Page 469 - Introduction to Business

CHAPTER 13 Financial Management of the Firm and Investment Management 443

What is the Firm’s Future Profitability?

aimlerChrysler, McDonald’s, Sony, and other companies make
decisions today that will affect their future success. Financial managers
Dare involved in this decision-making process by evaluating the future
potential profit prospects of their firms’ products and services. For example,
before DaimlerChrysler produces a new model automobile, it must project
future sales revenues, costs of production, sales costs, taxes, and so on, to
estimate net cash flows over time for the new car. These future net cash flows
are used to decide whether to produce the car, how many cars to produce, and
whether financing from a bank or another source is needed to begin
production. Typically, financial managers compare the future net cash flows
over time of all products and services within the firm, rank them in terms of
profitability, and then choose those that will tend to increase the value of the
firm’s stock price. Of course, nobody can know the future with certainty. There
is always risk associated with their decisions; namely, that the firm will fail in
reaching forecast net cash flows. For this reason financial managers are
constantly monitoring the profitability of the firm’s products and services.
Their main goal is to make decisions that maximize profit for the firm and, at
the same time, minimize the risk that profit goals will not be achieved.

Introduction

Financial management and investment management are concerned with analyzing
the returns and risks of firms. Imagine that you work for a firm as a financial man-
ager, and you must decide which of five new products should be produced. Infor-
mation from marketing, production, and accounting departments in the firm has
been used to make detailed projections of revenues and operating costs for each
product over the next five years. Your job is to use this information to rank the prof-
itability of each product. After ranking the products, you must make a decision as
to which products are acceptable and which should be rejected. Your analyses and
decisions will influence the future of the firm for years to come. Also, many employ-
ees in the firm will be affected. What financial tools can you utilize to analyze the
profitability of each product? How does risk come into play and possibly change
your ranking of products? These questions are central to the process of making cap-
ital budgeting decisions.
After successfully ranking the five new products and deciding on their feasibility,
financial managers must raise the funds needed to begin production. How should
acceptable projects be financed? Should you use internal funding by relying on
retained earnings? What if retained earnings are not sufficient to cover the start-up
costs of a number of new products? In this case you may well opt to seek external
funding. If so, should you use debt or equity funds? What are the costs of these exter-
nal sources of funds? How can you decide what mix of debt and equity to use? These
financing decisions are separate, or independent, of the capital budgeting decisions.
Unlike financial managers who work within the firm, investment managers are
external to the firm. Their job is to evaluate how well financial managers within the
firm are handling the capital budgeting and financing decisions. Later, as the new
products are actually produced and sold in the marketplace, investment managers
monitor the success of each product. This information is used to make buy-or-sell
decisions about the firms’ debt and equity securities that it issued to raise funds.
Stock and bond prices tend to rise if the firm’s products prove to be profitable.

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