1. Contemporary Financial Management
Lecture 1:
The Role and Objective of
Financial Management
© 2004 by Nelson, a division of Thomson Canada Limited

2. Introduction
• This lecture 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.
2 © 2004 by Nelson, a division of Thomson Canada Limited

3. 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?
3 © 2004 by Nelson, a division of Thomson Canada Limited

4. Forms of Business Organizations
• Sole proprietorship
• Partnership
• Corporation
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5. 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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6. 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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7. Partnership
• Owned by two or more persons
• Classified as general or limited
Advantages Disadvantages
Easy Formation Difficult to Raise Funds
Taxation occurs at the Partnership Dissolves if
level of the partner, not Partner Dies
the partnership
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8. 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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9. 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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10. Corporation
• A distinct, legal entity of its own
Advantages Disadvantages
Limited Liability Potential for Double
Taxation
Permanency
Some Owners Have
Ability to Minimal Control
Raise Capital
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11. Board of Directors
• Shareholders elect a Board of Directors
• Board of Directors appoints the officers of the
company:
• Chairman of the board
• Chief executive officer (CEO)
• Chief operating officer (COO)
• President
• Chief financial officer (CFO)
• Vice president
• Treasurer
• Secretary
11 © 2004 by Nelson, a division of Thomson Canada Limited

12. 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
12 © 2004 by Nelson, a division of Thomson Canada Limited

13. 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)
13 © 2004 by Nelson, a division of Thomson Canada Limited

14. Priority of Corporate Securities
Bonds: Debt securities often backed
by the corporation’s assets.
Priority
Preferred Stock: non-voting shares
that often offer a fixed dividend
to shareholders.
Common Stock
14 © 2004 by Nelson, a division of Thomson Canada Limited

15. Type of Organization Influenced by
• Cost
• Complexity
• Liability
• Continuity
• Need for capital
• Decision making
• Tax considerations
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16. 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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17. Social Responsibility
• Ethical issues will constantly confront financial
managers as they strive to achieve the goal of
Shareholder Wealth Maximization
• Managers must:
• Avoid personal conflicts of interest
• Maintain confidentiality
• Be objective
• Act fairly
17 © 2004 by Nelson, a division of Thomson Canada Limited

18. Agency Relationships/Problems
Caused by
Owners separation of Managers
principals Employees
Management may attempt to maximize
its own welfare instead of the owners’ wealth.
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19. 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.
19 © 2004 by Nelson, a division of Thomson Canada Limited

20. 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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21. Another Agency Problem
Caused by
Owners
separation of Creditors
Solution:
Creditors insert protective covenants in
loan agreements
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22. Examples of Protective Covenants
• Limitations on
• Dividends
• Capital expenditures
• Incurring additional debt
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23. 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
23 © 2004 by Nelson, a division of Thomson Canada Limited

24. 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
24 © 2004 by Nelson, a division of Thomson Canada Limited

25. Conditions Affecting Market Value
Factors outside of
management’s control
Factors within
management’s control Conditions
in Financial
Markets
Amount, Timing & Size of
Expected Cash Flows
Shareholder Wealth
(Market Price of the Shares)
25 © 2004 by Nelson, a division of Thomson Canada Limited

26. 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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27. 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
27 © 2004 by Nelson, a division of Thomson Canada Limited

28. 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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29. NPV Example: Intuition
0 1 2 3
$1 M $400K $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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30. NPV Example: Solution
NPV Decision:
Reject the project. Accepting the project will
destroy significant shareholder value
NPV=PV CashInflows -PV Cash Outflows
 1- ( 1+r ) -t   1- ( 1+r ) -t 
=PMTInflows   -PMTOutflows  
 r   r 
   
 1- ( 1.20 ) -3 
=400,000   -1,000,000
 0.20 
 
=$842,5923
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31. 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.
31 © 2004 by Nelson, a division of Thomson Canada Limited

32. End of Lecture -1
32 © 2004 by Nelson, a division of Thomson Canada Limited