAL BEHAVIOR
• Sometimes, it is difficult to judge whether
behavior is ethical or not
Was the manager too careful?
Did the manager take too much risk?
Was it an honest mistake?
Was it against policy, but well-intentioned?
A Framework for the Analysis of Ethical
Conflicts
