Chapter 1: Introduction to Managerial Finance (Role of Managerial Finance)

Finance – the science and art of managing money.

- Concern on individuals how they spend, save, borrow and invest.

- Concern on businesses how firms raise money from investors, invest to earn profits and decide to reinvest
profits or distribute to investors.
- Career opportunities in Finance:
 Financial Service – area of finance concerned with design and delivery of advice and financial products
to individuals, businesses, and governments.

 Career opportunities within areas of:

 Banking  Real Estate

 Personal Financial Planning  Insurance
 Investments

 Managerial Finance – concerned with duties of financial manager in a business.

 Financial Managers

- administer financial affairs pf all types of businesses-private and public, large or small, profit seeking and not for
profit.

- perform varied tasks as developing financial plan/ budgeting, extending credit to customers, evaluating proposed
large expenditures and raising money to fund the firm operations.

Professional Certifications in Finance:

1. Chartered Financial Analyst (CFA)

- Offered by the CFA Institute, the CFA program is a graduate-level course of study focused primarily on the
investments side of finance.
- To earn the CFA Charter, students must pass a series of three exams, usually over a 3-year period, and have
48 months of professional experience.
- Although this program appeals primarily to those who work in the investments field, the skills developed in the
CFA program are useful in a variety of corporate finance jobs as well.

2. Certified Treasury Professional (CTP)

- The CTP program requires students to pass a single exam that is focused on the knowledge and skills needed
for those working in a corporate treasury department.
- The program emphasizes topics such as liquidity and working capital management, payment transfer systems,
capital structure, managing relationships with financial service providers, and monitoring and controlling
financial risk.

3. Certified Financial Planner (CFP)

- To obtain CFP status, students must pass a 10-hour exam covering a wide range of topics related to personal
financial planning. The CFP program also requires 3 years of full-time relevant experience.
- The program focuses primarily on skills relevant for advising individuals in developing their personal financial
plans.
4. American Academy of Financial Management (AAFM)
- The AAFM administers a host of certification programs for financial professionals in a wide range of fields.
- Their certifications include the Chartered Portfolio Manager, Chartered Asset Manager, Certified Risk Analyst,
Certified Cost Accountant, Certified Credit Analyst, and many other programs.

5. Professional Certifications in Accounting

- Most professionals in the field of managerial finance need to know a great deal about accounting to succeed in
their jobs.
- Professional certifications in accounting include the Certified Public Accountant (CPA), Certified Management
Accountant (CMA), Certified Internal Auditor (CIA), and many other programs.

3 Common Legal Forms of Business Organization

 Sole Proprietorship
- A business owned by one person who operates for own profit.
 - Typically, small business that operates in wholesale, retail, service, and construction industries.
- 73% of all business are sole proprietorship.
- Ex: bike shop, personal trainer, and plumber.
- The owner (proprietor), along with few employees, operates business. The proprietor raises capital from
personal resources or by borrowing and he or she is responsible for all business decision.
- This form of organization appeals to entrepreneur who enjoy working independently.

Unlimited Liability

- A major drawback to sole proprietorship.

- The liabilities of the business are the entrepreneur’s responsibility, and creditors can make claims against the
entrepreneur’s personal assets if the business fails to pay its debts.
- The condition of a sole proprietorship (or general partnership), giving creditors the right to make claims
against the owner’s personal assets to recover debts owed by the business.

 Partnership
- A business owned by two or more people and operated for profit.
- 7% of all businesses and typically larger than sole proprietorship.
- Ex: Common in finance, insurance, and real estate.
- Public accounting and law partnership have large numbers of partners.
- A general (or regular) partnership, all partners have unlimited liability, and each partner is legally liable
for all debts of partnership.

Articles of Partnership

- The written contract used to formally establish a business partnership.

 Corporations
- An entity created by law and have legal powers of an individual in that it can sue and be sued make and be
party to contracts and acquire property in its own name.
- 20% of all business and it engage in all types of businesses, manufacturing firms account for the largest
portion of corporate business receipts and net profits.

Stockholders
 - owners of a corporation. Whose ownership, or equity, takes the form of either common stock or preferred
stock.
- They vote periodically to elect members of the board of directors.

Limited Liability

- A legal provision that limits stockholders’ liability for a corporation’s debt to the amount they initially invested
in the firm by purchasing stock.
- Losses are limited to the amount they invested in the firm when they purchased shares of stock.

Common Stock

- The purest and most basic form of corporate ownership.

Dividends (Residual Claimants)

- Stockholders expect to earn in return and the profit that firm earns.
- Periodic distributions of cash to the stockholders of a firm.
- Stockholders are paid last - after employees, suppliers, tax authorities, and lenders receive what they are
owed. If the firm does not generate enough cash to pay everyone else, there is nothing available for
stockholders.

Board of Directors

- Group elected by the firm’s stockholders and typically responsible for approving strategic goals and plans,
setting general policy, guiding corporate affairs, and approving major expenditures.
- They decide when to hire or fire top managers and establishes compensation packages for most senior
executives.
- Board consists of:

 “Inside” Directors – key corporate executives

 “Outside” or “Independent” Directors – executives from other companies, major shareholders, and national
or community leaders.
- Outside directors for major corporations receive compensation in the form of cash, stock, and stock options.
This compensation often totals $100,000 per year or more.

President or Chief Executive Officer (CEO)

- Corporate official responsible for managing the firm’s day-today operations and carrying out the policies
established by the board of directors.
 - Reports periodically to the firm’s directors.

Other Limited Liability Organizations

- A number of other organizational forms provide owners with limited liability.

The most popular are:

 Limited Partnership (LP),

- a specialized form of general partnership, made up of at least one or more general partners and at least one
or more limited partners. Attractive organizations for purposes of raising capital.
- Investors who have no expertise in the business operations. They seek investment opportunities with the hope
of earning a meaningful return on their investment in a successful venture.
 S Corporation (S Corp),
- a special type of corporation that's designed to avoid the double taxation drawback of regular C corps.
- Allow profits, and some losses, to be passed through directly to owners' personal income without ever being
subject to corporate tax rates.
 Limited Liability Company (LLC),
- a business entity that prevents individuals from being liable for the company’s financial losses and debt
liabilities.
- In the event of legal action or business failure, liability is assumed by the company rather than its constituent
partners or shareholders.
 and Limited Liability Partnership (LLP).
- a partnership in which some or all partners (depending on the jurisdiction) have limited liabilities. It therefore
can exhibit aspects of both partnerships and corporations.
- Each partner is not responsible or liable for another partner's misconduct or negligence.
- Cc

Why Study Managerial Finance?

The consequences of most business decisions are measured in financial terms, the financial
manager plays a key operational role. People in all areas of responsibility—accounting, information systems,
management, marketing, operations, and so forth—need a basic awareness of finance so they will understand
how to quantify the consequences of their actions.

Maximize Shareholder Wealth

- Finance teaches that managers’ primary goal should be to maximize the wealth of the firm’s owners—the
stockholders.
- The simplest and best measure of stockholder wealth is the firm’s share price, so most textbooks instruct
managers to take actions that increase the firm’s share price.
- The goal of the firm, and also of managers, should be to maximize the wealth of the owners for whom it
is being operated, or equivalently, to maximize the stock price.
 - This goal translates into a straightforward decision rule for managers—only take actions that are expected
to increase the share price. Although that goal sounds simple, implementing it is not always easy. To
determine whether a particular course of action will increase or decrease a firm’s share price, managers have
to assess what return (that is, cash inflows net of cash outflows) the action will bring and how risky that return
might be.
- We can say that the key variables that managers must consider when making business decisions are
return (cash flows) and risk.

Maximize Profit

Earnings Per Share (EPS)

- The amount earned during the period on behalf of each outstanding share of common stock, calculated by
dividing the period’s total earnings available for the firm’s common stockholders by the number of shares of
common stock outstanding.

“Does profit maximization lead to the highest possible share price?”

For at least three reasons the answer is often no.

1. Timing - is important because the firm can earn a return on funds it receives, the receipt of funds sooner
rather than later is preferred.
2. Profits and Cash Flows are not identical.
- The profit that a firm report is simply an estimate of how it is doing, an estimate that is influenced by many
different accounting choices that firms make when assembling their financial reports.
- Cash flow - is a more straightforward measure of the money flowing into and out of the company. Companies
have to pay their bills with cash, not earnings, so cash flow is what matters most to financial managers.
3. Risk - matters a great deal. A firm that earns a low but reliable profit might be more valuable than another
firm with profits that fluctuate a great deal (and therefore can be very high or very low at different times).
- The chance that actual outcomes may differ from those expected.
- A basic premise in managerial finance is that a trade-off exists between return (cash flow) and risk.
- Return and risk are, in fact, the key determinants of share price, which represents the wealth of
the owners in the firm.

Risk Averse

- Requiring compensation to bear risk.

- In other words, investors expect to earn higher returns on riskier investments, and they will accept lower
returns on relatively safe investments.

Stake Holders
 - Groups such as employees, customers, suppliers, creditors, owners, and others who have a direct economic
link to the firm.
- A firm with a stakeholder focus consciously avoids actions that would prove detrimental to stakeholders. The
goal is not to maximize stakeholder well-being but to preserve it

The Role of Business Ethics

Business Ethics

- Standards of conduct or moral judgment that apply to persons engaged in commerce.

- Violations of these standards in finance involve a variety of actions: “creative accounting,” earnings
management, misleading financial forecasts, insider trading, fraud, excessive executive compensation, options
backdating, bribery, and kickbacks.

Following questions used to assess the ethical viability of a proposed action.

1. Is the action arbitrary or capricious? Does it unfairly single out an individual or group?
2. Does the action violate the moral or legal rights of any individual or group?
3. Does the action conform to accepted moral standards?
4. Are there alternative courses of action that are less likely to cause actual or potential harm?

Ethics and Share Price

- An effective ethics program can enhance corporate value by producing a number of positive benefits.
- It can reduce potential litigation and judgment costs, maintain a positive corporate image, build shareholder
confidence, and gain the loyalty, commitment, and respect of the firm’s stakeholders. Such actions, by
maintaining and enhancing cash flow and reducing perceived risk, can positively affect the firm’s share price.

Ethical behavior - is viewed as necessary for achieving the firm’s goal of owner wealth maximization.

ORGANIZATION OF THE FINANCE FUNCTION

Treasurer

- The firm’s chief financial manager, who manages the firm’s cash, oversees its pension plans, and manages key
risks.

Controller

- The firm’s chief accountant, who is responsible for the firm’s accounting activities, such as corporate
accounting, tax management, financial accounting, and cost accounting.

Foreign Exchange Manager

- The manager responsible for managing and monitoring the firm’s exposure to loss from currency fluctuations.

RELATIONSHIP TO ECONOMICS

Marginal Cost–Benefit Analysis

- Economic principle that states that financial decisions should be made, and actions taken only when the added
benefits exceed the added costs.

RELATIONSHIP TO ACCOUNTING

Emphasis on Cash Flows

- The accountant’s primary function is to develop and report data for measuring the performance of the firm,
assess its financial position, comply with and file reports required by securities regulators, and file and pay
taxes.

Accrual Basis

- In preparation of financial statements, recognizes revenue at the time of sale and recognizes expenses when
they are incurred.

Cash Basis

- Recognizes revenues and expenses only with respect to actual inflows and outflows of cash.
 - Whether a firm earns a profit or experiences a loss, it must have a sufficient flow of cash to meet its
obligations as they come due.

Decision Making

- Accountants devote most of their attention to the collection and presentation of financial data.
- Financial managers evaluate the accounting statements, develop additional data, and make decisions on the
basis of their assessment of the associated returns and risks.
- This does not mean that accountants never make decisions or that financial managers never gather data but
rather that the primary focuses of accounting and finance are distinctly different.

PRIMARY ACTIVITIES OF THE FINANCIAL MANAGER

- The primary activities are making investment and financing decisions.

- Investment decisions determine what types of assets the firm holds.
- Financing decisions determine how the firm raises money to pay for the assets in which it invests.

Corporate Governance

- refers to the rules, processes, and laws by which companies are operated, controlled, and regulated.
- It defines the rights and responsibilities of the corporate participants such as the shareholders, board of
directors, officers and managers, and other stakeholders, as well as the rules and procedures for making
corporate decisions.
- A well-defined corporate governance structure is intended to benefit all corporate stakeholders by ensuring
that the firm is run in a lawful and ethical fashion, in accordance with best practices, and subject to all
corporate regulations.

Individual versus Institutional Investors

Individual Investors

- Investors who own relatively small quantities of shares so as to meet personal investment goals.

Institutional Investors

- Investment professionals, such as banks, insurance companies, mutual funds, and pension funds, that are
paid to manage and hold large quantities of securities on behalf of others.

Government Regulation

- generally, shapes the corporate governance of all firms.

- The misdeeds derived from two main types of issues:

(1) false disclosures in financial reporting and other material information releases and
(2) undisclosed conflicts of interest between corporations and their analysts, auditors, and attorneys and
between corporate directors, officers, and shareholders.

Sarbanes-Oxley Act of 2002 (SOX)

- An act aimed at eliminating corporate disclosure and conflict of interest problems. Contains provisions about
corporate financial disclosures and the relationships among corporations, analysts, auditors, attorneys,
directors, officers, and shareholders.

THE AGENCY ISSUE

- Shareholders give managers decision-making authority over the firm; thus managers can be viewed as the
agents of the firm’s shareholders. Technically, any manager who owns less than 100 percent of the firm is an
agent acting on behalf of other owners.

Principal–Agent Relationship

- An arrangement in which an agent acts on the behalf of a principal. For example, shareholders of a company
(principals) elect management (agents) to act on their behalf.

Agency Problems

- Problems that arise when managers place personal goals ahead of the goals of shareholders.
 - These problems in turn give rise to agency costs.

Agency Costs

- Costs arising from agency problems that are borne by shareholders and represent a loss of shareholder wealth.
- Ex: shareholders incur agency costs when managers fail to make the best investment decision or when
managers have to be monitored to ensure that the best investment decision is made, because either situation
is likely to result in a lower stock price.

Management Compensation Plans

- correspond with firm performance. In addition to combating agency problems, the resulting performancebased
compensation packages allow firms to compete for and hire the best managers available.

The two key types of managerial compensation plans are (1) incentive plans and (2) performance plans.

Incentive Plans

- Management compensation plans that tie management compensation to share price; one example involves
the granting of stock options.
- Stock Options - options extended by the firm that allow management to benefit from increases in stock
prices over time.

Performance Plans

- Plans that tie management compensation to measures such as EPS or growth in EPS. Performance shares
and/or cash bonuses are used as compensation under these plans.
- Performance Shares - shares of stock given to management for meeting stated performance goals.
- Cash Bonuses - cash paid to management for achieving certain performance goals.

The Threat of Takeover

- believes it can enhance the troubled firm’s value by restructuring its management, operations, and financing
can provide a strong source of external corporate governance. The constant threat of a takeover tends to
motivate management to act in the best interests of the firm’s owners.

FOCUS ON VALUE

- Chapter 1 established the primary goal of the firm—to maximize the wealth of the owners for whom the
firm is being operated.

REVIEW OF LEARNING GOALS

Define finance and the managerial finance function.

- Finance is the science and art of managing money.

- It affects virtually all aspects of business. Managerial finance is concerned with the duties of the financial
manager working in a business.
- Financial managers administer the financial affairs of all types of businesses—private and public, large and
small, profit seeking and not for profit.
- They perform such varied tasks as developing a financial plan or budget, extending credit to customers,
evaluating proposed large expenditures, and raising money to fund the firm’s operations.

Describe the legal forms of business organization.

- The legal forms of business organization are the sole proprietorship, the partnership, and the
corporation.
- The corporation is dominant in terms of business receipts, and its owners are its common and preferred
stockholders.
- Stockholders expect to earn a return by receiving dividends or by realizing gains through increases in share
price.

Describe the goal of the firm, and explain why maximizing the value of the firm is an appropriate goal for
a business.

- The goal of the firm is to maximize its value and therefore the wealth of its shareholders.
- Maximizing the value of the firm means running the business in the interest of those who own it—the
shareholders.
 - Because shareholders are paid after other stakeholders, it is generally necessary to satisfy the interests of
other stakeholders to enrich shareholders.

Describe how the managerial finance function is related to economics and accounting.

- All areas of responsibility within a firm interact with finance personnel and procedures.
- The financial manager must understand the economic environment and rely heavily on the economic principle
of marginal cost–benefit analysis to make financial decisions.
- Financial managers use accounting but concentrate on cash flows and decision making.

Identify the primary activities of the financial manager.

- The primary activities of the financial manager, in addition to ongoing involvement in financial analysis and
planning, are making investment decisions and making financing decisions.

Describe the nature of the principal–agent relationship between the owners and managers of a
corporation, and explain how various corporate governance mechanisms attempt to manage agency
problems.

- This separation of owners and managers of the typical firm is representative of the classic principal–agent
relationship, where the shareholders are the principals and managers are the agents.
- This arrangement works well when the agent makes decisions that are in the principal’s best interest but can
lead to agency problems when the interests of the principal and agent differ.
- A firm’s corporate governance structure is intended to help ensure that managers act in the best interests of
the firm’s shareholders, and other stakeholders, and it is usually influenced by both internal and external
factors.