Page 471 - Introduction to Business

CHAPTER 13 Financial Management of the Firm and Investment Management 445

share, or $20,000 for all 1000 shares. Hence, stock options are valuable to managers
and help align their interests with those of shareholders.

Accounting Profits Versus Economic Profits

Suppose that a firm has positive net income after taxes. From an accounting perspec-
tive, it is profitable. However, if the level of accounting profits is below other similar, or
peer, firms in its industry, we can infer that the managers are not doing a good job.
Another problem for a firm could be that profits are earned but only at the cost of tak-
ing excessive risks. It could be that the firm was lucky to make any profits! It is likely in
these situations that the value of the firm’s common stock would decline. Here we see
that stock values are a way to measure economic profits. Only if accounting profits economic profits Higher stock prices
lead to higher share values do they have economic value. The treasurer and controller due to earning higher accounting profits
or reducing the riskiness of profits
work together to turn accounting profits into economic profits by seeking to maximize
the share values of the firm and, therefore, the wealth of shareholders.

Role of the Financial Manager

LEARNING OBJECTIVE 1
Explain how financial managers fit into the organizational structure of a firm and
what their role is.
Financial managers have two basic functions in business firms—the administration
of assets and the acquisition of funds. The administration of assets involves evalu-
ating different investment opportunities or projects facing the firm. Firms must
consider whether the products or services they produce and sell are profitable.
Alternative investment projects are compared to one another in the process of
capital budgeting. For example, McDonald’s has a variety of hamburger and capital budgeting The process of
chicken sandwiches, and each of its products must be profitable in order to be sold comparing or ranking the profitability
of alternative investment projects
in its restaurants to consumers. If capital budgeting analyses reveal that a product
within a firm
is unprofitable, it must be discontinued or the value of McDonald’s common stock
could fall. Investors holding stock in the firm expect that only profitable invest-
ments will be undertaken by the firm.
Acquisition of funds by financial managers involves raising funds in the financial
marketplace to pay for profitable investment projects selected by capital budgeting
decisions. For example, if a particular type of hamburger is more profitable than
other sandwiches at McDonald’s, it would be reasonable to increase its production
and sales. To do this, the firm may need to obtain a bank loan, issue debt in the mar-
ketplace, or issue new common stock to raise funds for increased investment in
inventory, advertising, labor, equipment, and other expenditures. What types of
funds should the firm raise, debt or equity funds? Which source is least costly to the
firm? These are financing decisions, as outlined in Exhibit 13.2. financing decisions The choice made
between internal and external funding
and between debt and equity funds to
EXHIBIT 13.2 finance the firm’s investment projects
Capital Budgeting Decisions and Financing Decisions

Capital Budgeting Decisions Financing Decisions
Administration of funds Acquisition of funds
Investment in projects inside the business firm Getting bank loans
Issuing debt and equity

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