Chapter One

Overview
of
Managerial Finance

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Introduction
to Managerial
Finance
Introduction to Managerial Finance

WHAT IS The science and art of

FINANCE ?
managing money.
financial perspective

 How firms raise money from

investors.  How much of earnings
 How firms invest money to earn will spend.
a profit.  How much they save.
 How will invest the
 How firms decide whether to business Personal savings.
reinvest profits in the business level level
or distribute it back to investors.

LEGAL FORMS OF BUSINESS

ORGANIZATION
Sole Proprietorship Corporation
Partnership
 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
domestic economy 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?
 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: WEAKNESSES:
 Low organizational cost  Unlimited liability

 Income taxed once as  Limited funding

personal income  Proprietor must be all
 Independence  Difficult to develop staff
 Secrecy career opportunities
 Ease of dissolution  Lack of continuity on
death of proprietor

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Partnerships
STRENGTHS: WEAKNESSES:
 Improved funding  Unlimited liability to
sources all partners
 Increased
 Partnership
managerial talent
dissolved upon death
 Income split by
of partner
partnership contract,
taxed as personal  Difficult to liquidate
income or transfer ownership

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 Corporations

STRENGTHS: WEAKNESSES:
 Owners’ liability limited  Higher tax rates
 Large capitalization  Expensive
possible, greater funding organization
 Ownership readily  Greater government
transferable regulation
 Indefinite life  When publicly traded,
 Professional lacks secrecy
management

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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 Views
Accounting View Financial View
(Accrual Basis) (Cash Basis)
Income Statement Cash Flow Statement
Peakes Quay, Inc. Peakes Quay, Inc.
For year ended 12/31 For year ended 12/31

Sales revenue $100,000 Cash inflow $ 0

Less: Costs 80,000 Less: Cash outflow 80,000
Net Profit $ 20,000 Net cash flow ($80,000)

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Financial Manager–Key Activities

Financial Analysis & Planning

Balance Sheet
Current Current
Making Assets Liabilities Making
Investment _______________ _______________ Financing
Decisions Fixed Long-Term Funds Decisions
Assets (Debt & Equity)

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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 Ethics
The 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 return on
sales, investment,
 Maximize cash
equity.
flow.
 Ensure earnings
 Maximize market stability.
share.  Achieve target
 Maximize profit. goals for sales,
profits, market
 Minimize costs. share or return.

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The Modern Corporation

Modern Corporation

Shareholders Management

There exists a SEPARATION between

owners and managers.
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Role of Management

Management acts as an agent

for the owners (shareholders)
of the firm.
 An agent is an individual authorized by
another person, called the principal, to
act in the latter’s behalf.

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Agency Theory

Jensen and Meckling developed

a theory of the firm based on
agency theory.
 Agency Theory is a branch of economics
relating to the behavior of principals and
their agents.

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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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 Corporate Governance

 Corporate governance: represents the system by

which corporations are managed and controlled.
• Includes shareholders, board of directors, and senior
management.
 Then shareholder wealth maximization remains the
appropriate goal in governing the firm.

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