ISBN: 0-03-028931-9

Chapter 1 An Overview of Financial Management

This chapter is a general overview of the field of financial management. This is an outline of a few of the main concepts, please refer to the textbook for more comprehensive coverage.

Career Opportunities in Finance

In the finance field, there are three major sectors.

1. money and capital markets- deals with the interaction between institutions and security markets. In order to achieve success in this capacity, one must possess a keen knowledge of valuation techniques, as well as a good understanding of the financial environment and the factors that affect it.
2. investments- generally consists of the analysis of individual securities, selling investment analysis to prospective investors, and determining the appropriate mixture of securities for investors.
3. financial management- the broadest of the three categories, financial management is applicable to all enterprises and employment opportunities are seemingly vast. Prospective employers can range from government agencies to the retail industry, or the banking industry. A financial manager may be accountable for the maintenance of customer accounts, the management of working capital, planning possible expansion, or determining the distribution of corporate earnings.

Graduates pursuing a career in finance will need familiarity with all three areas. Even if you are not pursuing a finance career, the study of finance is significant because virtually all business decisions have financial implications and it gives you the tools to responsibly make personal financial decisions.

Financial Management in the New Millenium

The two driving forces in business and financial management for the future are globalization and information technology:

1. globalization- increasingly, companies across the world are diversifying their operations to promote overseas participation. The four main causes of increased globalization are: (1) improved transportation and communication, (2) the power of the consumer to demand higher quality and lower cost products, (3) the rising cost of new product development, due to increased technology, and (4) the growing ability of the firm to move production to areas of less cost.
2. information technology- technological advances in telecommunications and computer networking are occurring every day. In the presence of such advances, firms are constantly confronted by rapidly changing opportunities and threats. While it presents firms with the opportunity of reducing costs and expanding markets, new technology may also yield a firm more vulnerable to competition.

The Financial Staff

The financial staff is responsible for the acquisition and allocation of firm resources for the purpose of maximizing the value of the firm. Their activities include:

1. Forecasting and planning – interacting with people from other departments as they look ahead and lay out the plans that will shape the firm's future.
2. Major investment and financial decisions – determining the optimal sales growth rate, deciding what assets to acquire, and the best way to finance assets.
3. Coordination and control – ensuring the firm is operating as efficiently as possible and determining what implications the decisions made by other departments will influence the firm's activities.
4. Dealing with the financial markets – interacting with the financial markets where funds are raised, where the firm's securities are traded, and where investors either make or lose money.
5. Risk management – hedging the firm against risks ranging from natural disasters to volatile interest rates and fluctuating foreign exchange rates, thereby limiting the firm's overall risk exposure.

Alternative forms of business organizations

There are three main types of business organizations called sole proprietorships, partnerships, and corporations. In addition there are several hybrid forms of organizations that combine the aspects of multiple organization types.

A sole proprietorship is an unincorporated business owned by one individual. It has the advantages of: (1) being easily and inexpensively formed, (2) subject to few government regulations, and (3) avoiding corporate income taxes. However, sole proprietorships do have important disadvantages, such as: (1) difficulty in raising funds, (2) unlimited liability, and (3) limited life.

A partnership is an unincorporated business owned by two or more individuals. Partnerships have roughly the same advantages and disadvantages as sole proprietorships.

A corporation is a legal entity created by a state that is separate and distinct from its owners and managers. However, corporations have several important advantages, including: (1) unlimited life, (2) easy transfer of ownership, and (3) limited personal liability. However, as a corporation, businesses are also subjected to (1) double taxation of corporate earnings, (2) increased governmental regulation, and (3) greater state and federal income taxes.

A limited partnership is a hybrid organization consisting of general partners, who have unlimited liability for the partnership's debts, and limited partners, whose liability is limited to the amount of their investment.

A limited liability partnership, LLP, (also called a limited liability company, LLC) is a hybrid organization where all partners enjoy limited liability for the business's debts. It combines the limited liability advantage of a corporation with the tax advantages of a partnership.

A professional corporation (also called a professional association) is a type of corporation common among professionals that provide most of the benefits of incorporation but does not relieve the participants of malpractice liability.

The goals of the corporation

The central goal of the corporation is stockholder wealth maximization (achieved through stock price maximization). Those individuals charged with the day-to-day management of a corporation are empowered by the shareholders of the firm, thus it is logical that management should act on shareholder's behalf. This can prove to be a symbiotic relationship should shareholders seek to fuse managerial compensation with shareholder wealth.

An additional goal of the corporation could be social responsibility. However, initiating a socially responsible policy in an organization often carries a price. It is often a careful balance between social obligation and profit maximization.

Agency problems

Agency problems arise anytime an individual or organization depends upon another individual or organization to act on its behalf and make proxy decisions for them. In business, agency problems may arise in the context of: (1) stockholders versus managers and (2) managers versus creditors.

1. Stockholders versus managers- arises primarily when stockholders are unsatisfied with management's ability to maximize stock price. Some mechanisms stockholders may chose to use to motivate managers include: (1) managerial compensation, (2) direct intervention by shareholders, (3) the threat of firing, and (4) the threat of takeover.
2. Managers versus creditors- arises because managers are acting on the behalf of shareholders. The rates that bondholders lend to corporations is based upon perceived riskiness of the firm's assets, future assets, the present capital structure (how much debt the firm already has), and expectations of future capital structure decisions. The more leveraged the firm is (the more debt it has) stockholders face smaller downside risk and greater increased expected returns. Thus, stockholders may be more willing to assume risky projects than bondholders. Such actions decrease the value of bondholder's investments.

Managerial actions to maximize shareholder wealth

It is important to recognize that the key factors that determine stock price are: (1) expected cash flows, (2) the timing of cash flows, and (3) the perceived risk of these cash flows. Thus, these are the factors that shareholders are chiefly concerned with. Managers are charged with the responsibility to make operating and financing decisions that ultimately culminate in the determination of cash flows. Note: generally speaking, managers can increase stock price by engaging in one or any combination of the following: (1) increasing expected cash flows, (2) speeding up their fruition, or (3) reducing the their riskiness.

Return to Chapter

Copyright © Harcourt College Publishers, A Harcourt Higher Learning Company. All rights reserved.