Chapter 1

The Role of Managerial The Role of Managerial FinanceFinance

The Role of Managerial The Role of Managerial FinanceFinance

The Role of Managerial FinaanceManagerial Finaance

What is Managerial FinanceManagerial Finance? The Goal of the Firm Organization of the Managerial FinanceManagerial Finance

Function

What is Managerial FinanceManagerial Finance?

Concerns the acquisition, financing, and management of

assets with some overall goaloverall goal in mind.

Investment Decisions

What is the optimal firm size? What specific assets should be acquired? What assets (if any) should be reduced or

eliminated?

Most important of the three Most important of the three decisions.decisions.

Financing Decisions

What is the best type of financing? What is the best financing mix?

What is the best dividend policy? How will the funds be physically acquired?

Determine how the assets (LHS of Determine how the assets (LHS of balance sheet) will be financed (RHS balance sheet) will be financed (RHS

of balance sheet).of balance sheet).

Asset Management Decision

How do we manage existing assets efficiently? Financial Manager has varying degrees of

operating responsibility over assets. Greater emphasis on current asset

management than fixed asset management.

Maximization of Maximization of Shareholder Wealth!Shareholder Wealth!

Value creation occurs when we maximize the share price for current

shareholders.

Shortcomings of Alternative Perspectives

Could increase current profits while harming firm (e.g., defer maintenance, issue common stock to buy T-bills, etc.).

Ignores risk.

Profit MaximizationProfit Maximization Maximizing a firm’s earnings after taxes.

ProblemsProblems

Shortcomings of Alternative Perspectives

Does not specify timing or duration of expected returns. Ignores risk. Calls for a zero payout dividend policy.

Earnings per Share MaximizationEarnings per Share Maximization Maximizing earnings after taxes divided

by shares outstanding.

ProblemsProblems

Strengths of Shareholder Wealth Maximization

Takes account of: current and future profits and current and future profits and EPSEPS; the timing, duration, and risk of profits the timing, duration, and risk of profits and EPSand EPS; dividend policydividend policy; and all other relevant factors.

Thus, share priceshare price serves as a barometer for business performance.

The Modern Corporation

There exists a SEPARATION between owners and managers.

Modern Corporation

Shareholders Management

Role of Management

An agentagent is an individual authorized by another person, called the principal, to act in the latter’s behalf.

Management acts as an agentagent for the owners (shareholders)

of the firm.

Agency Theory

Agency TheoryAgency Theory is a branch of economics relating to the behavior of principals and their agents.

Jensen and Meckling developed a theory of the firm based on agency theoryagency theory.

Conflict of Goals : Agency ProblemConflict of Goals : Agency Problem

An agency problem is the conflict of goals An agency problem is the conflict of goals between a firm’s shareholders and its between a firm’s shareholders and its managers.managers.

For example, decision to establish a subsidiary in a particular area or to expand the business may be from the desire of managers to receive more responsibility and compensation.

Conflict of Goal : Agency ProblemConflict of Goal : Agency Problem

An agency problem exist mostly in big An agency problem exist mostly in big corporations where management is separated corporations where management is separated from ownership. In sole proprietorship it from ownership. In sole proprietorship it does not existdoes not exist

Agency problem is more visible in MNCs Agency problem is more visible in MNCs than domestic companiesthan domestic companies..

Corporate Control to reduce Agency ProblemCorporate Control to reduce Agency Problem

Principals must provide incentivesincentives so that management acts in the principals’ best interests and then monitormonitor results.

• Mangerial CompensationMangerial Compensation::To partially compensate the To partially compensate the management and board members by offering stock to them so that they management and board members by offering stock to them so that they take decisions that maximizes the value of the firmtake decisions that maximizes the value of the firm

a.a. Performance SharesPerformance Shares: : A type of incentive plan in which managers A type of incentive plan in which managers are awarded share of stock on the basis of the firm’s performance over are awarded share of stock on the basis of the firm’s performance over given intervals with respect to earnings per share or other measuresgiven intervals with respect to earnings per share or other measures..

b.b. Stock OptionsStock Options:: Allows managers to purchase stock at some future Allows managers to purchase stock at some future

time at a given pricetime at a given price

Corporate Control to reduce Agency ProblemCorporate Control to reduce Agency Problem

2. 2. The Threat of FiringThe Threat of Firing:: It is an effective measure today because ownership now a It is an effective measure today because ownership now a

days not widely distributed as in the past.days not widely distributed as in the past. Management control over voting mechanism is also not so Management control over voting mechanism is also not so

strong as in the paststrong as in the past Today it is easier for dissident shareholders to gain enough Today it is easier for dissident shareholders to gain enough

votes to overthrow the managers.votes to overthrow the managers. Recent examples of ousting the managers are Coca Cola, Recent examples of ousting the managers are Coca Cola,

Xerox, United Airlines etc.Xerox, United Airlines etc.

Corporate Control to reduce Agency ProblemCorporate Control to reduce Agency Problem

3. 3. Hostile Takeover threat:Hostile Takeover threat: The fear of taking The fear of taking over the firm by the by some other big firms over the firm by the by some other big firms against the desire of the managers, if the firm against the desire of the managers, if the firm is inefficiently managed. This threat may is inefficiently managed. This threat may encourage the management to run the firm as encourage the management to run the firm as per the desire of the shareholders.per the desire of the shareholders.

Social Responsibility

Wealth maximization does not preclude the firm from being socially responsiblesocially responsible.

Assume we view the firm as producing both private and social goods.

Then shareholdershareholder wealthwealth maximizationmaximization remains the appropriate goal in governing the firm.

Organization of the Financial Management Function

Board of Directors

President(Chief Executive Officer)

Vice PresidentOperations

Vice PresidentMarketing

VP ofFinance

TreasurerCapital BudgetingCash ManagementCredit Management

Dividend DisbursementFin Analysis/PlanningPension ManagementInsurance/Risk MngmtTax Analysis/Planning

Organization of the Financial Management Function

VP of Finance

ControllerCost Accounting

Cost ManagementData ProcessingGeneral Ledger

Government ReportingInternal Control

Preparing Fin StmtsPreparing Budgets

Preparing Forecasts

Multinational Corporations

A multi national corporation is a firm that operate in two or more nations. International operations are important to both

Individual and National Economy

Reasons for Companies going for multinational

To seek new markets To seek raw materials To seek new technology To seek production efficiency To avoid Political and regulatory hurdles

Distinguishing characteristics of Multinational Managerial Finance over Domestic Managerial Finance

Different Currency Denomination Economic and Legal Ramifications Difference of languages Difference of culture Role of Government Political Risk