THE ROLE OF FINANCIAL MANAGERS BASIC INFORMATION

To carry on business, companies need an almost endless variety of real assets. Many of these assets are tangible, such as machinery, factories, and offices; others are intangible, such as technical expertise, trademarks, and patents.

All of them must be paid for. To obtain the necessary money, the company sells financial assets, or securities.

These pieces of paper have value because they are claims on the firm’s real assets and the cash that those assets will produce. For example, if the company borrows money from the bank, the bank has a financial asset. That financial asset gives it a claim to a stream of interest payments and to repayment of the loan.

For present purposes we are using financial assets and securities interchangeably, though “securities” usually refers to financial assets that are widely held, like the shares of IBM. An IOU (“I owe you”) from your brother-in-law, which you might have trouble selling outside the family, is also a financial asset, but most people would not think of it as a security.

The company’s real assets need to produce enough cash to satisfy these claims. Financial managers stand between the firm’s real assets and the financial markets in which the firm raises cash.

The flow starts when financial assets are sold to raise cash. The cash is employed to purchase the real assets used in the firm’s operations.

Later, if the firm does well, the real assets generate enough cash inflow to more than repay the initial investment. Finally, the cash is either reinvested or returned to the investors who contributed the money in the first place.

Of course the choice is not a completely free one. For example, if a bank lends the firm money at stage 1, the bank has to be repaid this money plus interest.

This flow chart suggests that the financial manager faces two basic problems. First, how much money should the firm invest, and what specific assets should the firm invest in?

This is the firm’s investment, or capital budgeting, decision. Second, how should the cash required for an investment be raised? This is the financing decision.