Chapter 1. Goals and Functions of Finance

The financial manager's domain includes:
 Investment in assets and new products.
 Determining the best mix of financing and dividends in relation to a company’s overall valuation.

CREATION OF VALUE.
A company's financial goal is to maximize shareholder wealth. Value creation occurs when you do something for your shareholders that they cannot do for themselves.

Profit Maximization versus Value Creation.
An objective of maximizing earnings per share is not the same as maximizing market price per share, since the former does not consider:
1) The timing or duration of expected returns.
2) The risk or uncertainty of the prospective earnings stream.
3) The dividend the company might pay.

Agency Problems.
The agency theory of the firm says that the principals (stockholders) can assure themselves that the agent (management) will make optimal decisions only if appropriate incentives are given and only if the agent is monitored.

Agency costs involve conflicts between stakeholders -equity holders, lenders, employees, suppliers, etc.-, which usually arise because they have different objectives, thereby causing each party to want to monitor the others.

A Normative Goal.
The purpose of capital markets is to allocate savings efficiently in an economy, from ultimate savers to ultimate users of funds who invest in real assets. This allocation occurs on the basis of expected return and risk, which are embodied in the share price.

Social Responsibility. This is not to say that management should ignore social responsibility. Social goals and economic efficiency can work together to benefit multiple stakeholders, and not only the stockholders.

Functions of Finance. The functions of finance involve three major decisions a company must make: the investment decision, the financing decision, and the dividend/share repurchase decision. Each must be considered in relation to our objective; an optimal combination of the three will create value.


INVESTMENT DECISION.
Capital investment is the allocation of capital to investment proposals whose benefits are to be realized in the future. Because the future benefits are not known with certainty, investment proposals necessarily involve risk. Therefore, investments in capital projects should provide expected returns in excess of what financial markets require.

In addition to selecting new investments, a company must manage existing assets efficiently.


FINANCING DECISION.
Capital structure involves determining the best mix of debt, equity, and hybrid securities to employ. If a company can change its total valuation by varying its capital structure, an optimal financing mix would exist, in which market price per share could be maximized.


DIVIDEND/SHARE REPURCHASE DECISION.
Excess cash can be distributed to stockholders directly through dividends or indirectly via share repurchase (which allows to avoid tax consequences).

The value, if any, of these actions to investors must be balanced against the opportunity cost of the retained earnings lost as a means of equity financing, which could bring share prices down.


BRINGING IT ALL TOGETHER.
Financial management endeavors to make optimal investment, financing and dividend/share repurchase decisions.