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Contemporary Financial Management
Chapter 1:
The Role and Objective of
Financial Management
© 2004 by Nelson, a division of Thomson Canada Limited
Introduction
 This chapter introduces the financial
management process. It looks at the financial
manager, the field of finance, financial decisions
and their implications, and the daily questions
faced by the firm’s financial management.
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Questions Faced in Finance
 How is finance related to other fields of
study?
 What are financial managers’ goals and
objectives?
 How has the finance field evolved?
 How is the finance field changing today?
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© 2004 by Nelson, a division of Thomson Canada Limited
Forms of Business Organizations
 Sole proprietorship
 Partnership
 Corporation
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Sole Proprietorship
 Owned by one person
 Represent 75% of all businesses, but accounts
for less than 5% of dollar volume.
Advantages
Disadvantages
Easy Formation
Unlimited Liability
Difficult to Raise Funds
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Small Business
 Not the dominant firm in the industry
 Tend to grow more rapidly
 Lack management resources
 Have a high failure rate
 Shares not publicly traded
 Poorly diversified
 Owner/manager frequently the same
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Partnership
 Owned by two or more persons
 Classified as general or limited
Advantages
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Disadvantages
Easy Formation
Difficult to Raise Funds
Taxation occurs at the
level of the partner, not
the partnership
Partnership Dissolves if
Partner Dies
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Liability of Partners
 General Partner
Has unlimited liability for all obligations of the
business
 Limited Partner
Liability limited to the partnership agreement
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Limited Partnerships
 Must have at least one general partner who:
 Has unlimited liability
 Performs all management functions
 Can have many limited partners who:
 Have limited liability
 Cannot participate in management
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Corporation
 A distinct, legal entity of its own
Advantages
Limited Liability
Permanency
Ability to
Raise Capital
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Disadvantages
Potential for Double
Taxation
Some Owners Have
Minimal Control
Board of Directors
 Shareholders elect a Board of Directors
 Board of Directors appoints the officers of the
company:
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Chairman of the board
Chief executive officer (CEO)
Chief operating officer (COO)
President
Chief financial officer (CFO)
Vice president
Treasurer
Secretary
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Who Manages?
Board of Directors
Deals with broad policy
Develops 3-5 year
strategic plan
Management
Responsible for
implementing strategic plan
Makes day-to-day
management decisions
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© 2004 by Nelson, a division of Thomson Canada Limited
Shareholder Rights
 Right to share in company profits (or losses)
 Right to vote
 Some shares may be non-voting
 Some shares may carry multiple votes
 Right to share in the residual assets at
dissolution
 Right to acquire new common stock (preemptive
right)
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Priority of Corporate Securities
Priority
Bonds: Debt securities often backed
by the corporation’s assets.
Preferred Stock: non-voting shares
that often offer a fixed dividend
to shareholders.
Common Stock
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Type of Organization Influenced by
 Cost
 Complexity
 Liability
 Continuity
 Need for capital
 Decision making
 Tax considerations
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Shareholder Wealth Maximization
 Core objective of financial managers.
 Considers the timing and risk of the benefits
from stock ownership
 Determines that a good decision increases the
price of the firm’s common stock (C/S)
 Is an impersonal objective
 Is concerned for social responsibility
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Social Responsibility
 Ethical issues will constantly confront financial
managers as they strive to achieve the goal of
Shareholder Wealth Maximization
 Managers must:
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Avoid personal conflicts of interest
Maintain confidentiality
Be objective
Act fairly
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Agency Relationships/Problems
Owners
Caused by
separation of
principals
Managers
Employees
Management may attempt to maximize
its own welfare instead of the owners’ wealth.
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Job Security
 Management’s decisions may be based on
retaining management, rather than Shareholder
Wealth Maximization
Example:
 A decision is made to retain an existing supplier
rather than select a new supplier providing
higher quality and/or lower cost
 Why? If a change is made management will be
scrutinized, but if no change is made, the issue
will be ignored.
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Agency Costs
 Costs incurred by shareholders to minimize
agency problems
Examples:
 Management incentives
 Monitor performance
 Owners protection
 Complex organization structures
 Recent Trend: flatter organizational structures
have emerged to reduce costs.
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Another Agency Problem
Owners
Caused by
separation of
Creditors
Solution:
Creditors insert protective covenants in
loan agreements
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Examples of Protective Covenants
 Limitations on
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Dividends
Capital expenditures
Asset divestitures
Incurring additional debt
Poison pills
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SWM and Profit Maximization
 Shareholder Wealth Maximization is not the
same as Profit Maximization
Reasons:
 Profit maximization has no time dimension
 Profit is an accounting concept with many
different interpretations
 Profit maximization ignores risk
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Maximizing Shareholder Wealth
 To maximize shareholder wealth, the financial
manager must maximize the market value of the
firm’s common stock
 Three factors determine the market value of
common stock:
 Size of the firm’s cash flow
 Timing of the firm’s cash flow
 Risk of the firm’s cash flow stream
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Conditions Affecting Market Value
Factors outside of
management’s control
Factors within
management’s control
Amount, Timing & Size of
Expected Cash Flows
Shareholder Wealth
(Market Price of the Shares)
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© 2004 by Nelson, a division of Thomson Canada Limited
Conditions
in Financial
Markets
Cash Flow
 Cash flows, not accounting profits, are critical to
most financial analysis
 Important cash flow concepts:
 Timing of cash inflows versus cash outflows
 Cash flow is not equal to operating profit.
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Concept of Net Present Value
 The net present value (NPV) of an investment
represents the contribution of the investment to
the value of the firm
 To maximize shareholder wealth, reject all projects
with a negative NPV
 NPV = PV of cash inflows - PV of cash outflows
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NPV Example
 A firm is analyzing a new investment
opportunity. It can invest $1 million today to
generate free cash flows of $400,000 per year
for the next three years. After three years, the
project is worthless. The firm’s shareholders
require a 20% return. Should they proceed?
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NPV Example: Intuition
0
$1 M
1
$400K
2
3
$400K
$400K
Solution is calculated by discount each of the
cash flows back to time period zero using a
discount rate of 20%.
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NPV Example: Solution
NPV Decision:
Reject the project. Accepting the project will
destroy significant shareholder value
NPV=PV CashInflows -PV CashOutflows
 1- 1+r -t
=PMTInflows 

r


 1- 1+r -t
 -PMTOutflows 


r


 1- 1.20 -3 
 -1,000,000
=400,000 
 0.20 


=$842,5923
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© 2004 by Nelson, a division of Thomson Canada Limited

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Major Points
 Businesses may be established as
proprietorships, partnerships or corporations.
 Shareholders are entitled to a number of rights
as owners of a corporation.
 The separation between shareholders, managers
and creditors give rise to agency problems which
detract from a firm’s goal of shareholder wealth
maximization.
 Positive NPV projects enhance shareholder
wealth.
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© 2004 by Nelson, a division of Thomson Canada Limited