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© 2004 Pearson Education Canada Inc.
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Chapter OneOverview of Managerial Finance
Principles of Managerial Finance
First Canadian Edition
Lawrence J. Gitman and Sean Hennessey
© 2004 Pearson Education Canada Inc.
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Learning Goals
LG1 – Define finance and describe its three major areas and career opportunities.
LG2 – Review basic forms of business organization, their strengths and weaknesses.
LG3 – Describe managerial finance function and differentiate from economics and accounting.
© 2004 Pearson Education Canada Inc.
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Learning Goals (continued)
LG4 – Identify key activities of financial manager within the firm.
LG5 – Explain why wealth maximization is firm’s goal.
LG6 – Explain how EVA, stakeholder focus, and ethical behaviour relate to firm’s goal.
LG7 – Discuss agency issue as it relates to owner wealth maximization.
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What is Finance?
• At the macro level, finance is the study of financial institutions and financial markets and how they operate within the financial system in both the Canadian and global economies.
• At the micro level, finance is the study of financial planning, asset management, and fund raising for businesses and financial institutions.
• Financial management can be described in brief using the following balance sheet.
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What is Finance?
Assets: Liabilities & Equity:
Current Assets Current Liabilities
Cash & M.S. Accounts payable
Accounts receivable Notes Payable
Inventory Total Current Liabilities
Total Current Assets Long-Term Liabilities
Fixed Assets: Total Liabilities
Gross fixed assets Equity:
Less: Accumulated dep. Common Stock
Goodw ill Paid-in-capital
Other long-term assets Retained Earnings
Total Fixed Assets Total Equity
Total Assets Total Liabilities & Equity
WorkingCapital
WorkingCapital
InvestmentDecisions
FinancingDecisions
Macro Finance
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What is Finance?• A well-developed financial system is a hallmark and
essential characteristic of any modern developed nation.
• Financial markets, financial intermediaries, and financial management are the important components.
• Financial markets and financial intermediaries facilitate the flow of funds from borrowers to savers.
• Financial management involves the efficient use of financial resources in the production of goods.
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Areas of Specialization in Finance
• Financial Markets– Markets of users and savers of funds.
• Financial Services– Design and delivery of financial advice and
products to individuals, businesses, government.
• Managerial Finance– Financial management of business firms.
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Areas of Employment in Finance
• Financial Analyst
• Capital budgeting analyst/manager
• Project finance manager
• Cash manager
• Credit analyst/manager
• Pension fund manager
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Basic Forms of Business Organization
• Sole Proprietorship– Owned by one person, operated for personal profit.
• Partnerships– Owned by two or more people, operated for joint
profit.
• Corporations– “Legal entity”, owned by individuals, operated for
joint profit.
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Sole Proprietorship
STRENGTHS:• Low organizational cost
• Income taxed once as personal income
• Independence• Secrecy• Ease of dissolution
WEAKNESSES:• Unlimited liability
• Limited funding• Proprietor must be all• Difficult to develop staff
career opportunities• Lack of continuity on
death of proprietor
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Partnerships
STRENGTHS:• Improved funding
sources• Increased managerial
talent• Income split by
partnership contract, taxed as personal income
WEAKNESSES:• Unlimited liability to
all partners
• Partnership dissolved upon death of partner
• Difficult to liquidate or transfer ownership
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Corporations
STRENGTHS:• Owners’ liability limited
• Large capitalization possible, greater funding
• Ownership readily transferable
• Indefinite life• Professional management
WEAKNESSES:• Higher tax rates
• Expensive organization• Greater government
regulation• When publicly traded,
lacks secrecy
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Corporate Organization Chart
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Organization of Finance Functions
• CFO – Chief Financial Officer
• Treasurer responsibilities:– Financial planning, fund raising, capital
expenditure decisions, cash and credit management.
• Controller responsibilities:– Corporate accounting, cost accounting, and tax
management.
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Relationship to Economics
Fundamental Economic Principle:
• Marginal Analysis– Financial decisions should be made and actions
taken only when the added benefits exceed the added costs.
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Relationship to Accounting
• Cash Flows– Accrual Basis: recognizes sales revenue and
expenses incurred to make sale at time of sale.– Cash Basis: recognizes revenues and expenses
as they occur.
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Accounting vs. Financial ViewsAccounting View(Accrual Basis)
Income StatementPeakes Quay, Inc.
For year ended 12/31
Financial View(Cash Basis)
Cash Flow StatementPeakes Quay, Inc.
For year ended 12/31
Sales revenue $100,000Less: Costs 80,000Net Profit $ 20,000
Cash inflow $ 0Less: Cash outflow 80,000Net cash flow ($80,000)
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Financial Manager–Key Activities
Balance Sheet
CurrentAssets
_______________FixedAssets
CurrentLiabilities
_______________Long-Term Funds(Debt & Equity)
Financial Analysis & Planning
MakingInvestmentDecisions
MakingFinancingDecisions
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Should Firms Maximize Profit?
• Corporations commonly define profit as “Earnings per Share” (EPS).– A measure of total earnings divided by total
number of ownership shares.
• EPS ignores critical factors of– the timing of the returns.– cash flows available to common shareholders.– risk factors facing the firm.
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Or Should Firms Maximize Shareholder Wealth?
• Evaluating Shareholder Wealth addresses factors of timing, cash flows and risk ignored by the EPS.
• Therefore, Maximizing Shareholder Wealth is a more comprehensive goal for the firm, its managers and employees.
• This can be explored through “economic valued added” and a focus on stakeholders.
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Economic Value Added – EVA®
• EVA measures whether an investment contributes to shareholder wealth.
• EVA is calculated by subtracting cost of funds used from after-tax operating profits.
• While popular, EVA is essentially derived from the concept of “net present value.”
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What about Stakeholders?
• Stakeholders include groups that have direct economic links to the firm.
• Stakeholders include not only owners, but also employees, customers, suppliers, and creditors.
• Maintaining positive stakeholder relationships helps maximize long-term benefits to shareholders.
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Importance of EthicsThe standards of conduct or moral judgment:• Honesty, trustworthiness, fair dealing are
foundations of sustainable business relations:– With customers,– With suppliers,– With creditors,– With employees,– With owners.
• Ethical behaviour is necessary to achieve the goal of maximizing shareholder wealth.
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Internal Ethical Review
• Are rights of stakeholders being violated?• Does firm have extra duties to stakeholders?• Will a decision unfairly discriminate benefits
among stakeholders?• If stakeholders are harmed, should this be
remedied? How?• What is the relationship between shareholders
and stakeholders?
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Financial Goals of a Company
• Maximize sales.• Maximize cash flow.
• Maximize market share.
• Maximize profit.• Minimize costs.
• Maximize return on sales, investment, equity.
• Ensure earnings stability.
• Achieve target goals for sales, profits, market share or return.
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Agency Issues: The Principal-Agent Problem
• Whenever ownership is independent of management there exists potential problem of conflicts.
• The owner’s goals for the firm are best described as maximizing shareholder wealth.
• Managers are also concerned with personal wealth, job security, lifestyle, and benefits. These concerns may conflict with shareholder interests.
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Resolving the Agency Problem
• Good corporate governance by the Board of Directors is the heart of any resolution.
• Agency Costs – the costs of this governance:– Monitoring costs,– Bonding costs,– Structuring compensation costs.
• Market forces, such as the potential for hostile takeover provide some deterrence.
• Legal forces, fraud, and fiduciary misconduct laws aim to act as deterrents as well.
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Current View on Incentive Plans
• Executive compensation packages generally include incentive plans that grant stock options, performance based shares, or cash bonuses upon meeting or exceeding corporate goals.
• Such packages may also include long-term benefits that can protect the manager against poor corporate performance.
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Overview of Text
Part 1: Introduction to Managerial Finance
Part 2: Financial Analysis and Planning
Part 3: Important Financial Concepts
Part 4: Long-Term Financing Decisions
Part 5: Long-Term Investment Decisions
Part 6: Working Capital Management
Part 7: Special Topics in Managerial Finance