Chapter 1 Introduction to Managerial Finance

8/18/2019 Chapter 1 Introduction to Managerial Finance

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Chapter 1

The Role ofManagerial

Finance


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© Pearson Education Limited, 2015. 1-2

What is Finance?

• Finance can be defined as the science and art ofmanaging money.

• At the personal level, finance is concerned withindividuals’ 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.


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Career Opportunities in Finance: FinancialServices

• Financial Services is the area of financeconcerned with the design and delivery of adviceand financial products to individuals, businesses,and governments.

• Career opportunities include:• banking

• personal financial planning

• Investments

• real estate

• insurance


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Career Opportunities in Finance:Managerial Finance

• Managerial finance is concerned with the dutiesof the financial manager working in a business.

• Financial managers administer the financialaffairs 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.


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Legal Forms of Business Organization

• A sole proprietorship is a business owned by oneperson and operated for his or her own profit.

• A partnership is a business owned by two or morepeople and operated for profit.

• A corporation is an entity created by law.Corporations have the legal powers of an individualin that it can sue and be sued, make and be partyto contracts, and acquire property in its own name.


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Table 1.1 Strengths and Weaknesses of theCommon Legal Forms of Business Organization


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Figure 1.1 Corporate Organization



Table 1.2 Career Opportunities inManagerial Finance



Goal of the Firm:Maximize Shareholder Wealth

• Decision rule for managers: only take actions thatare expected to increase the share price.

Figure 1.2 Share Price Maximization Financial decisions andshare price


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Goal of the Firm:Maximize Profit?

• Profit maximization may not lead to the highest possible shareprice for at least three reasons:

1. Timing is important—the receipt of funds sooner rather than lateris preferred

2. Profits do not necessarily result in cash flows available tostockholders

3. Profit maximization fails to account for risk

Which Investment is Preferred?


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Goal of the Firm:What About Stakeholders?

• Stakeholders are groups such as employees,customers, suppliers, creditors, owners, and otherswho have a direct economic link to the firm.

• A firm with a stakeholder focus consciously avoids

actions that would prove detrimental tostakeholders. The goal is not to maximizestakeholder well-being but to preserve it.

• Such a view is considered to be "sociallyresponsible."


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The Role of Business Ethics

• Business ethics are the standards of conduct ormoral judgment that apply to persons engaged incommerce.

• Violations of these standards in finance involve a

variety of actions: “creative accounting,” earningsmanagement, misleading financial forecasts, insidertrading, fraud, excessive executive compensation,options backdating, bribery, and kickbacks.

• Negative publicity often leads to negative impactson a firm


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The Role of Business Ethics:Ethics and Share Price

• Ethics programs seek to:– reduce litigation and judgment costs

– maintain a positive corporate image

– build shareholder confidence

– gain the loyalty and respect of all stakeholders

• The expected result of such programs is topositively affect the firm’s share price.


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Managerial Finance Function

• The size and importance of the managerial financefunction depends on the size of the firm.

• In small firms, the finance function is generallyperformed by the accounting department.

• As a firm grows, the finance function typicallyevolves into a separate department linked directlyto the company president or CEO through the chieffinancial officer (CFO) (see Figure 1.1).


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Figure 1.1 Corporate Organization


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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 ofvarying levels of economic activity and changes in

economic policy.• They must also be able to use economic theories as

guidelines for efficient business operation.

• Marginal cost–benefit analysis is the economic

principle that states that financial decisions shouldbe made and actions taken only when the addedbenefits exceed the added costs


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Managerial Finance Function:Relationship to Accounting

• The firm’s finance and accounting activities areclosely-related and generally overlap.

• In small firms accountants often carry out thefinance 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 accountantsgenerally use the accrual method while in finance,the focus is on cash flows.


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Managerial Finance Function:Relationship to Accounting (cont.)

• Whether a firm earns a profit or experiences a loss,it must have a sufficient flow of cash to meet itsobligations as they come due.

• The significance of this difference can be illustrated

using the following simple example.


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The Nassau Corporation experienced the followingactivity last year:

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

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


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


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Finance and accounting also differ with respect todecision-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 makedecisions on the basis of their assessment of theassociated returns and risks.


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Figure 1.3Financial Activities


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Governance and Agency:Corporate Governance

• Corporate governance refers to the rules,processes, and laws by which companies areoperated, controlled, and regulated.

• It defines the rights and responsibilities of the

corporate participants such as the shareholders,board of directors, officers and managers, andother stakeholders, as well as the rules andprocedures for making corporate decisions.

• The structure of corporate governance waspreviously described in Figure 1.1.


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Governance and Agency:Individual versus Institutional Investors

• Individual investors are investors who ownrelatively small quantities of shares so as to meetpersonal investment goals.

• Institutional investors are investment

professionals, such as banks, insurance companies,mutual funds, and pension funds, that are paid tomanage and hold large quantities of securities onbehalf of others.

• Unlike individual investors, institutional investorsoften monitor and directly influence a firm’scorporate governance by exerting pressure onmanagement to perform or communicating theirconcerns to the firm’s board.


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Governance and Agency:Government Regulation

• Government regulation generally shapes thecorporate governance of all firms.

• During the recent decade, corporate governancehas received increased attention due to several

high-profile corporate scandals involving abuse ofcorporate power and, in some cases, allegedcriminal activity by corporate officers.


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Governance and Agency:Government Regulation

The Sarbanes-Oxley Act of 2002:• established an oversight board to monitor the accountingindustry;

• tightened audit regulations and controls;

• toughened penalties against executives who commit corporatefraud;

• strengthened accounting disclosure requirements and ethicalguidelines for corporate officers;

• established corporate board structure and membershipguidelines;

• established guidelines with regard to analyst conflicts of

interest;• mandated instant disclosure of stock sales by corporate

executives;

• increased securities regulation authority and budgets forauditors and investigators.


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Governance and Agency:The Agency Issue

• A principal-agent relationship is an arrangementin which an agent acts on the behalf of a principal.For example, shareholders of a company(principals) elect management (agents) to act ontheir behalf.

• Agency problems arise when managers placepersonal goals ahead of the goals of shareholders.

• Agency costs arise from agency problems that areborne by shareholders and represent a loss ofshareholder wealth.


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The Agency Issue:Management Compensation Plans

• In addition to the roles played by corporate boards,institutional investors, and government regulations,corporate governance can be strengthened byensuring that managers’ interests are aligned withthose of shareholders.

• A common approach is to structure managementcompensation to correspond with firm performance.

h


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The Agency Issue:Management Compensation Plans

• Incentive plans are management compensationplans that tie management compensation to shareprice; one example involves the granting of stockoptions.

• Performance plans tie managementcompensation to measures such as EPS or growthin EPS. Performance shares and/or cash bonusesare used as compensation under these plans.


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© P Ed ti Li it d 2015 1 31

The Agency Issue: The Threat of Takeover

• When a firm’s internal corporate governancestructure is unable to keep agency problems incheck, it is likely that rival managers will try to gaincontrol of the firm.

• The threat of takeover by another firm, whichbelieves it can enhance the troubled firm’s value byrestructuring its management, operations, andfinancing, can provide a strong source of externalcorporate governance.

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Chapter 1 Introduction to Managerial Finance

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