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Chapter 1
The Role of
Managerial
Finance
What is Finance?
• Finance can be defined as the science and art of

managing money.
• At the personal level, finance is concerned with
individuals’ decisions about:
• how much of their earnings they spend
• how much they save
• how they invest their savings
• In a business context, finance involves:
• how firms raise money from investors
• how firms invest money in an attempt to earn a profit
• how firms decide whether to reinvest profits in the
business or distribute them back to investors.
© Pearson Education Limited, 2015. 1-2

Career Opportunities in Finance: Financial
Services
• Financial Services is the area of finance

concerned with the design and delivery of advice
and financial products to individuals, businesses,
and governments.
• Career opportunities include:
• banking
• personal financial planning
• Investments
• real estate
• insurance

Career Opportunities in Finance:
Managerial Finance
• 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. Tasks include:
• developing a financial plan or budget
• extending credit to customers
• evaluating proposed large expenditures
• raising money to fund the firm’s operations.

Focus on Practice
• Professional Certifications in Finance:

– 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.
– 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.
– Certified Financial Planner (CFP) – To obtain CFP status,
students must pass a ten-hour exam covering a wide
range of topics related to personal financial planning.

Focus on Practice (cont.)
• Professional Certifications in Finance:

– American Academy of Financial Management (AAFM) – The
AAFM administers certifications including the Charter
Portfolio Manager, Chartered Asset Manager, Certified Risk
Analyst, Certified Cost Accountant, and Certified Credit
Analyst.
– Professional Certifications in Accounting –Professional
certifications in accounting include the Certified Public
Accountant (CPA), Certified Management Accountant
(CMA), and Certified Internal Auditor (CIA).

Corporate Finance Addresses the
Following Three Questions
1. What long- term investments should

the firm engage in? ( Investment
decision)
2. How the firm can raise the money for
the required investments? ( Financing
decision)
3. How much short- term cash flow does
a company need to pay its bills?
( Managing the working capital)

Macro Finance
ABC Company
Balance Sheet
As of December 31, 19xx
Assets: Liabilities & Equity:

Current Assets Current Liabilities
Working Cash & M.S. Accounts payable
Working
Capital Accounts receivable Notes Payable
Capital
Inventory Total Current Liabilities
Total Current Assets Long-Term Liabilities
Fixed Assets: Total Liabilities
Gross fixed assets Equity:
Investment Less: Accumulated dep. Common Stock Financing
Decisions Goodw ill Paid-in-capital
Decisions
Other long-term assets Retained Earnings
Total Fixed Assets Total Equity
Total Assets Total Liabilities & Equity

Legal Forms of Business Organization
• A sole proprietorship is a business owned by one

person and operated for his or her own profit.
• A partnership is a business owned by two or more
people and operated for profit.
• A corporation is an entity created by law.
Corporations have the 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.

Table 1.1 Strengths and Weaknesses of the
Common Legal Forms of Business Organization

Figure 1.1 Corporate Organization

Table 1.2 Career Opportunities in
Managerial Finance

Goal of the Firm:
Maximize Shareholder Wealth
• Decision rule for managers: only take actions that

are expected to increase the share price.
Figure 1.2 Share Price Maximization Financial decisions and
share price

Goal of the Firm:
Maximize Profit?
Which Investment is Preferred?
• Profit maximization may not lead to the highest possible share

price for at least three reasons:
1. Timing is important—the receipt of funds sooner rather than later
is preferred
2. Profits do not necessarily result in cash flows available to
stockholders
3. Profit maximization fails to account for risk

Goal of the Firm:
What About Stakeholders?
• Stakeholders are 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.
• Such a view is considered to be "socially
responsible."

Managerial Finance Function
• The size and importance of the managerial finance

function depends on the size of the firm.
• In small firms, the finance function is generally
performed by the accounting department.
• As a firm grows, the finance function typically
evolves into a separate department linked directly
to the company president or CEO through the chief
financial officer (CFO) (see Figure 1.1).

Figure 1.1 Corporate Organization

Managerial Finance Function:
Relationship to Economics
• The field of finance is closely related to economics.

• Financial managers must understand the economic
framework and be alert to the consequences of
varying levels of economic activity and changes in
economic policy.
• They must also be able to use economic theories as
guidelines for efficient business operation.

The Managerial Finance Function
• Relationship to Economics:
• The field of finance is closely related to
economics.
• The primary economic principle used in
managerial finance is Marginal Analysis
• Marginal Analysis: economic principle
that states that financial decision should
be made & actions taken only when
added benefit exceeds the added costs

Relationship to Economics (cont.)
• Marginal cost–benefit analysis is the economic

principle that states that financial decisions should
be made and actions taken only when the added
benefits exceed the added costs
• Marginal cost-benefit analysis can be illustrated
using the following simple example.

Relationship to Economics (cont.)
Nord Department Stores is applying marginal-cost

benefit analysis to decide whether to replace a
computer:

Relationship to Accounting
• The firm’s finance and accounting activities are

closely-related and generally overlap.
• In small firms accountants often carry out the
finance function, and in large firms financial
analysts often help compile accounting information.
• One major difference in perspective and emphasis
between finance and accounting is that accountants
generally use the accrual method while in finance,
the focus is on cash flows.

Relationship to Accounting (cont.)
• 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.
• The significance of this difference can be illustrated
using the following simple example.

The Nassau Corporation experienced the following
activity last year:
Sales: $100,000 (1 yacht sold, 100% still uncollected)

Costs: $80,000 (all paid in full under supplier terms)

Now contrast the differences in performance under
the accounting method (accrual basis) versus the
financial view (cash basis):

Finance and accounting also differ with respect to
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.

Relationship Between Accounting &
Finance
Finance Accounting
• Future • Past
• Take the financial • Record financial
decisions transaction
• Current market • Historical cost
value • Accrual Basis
• Cash basis (recognizes
(recognizes revenues at the
revenues & point of sale &
expenses only with recognizes
respect to actual expenses when
inflow & outflow of incurred)
cash)

Governance and Agency:
Individual versus Institutional Investors
• Individual investors are investors who own

relatively small quantities of shares so as to meet
personal investment goals.
• Institutional investors are 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.
• Unlike individual investors, institutional investors often
monitor and directly influence a firm’s corporate
governance by exerting pressure on management to
perform or communicating their concerns to the firm’s
board.

Corporate Governance
• 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.
• The structure of corporate governance was
previously described in Figure 1.1.

Government Regulation
• Government regulation generally shapes the

corporate governance of all firms.
• During the recent decade, corporate governance
has received increased attention due to several
high-profile corporate scandals involving abuse of
corporate power and, in some cases, alleged
criminal activity by corporate officers.

The Agency Issue
• A principal-agent relationship is 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 arise when managers place
personal goals ahead of the goals of shareholders.
• Agency costs arise from agency problems that are
borne by shareholders and represent a loss of
shareholder wealth.

Chapter 2
The Financial
Market
Environment
Financial Institutions & Markets
Firms that require funds from external sources can

obtain them in three ways:
1. through a financial institution
2. through financial markets
3. through private placements

Financial Institutions & Markets: Financial
Institutions
• Financial institutions are intermediaries that

channel the savings of individuals, businesses, and
governments into loans or investments.
• The key suppliers and demanders of funds are
individuals, businesses, and governments.
• In general, individuals are net suppliers of funds,
while businesses and governments are net
demanders of funds.

Commercial Banks, Investment Banks,
and the Shadow Banking System
• Commercial banks are institutions that:

– provide savers with a secure place to invest their funds
– offer loans to individual and business borrowers
• Investment banks are institutions that:
– assist companies in raising capital
– advise firms on major transactions such as mergers or
financial restructurings
– engage in trading and market making activities

Markets
• Financial markets are forums in which suppliers

of funds and demanders of funds can transact
business directly.
• Transactions in short term marketable securities
take place in the money market while transactions
in long-term securities take place in the capital
market.
• A private placement involves the sale of a new
security directly to an investor or group of
investors.
• Most firms, however, raise money through a public
offering of securities, which is the sale of either
bonds or stocks to the general public.

Markets (cont.)
• The primary market is the financial market in

which securities are initially issued; the only market
in which the issuer is directly involved in the
transaction.
• Secondary markets are financial markets in which
preowned securities (those that are not new issues)
are traded.

The Money Market
• The money market is created by a financial

relationship between suppliers and demanders of
short-term funds.
• Most money market transactions are made in
marketable securities which are short-term debt
instruments, such as:
• U.S. Treasury bills issues by the federal government
• commercial paper issued by businesses
• negotiable certificates of deposit issued by financial
institutions
• Investors generally consider marketable securities
to be among the least risky investments available.

The Capital Market
• The capital market is a market that enables

suppliers and demanders of long-term funds to
make transactions.
• The key capital market securities are bonds (long-
term debt) and both common and preferred stock
(equity, or ownership).
– Bonds are long-term debt instruments used by businesses
and government to raise large sums of money, generally
from a diverse group of lenders.
– Common stock are units of ownership interest or equity
in a corporation.
– Preferred stock is a special form of ownership that has
features of both a bond and common stock.

Broker Markets and
Dealer Markets
Broker markets are securities exchanges on which

the two sides of a transaction, the buyer and seller,
are brought together to trade securities.
– Trading takes place on centralized trading floors of national
exchanges, such as NYSE Euronext, as well as regional
exchanges.

Broker Markets and
Dealer Markets (cont.)
• Dealer markets, such as Nasdaq, are markets in

which the buyer and seller are not brought together
directly but instead have their orders executed by
securities dealers that “make markets” in the given
security.
– The dealer market has no centralized trading floors.
Instead, it is made up of a large number of market makers
who are linked together via a mass-telecommunications
network.
• As compensation for executing orders, market
makers make money on the spread (bid price – ask
price).

The Role of Capital Markets
• From a firm’s perspective, the role of capital

markets is to be a liquid market where firms can
interact with investors in order to obtain valuable
external financing resources.
• From investors’ perspectives, the role of capital
markets is to be an efficient market that allocates
funds to their most productive uses.
• An efficient market allocates funds to their most
productive uses as a result of competition among
wealth-maximizing investors and determines and
publicizes prices that are believed to be close to
their true value.

The Role of Capital Markets (cont.)
• Advocates of behavioral finance, an emerging

field that blends ideas from finance and psychology,
argue that stock prices and prices of other
securities can deviate from their true values for
extended periods.
• Examples of the principle that stock prices
sometimes can be wildly inaccurate measures of
value include:
• the huge run up and subsequent collapse of the prices of
Internet stocks in the late 1990s
• the failure of markets to accurately assess the risk of
mortgage-backed securities in the more recent financial
crisis

Financial Institutions & Markets Cont.
• Financial markets: provide a forum in which
supplier of funds and demanders of funds can
transact business directly
– Whereas financial institutions, loans and
investments are made without the direct
knowledge of supplier of funds
– The two key financial markets:
• Money market ( for short-term fund)
• Capital market ( for long-term fund)

Financial Institutions & Markets
1)The Money Market: a financial relationship
created between supplier & demanders of
short-term funds
• Most money market transactions are made in marketable
securities ( short –term debt instrument such as government
treasury bills and commercial paper).
Government Treasury bills are short-term instrument issued by
government. It is more secure than bank deposits or any other
investment alternatives, because the risk of the government being in
default, not being able to re-pay interest or principal, is very remote,
almost negligible compared to the risk of other borrowers.
In Egypt, there are three types of T-Bills i.e. 91 days, 182 days and
364days.
you pay a lower amount when you purchase T-bills compared to their
par value, which you will receive after a certain period i.e. 91 days. For
example, I pay LE 990 today for T-Bills 91 days and later receive LE
1000 after three months.
The method of offering Treasury bills to the market is through auctions.
The entity or financial institution that pays more than the other entities
will win the bid, which is the same process as any other auction in the
market.

The Capital Market
2) The Capital Market: a financial relationship created

between supplier & demanders of long-term funds
• The key capital market securities are bonds (long-term debt)
and both common and preferred stock (equity, or
ownership).
 Bonds are long-term debt instruments used by businesses and
government to raise large sums of money, generally from a diverse
group of lenders.
 Common stock are units of ownership interest or equity in a
corporation.
 Preferred stock is a special form of ownership that has features of
both a bond and common stock.
46

• To raise money, firms can use either private
placement or public offering
– Private placement: the sale of a new security issue,
typically bonds or preferred stock, directly to an
investor or group of investors such as insurance
companies & pension funds
– Public offering: the nonexclusive sale of either bonds or
stocks to general public

• Primary market: financial markets in which
securities are initially issued
• The only market in which the issuer is directly involved in
the transaction
• This is done through an intermediate named investment
bank
• Secondary market: financial markets in which
pre-owned securities ( those that are not new
issues) are traded
• The intermediate is the stock market
• Example: NASDAQ or New York stock exchange and
EGX

Types of securities
Equity(my
Equity money) Debt(borrowed)
Debt
• Capital
• Shares( both represent
• Long –term debts
the owned capital & • Bonds
they have no maturity)
maturity
• C.S.: • Bondholders
• Take variable • Take interest on
dividends depend on: the par value of the
• The amount of
net earning bond
• The decision to • Has a maturity date
distribute or to
retain the earning
• Have the right to
vote (every
share=one vote)
Types
Equity of money)
Equity(my securities Debt(borrowed)
Debt
• P.S.:
• Take fixed dividends • The shareholder’s
before common stock claim on firm value
• Preferred stock are
bought for the benefit is the residual
of its low risk as it amount that
has a fixed dividends
regardless of remains after the
• Amount of net debt holders are
earnings
• The decision of paid
distributing or
retaining earnings

Types of securities
The difference between interest &
dividends:
• Interest is an expense that the company
is going to pay each year to the
bondholders regardless of the amount of
profit i.e. the interest is one item of the
expenses that will be paid before
calculating the net profit or loss
• For dividends is paid only when there is
net earnings

Types of securities
Example:
ABC company’s capital is 500,000 C.S. Par value
$10 & 500,000 P.S. Par value $10, 8%
dividends; Suppose that:
– Net earnings is 1,000,000; What is the amount of
earnings available for c.S.?
– Net earnings is 300,000; What is the amount of
earnings available for c.S.?

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Chapter 1

• Finance can be defined as the science and art of

© Pearson Education Limited, 2015. 1-2

• Financial Services is the area of finance

© Pearson Education Limited, 2015. 1-3

• Managerial finance is concerned with the duties

© Pearson Education Limited, 2015. 1-4

• Professional Certifications in Finance:

© Pearson Education Limited, 2015. 1-5

• Professional Certifications in Finance:

© Pearson Education Limited, 2015. 1-6

1. What long- term investments should

© Pearson Education Limited, 2015. 1-7

Assets: Liabilities & Equity:

© Pearson Education Limited, 2015. 1-8

• A sole proprietorship is a business owned by one

© Pearson Education Limited, 2015. 1-9

© Pearson Education Limited, 2015. 1-10

© Pearson Education Limited, 2015. 1-11

© Pearson Education Limited, 2015. 1-12

• Decision rule for managers: only take actions that

© Pearson Education Limited, 2015. 1-13

• Profit maximization may not lead to the highest possible share

© Pearson Education Limited, 2015. 1-14

• Stakeholders are groups such as employees,

© Pearson Education Limited, 2015. 1-15

• The size and importance of the managerial finance

© Pearson Education Limited, 2015. 1-16

© Pearson Education Limited, 2015. 1-17

• The field of finance is closely related to economics.

© Pearson Education Limited, 2015. 1-18

© Pearson Education Limited, 2015. 1-19

• Marginal cost–benefit analysis is the economic

© Pearson Education Limited, 2015. 1-20

Nord Department Stores is applying marginal-cost

© Pearson Education Limited, 2015. 1-21

• The firm’s finance and accounting activities are

© Pearson Education Limited, 2015. 1-22

© Pearson Education Limited, 2015. 1-23

Sales: $100,000 (1 yacht sold, 100% still uncollected)

© Pearson Education Limited, 2015. 1-24

© Pearson Education Limited, 2015. 1-25

© Pearson Education Limited, 2015. 1-26

© Pearson Education Limited, 2015. 1-27

• Individual investors are investors who own

© Pearson Education Limited, 2015. 1-28

• Corporate governance refers to the rules,

© Pearson Education Limited, 2015. 1-29

• Government regulation generally shapes the

© Pearson Education Limited, 2015. 1-30

• A principal-agent relationship is an arrangement

© Pearson Education Limited, 2015. 1-31

Firms that require funds from external sources can

© Pearson Education Limited, 2015. 1-33

• Financial institutions are intermediaries that

© Pearson Education Limited, 2015. 1-34

• Commercial banks are institutions that:

© Pearson Education Limited, 2015. 1-35

• Financial markets are forums in which suppliers