FINANCIAL MANAGEMENT DECISIONS
A striking feature of large corporations is that the owners (the stockholders) are
usually not directly involved in making business decisions, particularly on a day-to-day
basis. Instead, the corporation employs managers to represent the owners’ interests and
make decisions on their behalf. In a large corporation, the financial manager would
oversee answering the three questions we raised in the preceding section. The financial
management function is usually associated with a top officer of the firm, such as a vice
president of finance or some other chief financial officer (CFO).
Capital Budgeting
The first question concerns the firm’s long-term investments. The process of
planning and managing a firm’s long-term investments is called capital budgeting. In
capital budgeting, the financial manager tries to identify investment opportunities that
are worth more to the firm than they cost to acquire. Loosely speaking, this means that
the value of the cash flow generated by an asset exceeds the cost of that asset.
The types of investment opportunities that would typically be considered depend in
part on the nature of the firm’s business. For example, for a large retailer such as Wal-
Mart, deciding whether to open another store would be an important capital budgeting
decision. Similarly, for a software company such as Oracle or Microsoft, the decision to
develop and market a new spreadsheet would be a major capital budgeting decision.
Some decisions, such as what type of computer system to purchase, might not depend
so much on a particular line of business.
Regardless of the specific nature of an opportunity under consideration, financial
managers must be concerned not only with how much cash they expect to receive, but
also with when they expect to receive it and how likely they are to receive it. Evaluating
the size, timing, and risk of future cash flows is the essence of capital budgeting. Infact,
as we will see in the chapters ahead, whenever we evaluate a business decision, the size,
timing, and risk of the cash flows will be, by far, the most important things we will
consider.
Capital Structure
The second question for the financial manager concerns ways in which the firm
obtains and manages the long-term financing it needs to support its longterm
investments. A firm’s capital structure (or financial structure) is the specific mixture of
long-term debt and equity the firm uses to finance its operations. The financial manager
has two concerns in this area. First, how much should the firm borrow? That is, what
mixture of debt and equity is best? The mixture chosen will affect both the risk and the
value of the firm. Second, what are the least expensive sources of funds for the firm?
If we picture the firm as a pie, then the firm’s capital structure determines how that
pie is sliced—in other words, what percentage of the firm’s cash flow goes to creditors
and what percentage goes to shareholders. Firms have a great deal of flexibility in
choosing a financial structure. The question of whether one structure is better than any
other for a particular firm is the heart of the capital structure issue.
In addition to deciding on the financing mix, the financial manager has to decide
exactly how and where to raise the money. The expenses associated with raising long-
term financing can be considerable, so different possibilities must be carefully
evaluated. Also, corporations borrow money from a variety of lenders in a number of
different, and sometimes exotic, ways. Choosing among lenders and among loan types
is another job handled by the financial manager.
Working Capital Management
The third question concerns working capital management. The term working capital
refers to a firm’s short-term assets, such as inventory, and its short-term liabilities, such
as money owed to suppliers. Managing the firm’s working capital is a day-to-day activity
that ensures that the firm has sufficient resources to continue its operations and avoid
costly interruptions. This involves a number of activities related to the firm’s receipt and
disbursement of cash.
Some questions about working capital that must be answered are the following:
1. How much cash and inventory should we keep on hand?
2. Should we sell on credit? If so, what terms will we offer, and to whom will we
extend them?
3. How will we obtain any needed short-term financing? Will we purchase on
credit, or will we borrow in the short term and pay cash? If we borrow in the short
term, how and where should we do it? These are just a small sample of the
issues that arise in managing a firm’s working capital.
