Goals of Financial Management

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I NTRODUCTION
CHAPTER 1

THE GOALS AND FUNCTIONS OF
FINANCIAL MANAGEMENT

Finance is a dynamic, rigorous discipline built on the
foundations of accounting and economics. The focus of
finance is on increasing value, as measured by market
share price, and this theme is played out daily in the
world’s financial markets. The financial manager performs
many functions to enhance value for the shareholder.

The Goals and
Functions of Financial
Management
LEARNING OBJECTIVES
1 Identify how finance builds
on the disciplines of accounting and economics.
2 Discuss the analytical
decision-making nature of
finance within a risk-return
framework.

3 Describe the primary goal of
finance as the maximization
of shareholder wealth as
measured by share price.

5 Outline the activities of financial managers based primarily
on the efficient raising and
investing of funds.

4 Identify possible conflicting
goals of finance such as
social goals or management
interests.

6 Identify the role of financial
markets in allocating capital,
determining value, and establishing yields.

A financial manager must perform effectively in
today’s competitive business environment for
the firm to be successful. The task requires constant analysis and adjustment to the changing
influences on the firm:
• Variable interest and exchange rates
• Capital acquisition and risk control
(stock, bond, derivative markets)
• Volatile commodity prices
• Technological innovations
• Modified consumer demand from marketing efforts and changes in optimism

These and other changes immediately
affect the flow of cash in and out of the firm and
impact its value. In this dynamic environment
financial managers are challenged to maintain
the firm’s financial viability.
Financial management is concerned with:
• Managing efficiently the capital (assets
and liabilities) of the firm
• Understanding global financial markets
• Determining value, and enhancing the
firm’s value
Understanding today’s sophisticated financial markets and the various tools of financial
management are vital to the financial manager.
It is in the financial marketplace that assets are
valued based on their current and best use.
Increasingly these financial markets and the
firm’s operations are international in scope.

CHAPTER 1 The Goals and Functions of Financial Management

3

THE FIELD OF FINANCE

Bank of Canada
www.bankofcanada.ca/en/

The finance discipline has developed rigorous decision-oriented analysis models that focus on
creating value within the firm by:
• Raising capital efficiently (debt from creditors and equity from shareholders)
• Investing in value-creating assets [current (short) and capital (long term)]
Financial management in pursuing value creation builds upon the disciplines of economics and accounting, which requires students of finance to appreciate the relationships
amongst these disciplines.
Economics provides the financial manager with:
• A broad picture of the economy and the key measures that influence the corporation’s decisions and performance (gross domestic product, industrial production, disposable income, unemployment, inflation, interest rates, taxes).
• An understanding of the institutional structure of our mixed capitalist system
(Government regulation, Bank of Canada, chartered banks, investment dealers, trusts,
insurance companies, stock exchanges, derivative markets). Capital is accumulated
and valued in competitive financial markets, affecting its cost and availability to
the firm.
• A structure for decision making (risk analysis, pricing theory through supply and
demand relationships, comparative return analysis).
Accounting provides the financial manager with:
• Much of the language of finance (assets, liabilities, cash flow).
• Financial data (income statements, balance sheets, statement of cash flows). The
financial manager must know how to interpret and use this data in allocating the
firm’s financial resources to generate the best value based on return and risk.
Finance links economic theory with the numbers of accounting, and all corporate managers—whether in the area of production, sales, research, marketing, management, or long-run
strategic planning—must know what it means to assess the financial performance of the firm.
The field of finance offers career opportunities as varied as banker, corporate treasurer,
stockbroker, financial analyst, portfolio manager, investment banker, financial consultant, and
personal financial planner. As you progress through the text, you will become familiar with
many of these roles in the financing and decision-making processes. A financial manager in
the firm may be responsible for decisions ranging from where to locate a new plant to raising
funds via a public share issue. Sometimes the task is simply to figure out how to get the
highest return on a million dollars of temporarily idle cash between 5:00 p.m. one afternoon
and 8:00 a.m. the next morning.
For the small business operator these many roles are often undertaken by one person.
Nevertheless, it is important for that individual to have knowledge of accounting and economics to assist them in financial decision making. Finance focuses on creating value and
these disciplines will help to focus the small businessperson on that goal.

EVOLUTION OF FINANCE AS A FIELD OF STUDY

Toronto Stock
Exchange
www.tsx.ca

To appreciate finance as a field of study, a historical perspective on its development is instructive. Finance is:
• A descriptive discipline
• An analytical, decision-oriented discipline
• A discipline used by financial managers
Description began with the development of the Toronto and Montreal stock exchanges
in the 1870s to identify their functions, procedures, and products in the raising of capital.
Financial instruments such as stocks and bonds were defined, as were the institutions of the
financial system such as investment dealers, brokers, and securities regulators. The Depression
of the 1930s focused descriptions on preservation of capital, maintenance of liquidity,

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The Foundations

1
Q

What recent economic events have
influenced market
values?

2
Q

Do Nortel’s current
statements reflect
the market value
of its equity?

Accounting provides information that the financial analyst can use to illuminate asset values of
the firm. To the astute financial analyst the financial statements can give clues to underlying
values. However, in the last few years we have
seen the manipulation of financial statements at
several corporations and this weakens the
analyst’s ability to use these statements to establish reliable valuations.
Nortel Networks on several occasions restated its financial results, causing dramatic changes
in its share price and incurring the concerns of
investors and regulatory bodies. Nortel’s statements have shown a considerable divergence
between the accounting or book value and the
market value of its equity.
Nortel shareholders’ equity (billions)
Book Value

Market Value

$29
2
3

$350
3
50

2000
2002
2004 (Mar.)

The market value of Nortel’s equity is a
reflection of investor expectations in its ability to
generate cash flow from its operations and
assets. In 2001 Nortel recorded a loss of U.S.
$27.3 billion in its financial statements to reflect
a decrease in asset values, a loss in value already
recognized by the market. More recently
investors have questioned the reliability of

Nortel’s accounting numbers and the ability of
the numbers to estimate future performance.
Economics, another building block of
finance, provides us with useful theories in
order to understand value formation. When the
terrorist attacks of September 11, 2001 on New
York and Washington shook people’s confidence in the American economy, the financial
markets declined in value reflecting the expectation that many firms would not be able to
produce the same returns in a suddenly more
uncertain world. In 2004 as oil prices rose
above U.S.$50 a barrel and interest rates
reached 40 year lows investors began to evaluate how increasing inflation might affect values.
These increased risks caused volatility in the
financial markets.
Accounting and economics provide indispensable tools to understand how value is
determined in financial markets.
When you examine Nortel’s financial statements do you find a significant difference
between GAAP income and pro forma income?
Compare the book value of equity to the market
value of equity (available at the TSX site).
The impact of the September 11, 2001 terrorist attacks on the economy and the financial
markets can be seen in the performance of the
S&P/TSX Composite Index. Examine how the
index has performed since September 11, 2001
at www.bigcharts.com (ca: S&P/TSX Composite
Index)

Nortel Share Value

60

www.nortelnetworks.
com
Symbol: NT
www.tsx.ca

Share Price

120

0
00

01

02

03

04

Year

reorganization of financially troubled corporations, and the bankruptcy process. Company
failures, together with the questionable treatment of outside investors’ interests by insiders,
led to the development of securities regulations.

CHAPTER 1 The Goals and Functions of Financial Management

5

A by-product of these regulations was the development of published data related to corporate performance, laying the groundwork for later analytical techniques that would use this
data and other corporate information. The accounting scandals of the early 21st century
(Nortel, Enron) have again lead to increased requirements for regulation, disclosure and better
corporate governance.
Analysis and decision-orientation developed in the mid-1950s with a focus on the allocation of financial capital (money) for the purchase of real capital (plant and equipment) and
the creation of value. Value was created within the interplay of projected returns and their risks.
Capital budgeting analysis1 developed to evaluate the long-run decisions of the firm that
might commit it to expensive strategies, technologies, or real capital. Sophisticated techniques
assisted the financial manager in an objective decision-making process to allocate the firm’s
scarce resources among competing managers and proposals. These competing investment proposals were valued based on their expected earnings, cash flows, risk and an acceptable rate of
return, usually suggested by the financial markets.
The use of value and rates of return from the markets lead to the study of how well the
markets reflected true or intrinsic value and how well they processed information. This study
is referred to as market efficiency. Recent research has examined the existence of asymmetric information in the markets. This study questions the appropriate functioning of financial
markets when there is an imbalance of pertinent information amongst investors and the management of firms.
Enthusiasm for sophisticated analysis spread to other decision-making issues such as cash,
inventory management and other important day-to-day decisions affecting the short- and longterm well-being of the firm. Capital structure theory, the study of the relative importance of
debt and equity in influencing the firm’s value, also began to receive analytical investigation.
Foundations were laid for financial theories of risk-return relationships in valuing assets
and of risk reduction through diversified portfolio management. In later years, financial
models were constructed to value options that assisted in the development of the huge derivatives markets of today.
Used by financial managers, these financial theories underlie the quantitative techniques
of decision analysis. Managers have focused on risk-return trade-offs, capital structure, and the
interrelationship between them when implementing strategies. Sometimes these strategies
have been successful, and at other times, managers have had to make adjustments due to
changes in the economy, new ideas, or new competition. Firms that at one time pursued diversification strategies to reduce risks, based on earlier theories, refocused on their core businesses by the late 1990s. Diversification, effective at the investor level, was questioned at the
corporate level. Meanwhile the derivatives market, built on financial theories during the late
20th century, has become huge in size as firms use it to reduce the risks faced from changes
in interest rates, exchange rates, and commodity prices.
Increasingly vigorous international competitiveness and rapid changes in the technologies
that define product markets and production processes have forced a sharpened focus on the
financial objectives of the firm. The use of analytical decision making has been emphasized
in large and small business. Financial theories are as applicable to the small business as to the
large corporation, although the analysis may not be as in-depth. The small-business owner will
be better prepared to adapt to the rigours of the changing marketplace if he or she is knowledgeable about the theories and techniques of decision analysis.
Today e-commerce presents more efficient ways to interact with customers—the business
to consumer model (B2C)—and with suppliers—the business to business model (B2B). In the
B2C model, credit and debit cards provide instantaneous cash flow. In the B2B model, orders
can be placed, inventory managed, and bids to supply product can be accepted on-line. The
B2B model can help companies lower their cost of managing inventory, accounts receivable,
and cash. As the pace of business increases analytical decision making must occur effectively
and quickly using well-founded techniques.
A starting point was Joel Dean, Capital Budgeting (New York: Columbia University Press, 1951).

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Nobel Prize Winners for Finance (Economics)

1
Q

Why were each of
these individuals
awarded the
Nobel Prize?

www.nobel.se

During the last couple of decades several individuals have been awarded the Nobel Prize in
economics for their body of work in the discipline of finance. These gentlemen have had a
significant impact on financial theory, financial
management of firms, and the techniques used
to determine value in today’s financial markets.
Financial managers, analysts, and investors
employ techniques derived from the models
developed by these Nobel laureates on capital
structure, dividend policy, portfolio management, risk-return relationships, the reduction of
risk through the use of derivatives, and how
financial markets incorporate information into
share values.

The Nobel laureates are:
• Franco Modigliani 1985
• Harry Markowitz
1990
• Merton Miller
1990
• William Sharpe
1990
• Robert Merton
1997
• Myron Scholes
1997
• Joseph Stiglitz
2001
Brief descriptions of the men, their theories,
and their influence on the discipline of
finance, in theory and in practice, can be
viewed at the Nobel web site. Search for each
laureate by name.

GOALS OF FINANCIAL MANAGEMENT
Financial management is concerned with the efficient management of the firm by employing
its resources in the most productive manner. There are several goals or objectives that might
be suggested:
• Customer satisfaction
• Product quality
• Happy employees
• Payment of taxes for society’s welfare
• Contributing to the local community
• Enriching management
• Creating value for shareholders
However, is there one goal that best encompasses the productive use of the firm’s
resources? Might one goal capture the other suggested objectives of the firm?

Maximizing Shareholder Wealth
Despite the different interests at play in formulating a company strategy, all interests are probably best served by creating as much value in the firm as possible. Although we might question for whom the value is created, the broad goal of the firm can be brought into focus if
we say the financial manager’s goal is shareholder wealth maximization. The firm is owned
by the shareholders and they retain its residual value. Analysis of the motivations and actions
of the firm are also best explained with maximization of shareholder wealth considered the
firm’s goal.
There are suggestions that other goals may explain the actions of the firm. Agency
theory, a branch of financial research, examines the potential for conflict between the owners
of the firm and the firm’s managers who make the day-to-day decisions. Diversified ownership interests may allow managers to follow their own interests that differ from those of the
shareholders and other interested parties. This can affect the financial decisions of the firm
in such issues as management compensation, corporate restructuring, accounting statement
reliability and appropriate strategic investments. Agency theory is important in assessing
management’s effect on the goals and value of the firm.
To some extent management power is checked by institutional investors such as pension
funds and mutual funds that own a large percentage of major Canadian companies. They

7

CHAPTER 1 The Goals and Functions of Financial Management

have more to say about the way publicly owned corporations are managed through their
ability to vote large blocks of shares and replace poorly performing boards of directors. Since
these institutions represent individual workers and investors, they have a responsibility to see
that the firm is managed in an efficient and ethical way.

Measuring the Goal
We may agree that maximizing shareholder wealth is an appropriate goal for the firm.
However, how can we measure whether or not we have been successful in achieving this goal?
Is it:
• Market share
• Earnings or profits
• Size of the firm
• Share price
• Return on investment
We may be tempted to suggest that the most important goal for financial management is
“to earn the highest possible profit for the firm.” This seems to be reinforced by income statements where the bottom line is earnings. Under this criterion each decision would be evaluated on the basis of its overall contribution to the firm’s earnings. While this seems to be a
desirable approach, there are some serious drawbacks to selecting profit maximization as the
primary goal of the firm as it may not increase shareholder value.
First, a change in profit may also represent a change in risk. For example, a conservative firm
that earned $1.25 per share may become a less desirable investment as its earnings per share
increase to $1.50 per share if it has taken on more risk to achieve the increase in earnings. The
firm may have incurred more debts or invested in projects that have cyclical earnings.
Shareholders of the firm may consider the increase in risk insufficient for the increased earnings.
A second possible drawback to the goal of maximizing profit is that it fails to take into
account the timing of benefits. For example, if we could choose between the following two
alternatives, we might be indifferent if our emphasis were solely on maximizing earnings.
Earnings per Share
Alternative A . . . . . . . .
Alternative B . . . . . . . .

Period One
$1.50
2.00

Period Two
$2.00
1.50

Total
$3.50
3.50

Both investments would provide $3.50 in total earnings, but Alternative B is clearly superior because the larger benefits occur earlier. We could reinvest the difference in earnings for
Alternative B for an extra period.
Finally, the goal of maximizing profit suffers from the almost impossible task of accurately measuring the key variable—profit. There are different economic and accounting definitions of profit (earnings), each of which is open to its own set of interpretations.
Furthermore, earnings may or may not correspond to current values due to the methods
used to capture accounting accruals and the amortization of capital expenditures. Financial
statements are also subject to manipulation by managers and therefore reported earnings
may be misleading.

Market Share Price
Although profits are connected to the goal of maximizing shareholder wealth, they don’t
necessarily measure it well. Wealth is best measured in our mixed capitalist system by what
people are currently willing to pay for something, and what investors are willing to pay for
a firm is its market determined share price. Share price is a value that investors collectively are prepared to pay, whereas earnings are a paper entry prepared by management and their
accountants. Market share price directly ties the firm’s success back to the goal of shareholder
wealth maximization.

8

PART 1

Introduction

In an analysis of the firm’ market share value the investor will consider:
• The risk inherent in the firm (nature of its operations and how the firm is financed)
• The time pattern of the firm’s earnings and cash flows
• The quality and reliability of reported earnings (as a guidepost to future earning
power)
• Economic and political factors
As share price is a more complete measure of the achievement of shareholder wealth the
financial manager must be sensitive to the effect of each decision on the firm’s overall valuation. If a decision maintains or increases the firm’s overall value, it is acceptable from a financial viewpoint; otherwise, it should be rejected. This is the one basic principle upon which
everything in this text is predicated.
However, achieving the highest possible share price for the firm is not a simple task. The
financial manager cannot directly control the firm’s share price as it is affected by investors’
future expectations as well as by the general economic environment. Even firms with good
earnings and favourable trends do not always perform well in the financial markets. Effective
financial management to help achieve this measurement yardstick is therefore quite important.
We observe that investor expectations change. In the 1950s and 1960s, investors emphasized maintaining rapid rates of earnings growth. In the 1970s and 1980s investors became
more conservative, putting a premium on lower risk and, at times, high current dividend payments. In the 1990s investors focused on globally competitive firms. High-tech Internet companies, with no earnings, were the rage in the late 1990s and some proclaimed the end to old
valuation models. In the new millennium the old valuation models based on earnings and
cash flow regained adherents as share prices for many high-tech companies plunged in value.
The key model of finance is the present value model that determines the value of assets
based on their future “expected” cash flows. Expected implies that there is uncertainty as to
the amount and the timing of these cash flows and therefore valuation must consider how risk
will influence asset values and the return to investors. The present value model, with riskreturn considerations, requires an appropriate discount rate to value cash flows. We look to
the financial markets to supply us with this discount rate.

Management and Shareholder Wealth
In line with the earlier discussion of agency theory, one might ask, “Does modern corporate
management actually follow the goal of maximizing shareholder wealth and does it try to
increase market share price?” Management likely has its own interests to look after in operating the firm. Financial managers are interested in:
• maintaining their jobs (may discourage value-enhancing takeovers)
• protecting “private spheres of influence”
• maximizing their own compensation package
• arbitrating among the firm’s different stakeholders (shareholders, creditors, employees,
unions, environmentalists, consumer groups, Canada Revenue Agency, government
regulatory bodies, customers)
Pursuit of these interests may emphasize short-term results over long-term wealth building. Management may also perceive the risk of investment decisions in a manner different
from shareholders, leading to different points of view as to the best decision regarding the
investment of the firm’s resources.
Recognizing that there may be different motivations between managers and shareholders
introduces the need to monitor the performance of management through independent boards
of directors, compensation packages, audited financial statements, and regulatory bodies. The
conflicts or frictions that exist and the devices established to control them, impose “agency”
costs on the firm that may reduce share values. Other agency costs are imposed by banks
and bondholders that place restrictions on the actions of management to protect their positions in exchange for providing debt. Therefore tradeoffs exist amongst the agency costs of

9

CHAPTER 1 The Goals and Functions of Financial Management

Power Corporation
www.powercorp.ca

monitoring management actions, allowing sufficient discretion for management decisionmaking and designing compensation packages to motivate management to perform in the
interests of the shareholders.
Managers often have their compensation determined from a combination of measurement yardsticks focused on several objectives. Stock options and bonuses are paid based on
accounting measures that are subject to manipulation by managers and do not necessarily correlate well with the goal of maximizing shareholder wealth. These measures that have enriched
many executives do not necessarily produce the same results experienced by long-term owners
of shares. This has lead to a divergence of interests between managers and investors often
resulting in questionable business decisions.
Despite their own interests there are still reasons for management to act to maximize
shareholders’ wealth. First, in most cases, “enlightened management” is aware that the only
way to maintain its position over the long run is to be sensitive to shareholder concerns. Poor
stock price performance relative to other companies often leads to takeovers and proxy fights
for control. Second, members of top management often own shares in the firm, which motivates them to achieve market value maximization for their own benefit. Third, powerful institutional investors are making management more responsive to shareholders.
Share ownership that is widely held amongst many investors may allow management to
pursue its own interest, although patterns of share ownership in Canada may mitigate this tendency. Traditionally share ownership in Canada has been tightly held, although Table 1–1
reveals some evidence of widely diffused stock ownership in 36 of our 100 largest companies.
Many are subsidiaries of U.S. or other foreign multinational companies and several are controlled directly by one family, such as the Desmarais family through Power Corporation.
However through pension funds, insurance companies, and mutual funds, the average
Canadian is participating indirectly in share ownership to the tune of hundreds of billions of
dollars. Pension fund managers are taking a more active role in the corporations in which they
have an investment and are holding managers accountable. These ownership patterns suggest
that management interests at least coincide with at least one shareholder.
The patterns of share ownership and concentration of wealth provide hints as to
the reasons for the difficulties experienced by the smaller entrepreneur in accessing capital
in Canada.

TABLE 1–1
Ownership of
Canada’s 100 largest
companies*
*As determined by
revenues.

Widely held
Family or individually controlled
United States controlled
Other foreign country controlled
Government controlled
Other controlled

36
25
15
6
13
5
100

Source: National Post, The Financial Post 500, June 2004.

Social Responsibility and Ethical Behaviour
Corporations play a dominant role in our society and as such have a duty to act in an appropriate manner. Is, however, the goal of shareholder wealth maximization consistent with a
concern for social responsibility? We believe that in most instances the answer is yes. By
adopting policies that maximize values in the market, the firm can attract capital, provide
employment, and offer benefits to its host community. This is the basic strength of the
private enterprise system. Successful business firms can support the fund drives for endeavors by fine arts organizations, social assistance groups and post secondary institutions.

10

PART 1

Introduction

Corporations, which receive their operational charters from society, should consider
socially desirable actions that include:
• community works (charitable giving, employment opportunities for marginalized
groups)
• customer respect (safe products, fair pricing, appropriate advertising and communication)
• strong employee relations (fair benefits and compensation, equitable hiring, education, health and safety)
• environmental health (pollution controls, appropriate use and renewal of resources)
• human rights promotion (respecting the dignity of individuals globally)
There are good recent examples of responsible Canadian corporations. Tembec
(www.tembec.com) is seeking certification for all its forestry operations by the Forestry
Stewardship Council, an international coalition stressing forestry conservation and respect for
aboriginal interests. As well there is Suncor Energy (www.suncor.ca) with its commitment to
“green” energy sources and its working relationship with aboriginal and Metis groups.
Nevertheless, certain socially desirable actions may at times be inconsistent with earning
the highest possible profit or achieving maximum valuation in the market. For example, pollution control projects frequently offer a negative return on investment. Does this mean firms
should not exercise social responsibility in regard to pollution control? The answer is no—but
certain cost-increasing activities may have to be mandatory rather than voluntary, at least initially, to ensure that the burden falls equally over all business firms.
Regularly, we hear of unethical and illegal financial practices, on Bay and Wall Streets, by
corporate financial “deal makers.” When we speak of ethics in business there are perhaps two
key aspects:
• fairness (obeying the established rules of regulatory bodies and the company bylaws,
appropriate compensation to managers and employees, and equitable share voting)
• honesty (timely and full disclosure of pertinent company developments, rigorous
financial reporting and scrutiny)
Fairness often is questioned when employee salaries are compared to those of top executives. In 2003 the average Chief Executive Officer (CEO) of Canadian corporations earned
$3.2 million versus an average worker salary of $36,000. Extremes such as Frank Stronach’s
$53.6 million at Magna and Robert Gratton $52.4 million at Power only magnify the discrepancy. Executive compensation is generally composed of base salary, bonuses, stock
options and lucrative pension entitlements. What is currently missing from these corporations
is an appropriate disclosure of the connection between the compensation schemes for top
executives and the performance of the corporation in wealth creation for other shareholders.
Honesty, within the capitalist system, comes into question when the top executives seem
to benefit from “confidential information” at the expense of regular shareholders. Insider
trading has been a widely publicized issue in recent years. Insider trading occurs when
someone has information that is not available to the public and then uses this information to
profit from trading in a company’s common stock. This practice is illegal and is protected
against by the various securities commissions across Canada. Sometimes the insider is a
company manager or friend; other times it is the company’s lawyer, investment dealer, or even
the printer of the company’s financial statement. Anyone who has knowledge before public
dissemination of that information stands to benefit from either good news or bad news.
Martha Stewart, of homemaking fame, had been suspected of insider trading when she
sold 3,928 shares of ImClone Systems before the market was informed that its drug for the
treatment of colon cancer had been rejected by the government. She saved $45,000 with the
early sale. In 2004 Ms. Stewart was found guilty and sentenced to five months in jail, with
probation and a fine, not for insider trading but for lying to federal investigators. Canadian
examples aren’t as prevalent, although Larry Ryckman, who at one time owned the Calgary
Stampeders, was charged with stock manipulation during the 1990s, and Viola MacMillan
served a prison sentence for improper trading practices, but later returned to business eventually receiving the Order of Canada. In 1964, Ms. MacMillan was an established member of

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Decisions for Value
Dell Computers prides itself on holding only 4
days inventory and shipping customized
product to the customer almost instantaneously.
Delivery requires close liaison with the shipping
and airline businesses. This allows Dell to minimize its investment in current assets and liabilities, which is a working capital decision.
In early 2002 PanCanadian and Alberta
Energy agreed to merge, creating the world’s
largest independent oil and gas company,
EnCana. In 2004 Canfor completed the acquisition of Slocan Forest Products creating the
world’s second largest lumber company. This
occurred when the U.S. duty on softwood
lumber and rising interest rates could have
decreased demand for lumber for housing.
Mergers, takeovers, and company expansion
are capital budgeting decisions made to create
value. These investments require an appropriate
assessment of risk to determine a rate of return,
known as the cost of capital.
In 1999 TransCanada Corporation decreased
its dividend unexpectedly and its share price
declined significantly. Management was
attempting to increase internal cash flow to
reduce its debt and improve earnings. By 2001,
as investors saw the improved results at TCPL,
the share price increased about 90 percent to
$19.00. Back in 1987 Inco, one of the world’s
largest nickel producers, had so much cash it
didn’t know what to do with it. A U.S. $10 per
share dividend was paid and share prices were

bid up. Decisions to alter the relationship
between debt and equity in the firm are referred
to as capital structure decisions.
These are some of the decisions made by
corporations as they attempt to create value for
shareholders. By going to the TSX web site you
can see how the share prices of these companies have performed since these decisions were
made.
While these decisions have created value for
the firm and its shareholders the stewardship of
the corporation by management and the Board of
Directors has been questioned in recent years.
Nortel management was fired in 2004 for apparently manipulating the financial results to
increase management bonuses. This also
increased scrutiny of how bonuses and compensation were determined at corporations. At Shaw
Cable, for instance, a bonus is paid to the
Chairman based on operating profits, ignoring
capital expenditures and debt costs ($260 million
in 2003), which are determined largely by strategic decisions of the chairman. Magna pays a
bonus for “personal performance.”
When investors doubt the integrity of the
leadership of a firm, there is a loss of value in
the markets. The Ontario Securities Commission
in 2004 introduced new governance standards
to replace the Toronto Stock Exchange (TSX)
guidelines of 1994. The TSX had been largely
self-governing in these matters before 2004.

1
Q

Do these companies create value
despite corporate
governance issues?

www.encana.com
Symbol: ECA
www.canfor.com
Symbol: CFP
www.transcanada.com
Symbol: TRP
www.magnaint.com
Symbol: MG.A
www.shaw.ca
Symbol: SJR.B

the mining industry and well connected to the securities regulators. Her company, Windfall
Oil and Mines Ltd., soared in price from $0.56 to $5.60 over a month, as people speculated
on the results of copper, zinc and silver assay results from properties in Northern Ontario.
She sat on the assay results, which were not favourable, and made suggestive comments while
investors wildly bid up the share prices. Relevant information was not disclosed. Viola
MacMillan was later convicted, not for insider trading, but for wash trading in another
company. Wash trading by an individual involves the simultaneous buying and selling of
company shares to create the illusion of increased investor interest.
The rules of fairness are laid out by the securities commissions, stock exchanges, accounting bodies, government laws and the employees of firms. The Canadian Corporations Act
(http://laws.justice.gc.ca/en/C-44/) states in Section 122 that directors and officers of the firm
should “act honestly and in good faith with a view to the best interests of the corporation.”
Nevertheless we have also heard of financial officers manipulating financial results, sometimes
with the collaboration of accounting firms, to enrich themselves at the expense of the ordinary investor. Strong ethical standards for a corporation should be established by the Board
of Directors. Good corporate governance results from:
• board composition (strong leadership, competent education, balanced competencies)
• director and officers ownership positions in the firm (other than by stock options)
• a published code of ethics
• independent audits and a financially literate audit committee

12

PART 1

Introduction

There is some academic research that suggests that good governance leads to superior
wealth creation in firms; see http://viking.som.yale.edu/finance.center/Conference-Papers/
Fall2001/gov.pdf and a paper by Brown and Caylor found at www.issproxy.com. Institutional
investors realizing the importance of ethical leadership formed the Canadian Coalition for
Good Governance (www.ccgg.ca) to promote best practices.
There have been increased demands for additional corporate governance practices by
firms, despite the increased costs of compliance and sometimes delays in timely reporting of
financial results. These measures include:
• separating the roles of CEO and Chair of the Board
• independent Board of Directors members
• improved accounting standards (stock options, internal audit controls, “off balance
sheet items”) (Chapter 2)
• more stringent reporting and disclosure requirements (Chapter 14)
• closer monitoring by regulatory bodies (securities commissions) (Chapter 14)
• questioning the use of “dual class” shares (Chapter 17)
Such activities as insider trading or the manipulation of financial statements to distort the
true financial results of the firm serve no beneficial economic or financial purpose, and it
could be argued that they have a negative impact on shareholders interests. Illegal security
trading and poor corporate governance destroys confidence in securities markets making it
more difficult to achieve shareholder wealth maximization.

FUNCTIONS OF FINANCIAL MANAGEMENT
The study of finance leads to a variety of functions within the capital and real markets of our
system. These include:
• corporate finance
• banking
• securities trading and underwriting
• money management
• financial planning
• risk management (insurance)
Within the firm it is the responsibility of financial management to allocate funds to current
and capital assets, to obtain the best mix of financing alternatives, and to develop an appropriate
dividend policy within the context of the firm’s objectives. These functions are performed on a
day-to-day basis as well as through infrequent approaches to the capital markets to acquire new
funds. The daily activities of financial management, as outlined in Figure 1–1, require careful
monitoring of the cash position of the firm. These duties consume most of the financial
manager’s time. Less routine functions of a longer-term nature often require extensive analysis, as
these functions sometimes suggest decisions of strategic importance and large capital investment.
As indicated in Figure 1–1, all of these functions are carried out with the awareness of the
need to maintain the proper balance among the profitability and risk components of the
firm’s situation. The appropriate risk-return trade-off must be determined to maximize the
market value of the firm for its shareholders. The risk-return decision influences not only the
operational side of the business (capital versus labour or Product A versus Product B), but also
the financing mix (stocks versus bonds versus retained earnings).
The tasks of the financial manager are being reshaped by increased domestic and international competition, by advances in information technology and management techniques,
and by innovations in the types of financial markets and products. The functions of the financial manager are often organized into several positions. A chief financial officer usually takes
responsibility for long-term financing and investment; the controller looks after information
flows related to planning, control, and external reporting; and the treasurer looks after external relations, particularly as they apply to daily cash management. A large firm often has
many individuals who report to these positions and specialize in the duties required of the
functions outlined in Figure 1–1.

13

CHAPTER 1 The Goals and Functions of Financial Management

Figure 1–1
Functions of the
financial manager

Daily
Cash management
(receipt and disbursement
of funds)
Credit management
Inventory control
Short-term financing
Exchange and interest
rate hedging
Bank relations

Occasional
Intermediate
financing
Bond issues
Leasing
Stock issues
Capital budgeting
Dividend decisions
Forecasting

Profitability

Trade-off

Goal:
Maximize
shareholder
wealth

Risk

FORMS OF ORGANIZATION
The finance function may be carried out within a number of different forms of organization.
Of primary interest are the sole proprietorship, the partnership, and the corporation.
Sole Proprietorship A sole proprietorship is characterized by:
• single-person ownership
• simplicity of decision making
• low organizational and operating costs
• unlimited liability to the owner (can lose personal assets in settlement of firm’s debts)
• profits or losses taxed in hands of individual owner
Most small businesses with one to ten employees are sole proprietorships. The unlimited
liability is a serious drawback and few lenders are willing to advance funds to a small business
without a personal liability commitment from the owner.
Partnership A partnership is characterized by:
• multiple ownership
• ability to raise more capital and share ownership responsibilities
• unlimited liability for the owners (one wealthy partner may have to bear a disproportionate share of losses in a general partnership)
• taxation of profits or losses are allocated in percentages to partners
Most partnerships are formed through an agreement between the participants, known as
the partnership agreement, which specifies the ownership interest, the methods for distributing
profits, and the means for withdrawing from the partnership.
To circumvent the unlimited liability feature, a special form of partnership, called a
limited partnership, can be utilized. Under this arrangement one or more partners are designated general partners and have unlimited liability for the debts of the firm; other partners
are designated limited partners and are liable only for their initial contribution. The limited
partners are normally prohibited from being active in the management of the firm. Limited
partnerships are common in real estate and trust syndications.
Corporation A corporation is characterized by:
• a legal entity unto itself (may sue or be sued, engage in contracts, acquire property)
• ownership by shareholders (each with limited liability, although bankers may require
small business owners to give their personal guarantee)
• divisibility of the ownership (many shareholders)
• continuous life span (not dependent on life of one shareholder)
• taxation on its own income (individual shareholders pay tax on dividends or capital
gain tax when shares are sold)
In terms of revenue and profits produced, the corporation is by far the most important
form of economic unit. Thus the effects of many decisions in this text are considered from
the corporate viewpoint.

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Where Did Those Earnings Go?
Nortel Networks in 2003 recorded the following in the equity portion of its balance sheet (in
billions of U.S. dollars):
Contributed capital (common shares)
Retained earnings (deficit)
Equity

1
Q

In 2003 the market value of its equity was
$23 billion and in 2000 the book value of
equity had been $29 billion. Despite the negative earnings Nortel remains a going concern.

$37.4
<34.0>
3.4

How did Nortel get
a negative position
in retained earnings?

www.nortelnetworks.
com
Symbol: NT

Bell Canada Enterprises
www.bce.ca

The corporation is generally incorporated federally or in a single province with registration in all other provinces in which it conducts business. Although the incorporating procedure varies across Canada, to proceed with articles of incorporation, a firm will require a company
charter and the company by-laws. The charter contains the organization’s founding principles
and is relatively unalterable. The by-laws contain details of company policies and procedures
and can be changed by vote of the board of directors and shareholders.
A corporation may have thousands of shareholders, each with the right to vote. For
example, Bell Canada Enterprises, probably the most widely held Canadian company, has
almost 185,000 registered common shareholders. The shareholders’ interests are ultimately
managed by the corporation’s board of directors. The board of directors, who generally
include key management personnel as well as outside directors not permanently employed by
it, serve in a stewardship capacity and may be liable for the mismanagement of the firm or for
the misappropriation of funds.
The corporation is established with capital supplied by the shareholders and recorded on
its books as contributed capital (common stock). Earnings generated by the corporation are
owned equally by each shareholder and the Board of Directors has two choices for these earnings. Earnings can be:
• paid out as dividends (shareholders pay tax on dividends: a dividend tax credit
reduces the effect of double taxation)
• reinvested in the firm (recorded as retained earnings)

THE ROLE OF THE FINANCIAL MARKETS
The effect of managerial efforts and ethical (or unethical) behaviour on the value of the
company is decided daily through price changes in the financial markets. But what are the
financial markets? Financial markets are the meeting place for people, corporations, and
institutions that either need money or have money to lend or invest. In a broad context, the
financial markets exist as a vast global network of individuals and financial institutions that
may be lenders, borrowers, or owners of public companies. Governments also participate in
financial markets primarily as borrowers of funds for public activities; their markets are
referred to as public financial markets. Corporations such as Bombardier, Nortel, and CN
Rail, on the other hand, raise funds in the corporate financial markets. Today we increasingly see the sale of government assets through share issues. In 2004 or 2005 we expect the
Federal Government to sell the last of its interest in PetroCanada.

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The Pricing Mechanism of Financial Markets
In the late 1990s we saw a tremendous increase
in value of Internet stocks. Capital was being
reallocated to those companies that appeared to
be at the forefront of a new age. The reallocation was by way of the pricing mechanism of
the financial markets. As prices rose, more
capital flowed to the “new age” companies.
Internet companies had little in the way of tangible or hard assets. Their value flowed from
their ability to manipulate and supply information, which suggested that in the future they
would be able to generate large cash flows for
shareholders. Then their market values tumbled
and the “old” economy companies saw their
prices rise.
Gold traditionally has been a hard asset. It
has been used to conduct business transactions,
as a store of wealth and, due to its scarcity, it has
been used to back the major currencies of the

world. Gold that sold for U.S.$850 per ounce in
1980, sold for U.S.$278 per ounce in 2002.
Most major currencies have gone off the gold
standard and many countries have begun to sell
their gold reserves. In an age where capital can
be transferred instantaneously around the globe
and where many governments have learned to
effectively manage their economies with low
rates of inflation, gold has lost its significance as
a store of wealth and as a reserve currency.
Falling gold prices suggest that financial markets
no longer value gold as highly as before and are
reallocating capital elsewhere.
Where will the pricing mechanism of the
financial markets allocate capital resources
next?
There are several noteworthy financial
markets:

Equity (stock)

Derivative

TSX www.tsx.ca
Nikkei www.nni.nikkei.co.jp
NASDAQ www.nasdaq.com
LSE www.londonstockexchange.com

ME www.me.org
CBOE www.cboe.com
CME www.cme.com
LIFFE www.liffe.com

1
Q

What is the high,
low and current
price of gold over
the last thirty years?

www.kitco.com

Structure and Functions of the Financial Markets
Financial markets can be divided into many distinct parts. Some divisions, such as domestic
and international markets or corporate and government markets, are self-explanatory. Others,
such as money and capital markets, need some explanation. Money markets refer to those
markets dealing with short-term securities that have a life of one year or less. Securities in
these markets can include Treasury bills offered by the federal or provincial government, commercial paper sold by corporations to finance their daily operations, or certificates of deposit
with maturities of less than one year sold by banks. Examples of money market securities are
presented more fully in Chapter 7.
Capital markets are generally defined as those markets in which securities have a life of
more than one year. Although capital markets are long-term markets as opposed to short-term
money markets, it is often common to break down the capital markets into intermediate
markets (one to ten years) and long-term markets (greater than ten years). Capital markets
include securities such as common stock, preferred stock, and corporate and government
bonds. Capital markets are fully presented in Chapter 14.

Allocation of Capital
Corporations rely on the financial markets to provide funds for short-term operations and for
new plant and equipment. A firm may go to the markets and raise new financial capital by
either borrowing money through a debt offering of corporate bonds or short-term notes or by
selling ownership in the company through an issue of common stock. When a corporation
uses the financial markets to raise new funds, the sale of securities is said to be made in the
primary market by way of a new issue. After the securities are sold to the public (institutions
and individuals), they are traded in the secondary market between investors. In the secondary market, prices are continually changing, as investors buy and sell securities based on their

16

Petro-Canada
www.petro-canada.ca
Talisman Energy
www.talismanenergy.com

PART 1

Introduction

expectations of the corporation’s prospects. Also in the secondary market, financial managers
are given feedback about their firm’s performance. The markets determine value and allocate
capital to its most profitable uses. The present value calculations of Chapters 9 and 10 value
financial assets in much the same way as properly functioning markets.
How does the market allocate capital to the thousands of firms that are continually in
need of money? Let us assume that you graduate from college as a finance major and are hired
to manage money for a wealthy family like the Bronfmans. You are given $250 million to
manage, and you can choose to invest the money anywhere in the world. For example, you
could buy common stock in Bombardier, the Canadian transportation manufacturer, in
Nestlé, the Swiss food company, or in Telefonos DeMexico, the Mexican telephone company;
you could choose to lend money to the Canadian or Japanese government by purchasing their
bonds; or you could lend money to PetroCanada. Of course, these are only some of the
endless choices you would have.
How do you decide to allocate the $250 million? You will try to maximize your return and
minimize your risk. Some investors will choose a risk level that meets their objective and maximizes return for that given level of risk. By seeking this risk-return objective, you will bid up
the prices of securities that seem underpriced and have potential for high returns, and you will
avoid securities of equal risk that seem overpriced in your judgement. Since all market participants play the same risk-return game, the financial markets become the playing field and price
movements become the winning or losing score. With companies of equal risk, those with
expectations for high return will have higher common stock prices relative to those companies
with poor expectations. Since the prices in the market reflect the combined judgement of all
the players in the market, securities price movements provide feedback to corporate managers
and let them know whether the market thinks they are winning or losing the competition.
Those companies that perform well and are rewarded by the market with high-priced
securities have an easier time raising new funds in the money and capital markets than their
competitors. They are also able to raise funds at a lower cost. Go back to that $250 million
you are managing. If Petro-Canada wants to borrow money from you at 6 percent and
Talisman Energy is willing to pay 5 percent but is also riskier, to which company will you
choose to lend money? If you choose Petro-Canada you are on your way to understanding
finance. The competition between the two firms for your funds will eventually cause Talisman
either to offer higher returns than Petro-Canada or to go without funds. In this way, the
money and capital markets allocate funds to the highest quality companies at the lowest cost
and to the lowest quality companies at the highest cost. In other words, there is a penalty for
firms that fail to perform up to competitive standards.

Reliance on Debt
A reality in contemporary finance is the raising of debt in the capital markets to fund the
expansion of firms and of government programs. Too much debt can erode a firm’s or government’s ability to generate sufficient cash flow to comfortably cover its interest expenses.
The use of debt is not a short-term, cyclical phenomenon; rather, it appears to be a steady
evolution that has occurred in good times as well as bad.
Governments, and in particular the federal government, have been heavy borrowers in the
capital markets. The federal fiscal deficit represents the difference between the revenues and
expenses of the government of Canada. Annual deficits of over $30 to $40 billion persisted
into the 1990s despite higher taxes. Deficits accumulate to become total debt. The accumulated debt of the federal government and the provinces exceeded $800 billion by 1996, when the
federal debt topped out at $570 billion. By the late 1990s, the federal government was generating surpluses. However, debt and deficit reduction has forced cutbacks in the services offered
by governments and in some cases the sale of public corporations to help reduce the debts.
The government’s demand for funding has put direct upward pressure on interest rates.
Recently, however, investors have found a decreased supply of government securities in which to
invest their excess funds. Additionally, foreign capital is important in providing funds for corporate and government borrowings. This means that Canada has to have attractive interest rates and

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The Markets for Valuation and Rates of Return
In 1999 Nortel shares sold in the market for less
than $20.00. By 2000 they sold for over
$120.00 per share and the market value of
Nortel shareholders’ equity was $350 billion.
By late 2002 the market value was down to
$3 billion and a share sold for about $0.69. The
market had demonstrated drastically different
views of Nortel’s share value.
The S&P/TSX Composite Index is representative of the market value of the equity of the top
companies listed on Canada’s premier stock
exchange. In August of 2000 the S&P/TSX
Composite Index had a value over 11,000. In
early 2002 its value was about 7,600. Search for
its value under indexes at the TSX web site,

www.tsx.ca. The shareholder market value of
these companies (primarily Nortel) had dropped
considerably in a little over a year. Can you
determine the current value of Nortel (NT) and
the S&P/TSX Composite Index?
The bedrock interest rate or yield in the
economy is the overnight rate, the rate at which
financial institutions lend money amongst themselves for one day. Other yields in the economy
take their clues from this rate. In 1981 Canada’s
overnight rate reached 21.57 percent. In early
2002 the overnight rate was down to 2 percent,
while in England www.bankofengland.co.uk it
was 4 percent (repo rate) and 0.10 percent in
Japan (www.boj.or.jp/en).

1
Q

What are current
overnight rates in
these countries?

www.bankofcanada.ca

a stable currency (as foreign investors are concerned about foreign exchange risk). Thus, protection of the foreign exchange value of the Canadian dollar, and a declared resolve to stem inflationary pressures, are driving forces behind the Bank of Canada’s interest rate policy.
Corporations are also heavily dependent on raising large amounts of capital with debt. In
2003 the long-term debt positions of Canadian firms capital structure included HydroQuebec ($39.7 billion), BCE ($13.6 billion), TransCanada Corporation ($10.8 billion) and
Alcan ($10.2 billion).

Interest Rates

Statistics Canada
Monthly CPI Report
www.statcan.ca/
english/Subjects/Cpi/
cpi-en.htm

Interest rates are a key factor in the financial markets, as they determine the rates of return
required on investments and this in turn helps establish the allocation of capital. Interest rates
have been volatile in recent history. Short-term interest rates surpassed the 20 percent mark in
the 1980s before beginning a sharp decline. One of the key short-term interest rates is the
prime rate, which is the rate charged by the banks to their most creditworthy customers on a
short-term basis. By 2004 the prime rate was 3.75 percent, a forty-year low. A key determinant
of short-term interest rates is the rate of inflation, which will be explored further in chapter 10.
These movements are portrayed in Figure 1–2 along with the annual rate of inflation as
measured by the changes in the consumer price index (CPI). Note that in all years except 1974
and 1975, the average prime rate exceeded the average rate of inflation. Also note that the difference between the prime rate and the inflation rate was very small between 1972 and 1978.
After inflation began to subside in 1983, the spread between the rates widened considerably.
This unprecedented situation was largely the result of the Bank of Canada’s fears of increased
inflation and its policy aimed at squeezing inflation down.
The low interest rates of the 1990s acted to spur the stock and bond markets to record
levels. The spread between the prime rate and the CPI remained high. Lower interest rates
result in investors placing higher values on the promised or expected payments from corporate securities. Lower rates result in cheaper financing for new capital projects of the firm, but
they have also reduced savings rates (percent of disposable income) to 2 percent in 2003 from
20 percent in 1982.
By 1993, inflation was reduced to an annualized rate of about 2 percent. Inflation rates
and related interest rates had not been this low in 30 years. Double-digit inflation had seemed
the norm in the late 1970s and early 1980s, although more recent inflation rates are closer to
long-term historical norms. The inflation-induced profits of the late 1960s and 1970s are
somewhat in the past, but students should not ignore the lessons of inflated phantom profits

18

PART 1

Introduction

FIGURE 1–2
Prime rate versus
percent change in
the CPI

20.00

Consumer price index (average annual rate)
Prime rate (December)

18.00
16.00

Percent

14.00
12.00
10.00
8.00
6.00
4.00

19
71
19
73
19
75
19
77
19
79
19
81
19
83
19
85
19
87
19
89
19
91
19
93
19
95
19
97
19
99
20
01
20
03

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69

2.00
0.00

Year
Source: www.bank-banque-canada.ca; www.statcan.ca.

and undervalued assets of those past decades. The benefits, drawbacks, and implications of
disinflation (a slowing of price increases) will be explored in Chapter 3 on financial analysis.

Internationalization of Financial Markets
Trade between countries is a growing trend that is likely to continue. Global companies are
becoming more common, and international brand names such as Sony, Bombardier, CocaCola, Nokia, and Mercedes Benz are known the world over. McDonald’s food is eaten
throughout the world, and McDonald’s raises funds on most major international money and
capital markets. The growth of the global company has led to the growth of global fund
raising, as companies search for the cheapest sources of funds wherever possible.
Financial managers, adjusting to the changing economic environment, should also consider the war on terrorism, the creation of the free trade zone and the Euro of the European
Common Market, the North American Free Trade Agreement (NAFTA), and the emergence
of the industrial nations of the Far East in addition to Japan. In 1998 the collapsing
economies of the Far East had a quick impact on the North American markets. Resource
prices dropped over 20 percent in less than a year, which had a dramatic effect on many
Canadian companies and the value of our dollar.
We live in a world where international events influence the economies of all industrial
countries and where capital moves from country to country faster than was ever thought possible. Computers interact in a vast international financial network, and markets are more vulnerable to changing investor sentiment than they have been in the past. The corporate financial
manager has an increasing number of external effects to consider. Future financial managers
will need to have the sophistication to understand international capital flows, computerized
electronic funds transfer systems, foreign currency hedging strategies, and many other factors.
The following chapters will help you learn how corporations manage these challenges.

FORMAT OF THE TEXT
The material in this text is covered under six major parts. You progress from the development
of basic analytical skills in accounting and finance to the utilization of decision-making techniques in working capital management, capital budgeting, long-term financing, and other
related areas. A length of 21 chapters makes the text appropriate for one-semester coverage.

CHAPTER 1 The Goals and Functions of Financial Management

19

You are given a thorough grounding in financial theory in a highly palatable and comprehensive fashion—with careful attention to definitions, symbols, and formulas. The intent
is, above all, that you develop a thorough understanding of the basic concepts in finance.

Parts
1. Introduction This part examines the goals and objectives of financial management. The
emphasis on decision making and risk management is stressed, with an update of significant events influencing the study of finance.
2. Financial Analysis and Planning You are first given the opportunity to review the basic
principles of accounting as they relate to finance (financial statements and funds flow).
This review material in Chapter 2 is optional; you may judge whether you need this review
before progressing through the section.
Additional material in this part includes a thorough study of ratio analysis, budget
construction techniques, and development of comprehensive pro forma statements. The
effect of heavy fixed commitments, in the form of either debt or plant and equipment, is
examined in a discussion of leverage.
3. Working Capital Management The techniques for managing short-term assets of the firm
and the associated liabilities are examined. The material is introduced in the context of
risk-return analysis. The financial manager must constantly choose between liquid, lowreturn assets (perhaps marketable securities) and more profitable, less liquid assets (such as
inventory). Sources of short-term financing are also considered.
4. The Capital Budgeting Process The decision on capital outlays is among the most significant a firm will have to make. In terms of study procedure, we attempt to carefully develop
“time-value-of-money” calculations; we then proceed to the valuation of bonds and stocks,
emphasizing present-value techniques. The valuation chapter develops the traditional dividend valuation model and examines bond price sensitivity in response to discount rates
and inflation. An appendix presents the supernormal dividend growth model, or what is
sometimes called the two-stage dividend model. After careful grounding in valuation practice and theory, we examine the cost of capital and capital structure. The text then moves
to the actual capital budgeting decision, using previously learned material and employing
the concept of marginal analysis. The concluding chapter in this part covers risk-return
analysis in capital budgeting with a brief exposure to portfolio theory and a consideration
of market value maximization.
5. Long-Term Financing You are introduced to Canadian financial markets as they relate to
corporate financial management. You consider the sources and uses of funds in the capital
markets, with coverage given to warrants and convertibles as well as the more conventional methods of financing. Derivative instruments are also explored. The guiding role of the
investment dealer in the distribution of securities is also analyzed. Furthermore, you are
encouraged to think of leasing as a form of debt.
6. Expanding the Perspective of Corporate Finance A chapter on corporate mergers considers
external growth strategy and serves as an integrative tool to bring together such topics as
profit management, capital budgeting, portfolio considerations, and valuation concepts. A
second chapter on international financial management describes the growth of the international financial markets, the rise of multinational business, and the effects on corporate
financial management. The issues discussed in these two chapters highlight corporate
diversification and risk-reduction attempts prevalent in the 1980s, 1990s, and today.

20

PART 1

Introduction

SUMMARY*
1. Finance builds on analytical techniques for decision making from economics and calls on financial
data produced from accounting statements. Finance links these two disciplines.
2. With the development of sophisticated analytical techniques for financial management, its focus
has broadened to include not only adequate returns, but also returns in the context of risk assumed
by the firm.
3. The primary goal of the firm is the maximization of shareholder wealth as measured by share price.
This is a more satisfactory goal than profit maximization because it incorporates the risk and timing
of cash flows and because share value is objectively determined in the marketplace. Furthermore,
this goal best helps to explain decisions made by corporations.
4. The management of corporations may not always act in the best interest of shareholders.
Management has other demands, including its own interests. Agency theory studies the conflicts
between shareholders and management, and measures adopted to control the conflicts. The pursuit
of socially or ethically acceptable goals may come at the expense of shareholders’ wealth.

www.mcgrawhil.ca/college/block

5. Financial managers are involved in raising funds for the firm and in investing those funds in the
most efficient way. The activities of the financial manager include working capital management,
capital budgeting, and capital structure financing decisions.
6. Financial markets allocate capital to its best use if they operate freely and properly. The markets
determine value, a key variable in decision making. The markets also establish appropriate rates of
return or yields for investments.
*Each chapter summary is keyed to the learning objectives at the beginning of the chapter.

LIST OF TERMS
economics 3
accounting 3
financial capital 5
real capital 5
capital budgeting analysis 5
asymmetric information 5
market efficiency 5
capital structure theory 5
shareholder wealth maximization 6
agency theory 6
institutional investors 6
market determined share price 7
present value model 8
insider trading 10
sole proprietorship 13

general partnership 13
limited partnership 13
corporation 13
financial markets 14
public financial markets 14
corporate financial markets 14
money markets 15
capital markets 15
primary market 15
secondary market 15
fiscal deficit 16
prime rate 17
inflation 17
disinflation 18

DISCUSSION QUESTIONS
1. What was the first area of study to generate newfound enthusiasm for decision-related analysis in
finance?
2. If shares of both a high-tech startup company and the Royal Bank promised cash flow of $2.00 per
share over the next year, for which shares would you be prepared to pay the higher price? Why?
3. What is meant by the goal of maximization of shareholder wealth? Why is profit maximization, by
itself, an inappropriate goal?
4. What issue does agency theory examine? Why has it become more important in recent times?
5. Why are institutional investors important in today’s financial markets?

CHAPTER 1

The Goals and Functions of Financial Management

21

6. When does insider trading occur? What government agency is responsible for protecting against the
unethical practice of insider trading?
7. The government has passed regulations over the years that require pollution controls, development
restrictions, hiring equity, and pay equity. Can a firm still achieve the maximization of shareholder wealth?
8. The senior management of corporations has often received large compensation even after the firms
have suffered significant losses. Are senior managers paid too much?
9. Suggest two forms of daily functions and two forms of occasional functions that the financial
manager performs.
10. Contrast the liability provisions for a sole proprietorship, a partnership, a limited partnership, and
a corporation.
11. Why is the corporate form of organization best suited to a large organization?
12. In terms of the life of securities offered, what is the difference between money and capital markets?
13. What is the difference between a primary and a secondary market?
14. What effect do government debt loads have on the financial markets?
15. Who are the stakeholders in the corporation?

PROBLEMS

a. In its first year its income showed a deficit of $7,000. What would the equity section of its
balance sheet show?
b. In the second year it had income of $15,000 and a dividend of $6,000 was paid. What would
the equity section of its balance sheet show?
c. In the third year Incubus sold more shares for a value of $20,000, earned income of $12,000
and paid a dividend of $6,000. What would the equity section of its balance sheet show?
2. Puppet Corporation began with an investment by shareholders of $20,000.
a. In its first year its income earned $2,000. What would the equity section of its balance sheet
show?
b. In the second year it had income of $9,000 and a dividend of $3,000 was paid. What would
the equity section of its balance sheet show?
c. In the third year Puppet sold more shares for a value of $10,000, earned income of $5,000 and
paid a dividend of $2,500. What would the equity section of its balance sheet show?
3. Two to Ten Dollar Corporation has expected earnings per share of $2.00 in its first year, $4.00 its
second year and then $10.00 per year for many more years. Ten Dollar Corporation has expected
earnings of $10.00 a share for three years only. Which company would you value higher and why?
4. A well known financial institution expects that it will have no earnings for the next three years as
the result of restructuring activities. Then it will begin to return to earnings of $3.00 a share. A
somewhat new health services company expects $3.00 a share beginning immediately. Which
company would you value higher and why?
5. The Board of Directors is faced with making a decision on one of the following projects:
a. A new product with high profit margins and with preliminary research showing strong consumer acceptance
b. New software that will produce more detailed disclosure of relevant and required financial
information in a user friendly, web-based environment
c. Pollution control mechanisms that will reduce effluent into the nearby river, which is popular
with local residents, to zero
d. A report from compensation experts that will closely align executive compensation and their
motivation with the goals of the shareholders
Discuss the merits of each project and identify which project, as opposed to the others, that you
believe will create the most shareholder wealth and why.

www.mcgrawhil.ca/college/block

1. Incubus Corporation began with an investment by shareholders of $40,000.

22

PART 1

Introduction

INTERNET RESOURCES AND QUESTIONS
The Nobel Web site has a brief description of the work of the winners of the Nobel Prize in economics:
www.nobel.se
The federal government’s finances are available from the finance department: www.fin.gc.ca
The Bank of Canada has statistics on interest rates and the CPI: www.bankofcanada.ca
1. Select one of the Nobel laureate professors in finance and briefly describe his contribution to the
field of finance.
2. What is the current federal government’s deficit and accumulated debt?
3. What is the current prime interest rate and CPI?
4. Contrast the stated goal(s) of Onex Corporation (http://www.onex.com/onex/on_principles/on_
principles.asp) with those of the Royal Bank (http://www.rbc.com/aboutus/visionandvalues.html).
5. Who does BCE Inc. (http://www.bce.ca/en/company/responsibility/index.php) identify as its stakeholders and what objectives does it set to meet the desires of these stakeholders?

www.mcgrawhil.ca/college/block

SELECTED REFERENCES
Azarchs, Tanya. “Market Discipline: the Holy Grail.” Journal of Lending and Credit Risk Management 82
(May 2000), pp. 35–39.
Byrd, John; Robert Parrine; and Gunnar Pritsch. “Stockholder-Manager Conflicts and Firm Value.”
Financial Analysts Journal 54 (May–June 1998), pp. 14–30.
Claessens, Stijn; Simon Djankov; Joseph P. H. Fan; and Larry Rees. “Disentangling the Incentive and
Entrenchment Effects of Large Shareholdings.” Journal of Finance 57 (December 2002), pp. 2741–71.
Cooper, Dan, and Glenn Petry. “Corporate Performance and Adherence to Stockholder WealthMaximizing Principles.” Financial Management 23 (Spring 1994), pp. 71–78.
Franks, Julian; Colin Mayer; and Luc Renneborg. “Who Disciplines Management in Poorly
Performance Companies?” Journal of Financial Intermediation 10 (July–October 2001), pp. 209–48.
Gilbert, Erika, and Alan Reichert. “The Practice of Financial Management among Large United States
Corporations.” Financial Practice and Education 5 (Spring/Summer 1995), pp. 16–23.
Gup, Benton E. “The Five Most Important Finance Concepts: A Summary.” Financial Practice and
Education 4 (Fall–Winter 1994), pp. 106–9.
Jensen, Michael C. “The Eclipse of the Public Corporation.” Harvard Business Review 67
(September–October 1989), pp. 61–74.
Kahn, Charles, and Andrew Winton. “Ownership Structure, Speculation, and Shareholder
Intervention.” Journal of Finance 53 (April 1998), pp. 99–129.
McLean, Bethany. “Why Enron Went Bust.” Fortune 144 (December 24, 2001), pp. 58–68.
Mehrling, Perry. “Minsky and Modern Finance.” The Journal of Portfolio Management 26 (Winter 2000),
pp. 81–88.
Tutano, Peter. “Agency Costs of Corporate Risk Management.” Financial Management 27 (Spring 1998),
pp. 67–77.

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