Principals of Finance

Finance

The financial manager of a firm deals specifically with the acquisition, financing, and management of assets with the overall financial security and profitability of the firm as his goal. Decisions concerning what are the best types of financing, the best financing mix; the appropriate dividend policy and how the funds will be physically acquired are all the responsibility of the financial manager. The financial manager has different degrees of operating responsibility over the firm's assets with a greater emphasis on current asset management rather than fixed asset management.

Responsibilities of the financial manager also include capital budgeting, cash management, credit management, dividend disbursement, financial analysis and planning, pension management, insurance/risk management, and tax analysis and planning through cost accounting, cost management, governmental reporting, internal control, the preparation of financial statements, and preparing budgets and financial forecasts.

The overall goal of the firm is the maximization of shareholder wealth and profit maximization or maximizing the firm's earnings after taxes. There are risks involved in both perspectives. In maximizing shareholder wealth there is the possibility of increasing current profits while harming the firm through deferring maintenance, issuing common stock to purchase treasury bills, and ignoring changes in the risk level of the firm. Problems associated with profit maximization include the ignoring of changes in the risk level of the firm, a zero payout dividend policy, and it does not specify timing or the duration of expected returns.

Shareholder wealth maximization takes into account the current and future profits and EPS, the timing, duration, and risk of profits and EPS, dividend policy, and other factors. Profit maximization does not prohibit the firm from being socially responsible.

The DuPont system of financial control enables the financial manager to show profitability through a return on assets. This is determined by dividing the firm's net income for the past 12 months by the total average assets. The result is a percentage which can then be shown as a return on sales or net income of sales multiplied by asset utilization or sales of assets.

Accounting practices within the firm must take into consideration inflation, disinflation, and estimation. A clause in a contract provides for increases and decreases in inflation depending on the fluctuations in the firm's cost of living wages and production costs. Securities such as bonds or notes guarantee a higher return than the rate of inflation if the security is held to maturity.

The percentage-of-sales method calls for the budgeting based on a percent of a sales figure, such as past sales, anticipated sales, or a combination of both. The percentage-of-sales is the most commonly used method when preparing the firm's advertising budget.

In the breakeven analyses method, the firm can determine increased sales in order to gain a profit if the product price is discounted. It may be used to show that an increased price with subsequent reduced sales may prove to be a better strategy for the firm in achieving a profit.

Of critical importance to the firm is working capital management. Financial managers spend about 70% of their time managing the short-term accounts of the firm such as current assets and current liabilities. There are several methods in which the financial manager can administer working capital including through cash conversion or the time between paying for inventory and collecting on receivables; using the time between ordering materials and collecting cash from receivables wisely; the accounts receivable period or the average time between when a product is sold and cash is received.

Strategies such as stretching out accounts payable, turning over receivables as quickly as possible, and utilizing just-in-time inventory methods can be used to hold down the firm's investment in inventories.

The concepts of time-value money can be used to evaluate investment opportunities such as real estate, life insurance, and mortgages. The future value of money is the sum of money invested today that will grow based on an appreciation rate. The formula for interest compounded monthly is: principal time rate times the term in years. Present value is the value in today's dollars which is assigned to an amount of money for the future, based on an estimated rate-of-return over the long-term. Rate-of-return is calculated based on monthly compounding. Valuation, the process of determining the value of stocks and bonds, also helps the financial manager in determining the cost of financing projects for the firm. The present value of a financial asset must be known. The valuation of bonds provides investors with interest payments and the principal which is returned to the investor at the bond's maturity. Interest payments are typically paid out semiannually.

The value of common stock is the present value of an expected stream of future dividends. Earnings must be translated into cash flows for the shareholder. If the shares of common stock do not pay dividends, then they are valued just like shares of preferred stock. Preferred stock is valued as perpetuity because it has no maturity date. It carries a fixed dividend payment and can be calculated by dividing the fixed dividend payment by the required rate of return for the investor.

The weighted average cost of capital represents the expected return on all the firm's securities. Capital including stocks, bonds, and other debt, are given weight in the calculation according to its importance in the firm's capital structure.

Capital budgeting or the process of choosing the firm's long-term capital assets, takes into consideration payback or the length of time it takes to recover the initial cost of the project without regard to the time value of money. The internal rate of return takes into account the discount rate at the net present value investment of zero. The rate of a bond's future cash flows, discounted back to today, equals its price. The net present value of the expected future cash flows is minus the cost.