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Copyright 2012 Pearson Prentice Hall.All rights reserved.

Chapter 1

The Role ofManagerial

Finance


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2012 Pearson Prentice Hall. All rights reserved. 1-2

Learning Goals

LG1 Definefinanceand the managerial finance function.

LG2 Describe the goal of the firm, and explain whymaximizing the value of the firm is an appropriate

goal for a business.


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Learning Goals (cont.)

LG3 Describe how the managerial finance function isrelated to economics and accounting.

LG4 Identify the primary activities of the financialmanager.

LG5 Describe the nature of the principle-agent relationship

between the owners and managers of a corporation,and explain how various corporate governance

mechanisms attempt to manage agency problems.


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What is Finance?

Financecan be defined as the science and art of managingmoney.

At the personal level, finance is concerned with

individualsdecisions about how much of their earningsthey spend, how much they save, and how they invest

their savings.

In a business context, finance involves the same types of

decisions: how firms raise money from investors, howfirms invest money in an attempt to earn a profit, and howthey decide whether to reinvest profits in the business ordistribute them back to investors.


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Career Opportunities inFinance: Financial Services

Financial Servicesis 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 financialplanning, investments, real estate, and insurance.


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Career Opportunities inFinance: Managerial Finance

Managerial financeis concerned with the duties of the

financial manager working in a business.

Financial managersadminister the financial affairs of all

types of businessesprivate and public, large and small,profit-seeking and not-for-profit.

They perform such varied tasks as developing a financial

plan or budget, extending credit to customers, evaluatingproposed large expenditures, and raising money to fund

the firms operations.


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Career Opportunities in Finance:

Managerial Finance (cont.)

The recent global financial crisis and subsequent

responses by governmental regulators, increased global

competition, and rapid technological change also increase

the importance and complexity of the financial managersduties.

Increasing globalization has increased demand for

financial experts who can manage cash flows in different

currencies and protect against the risks that naturally arisefrom international transactions.



Table 1.2 Career Opportunitiesin Managerial Finance



Goal of the Firm:Maximize Shareholder Wealth

Decision rule for managers: only take actions that are

expected to increase the share price.



Goal of the Firm:Maximize Profit?

Profit maximization may not lead to the highest possible share pricefor at least three reasons:

1. Timing is importantthe 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

Which Investment is Preferred?



Goal of the Firm:What About Stakeholders?

Stakeholdersare groups such as employees, customers,

suppliers, creditors, owners, and others who have a direct

economic link to the firm.

A firm with astakeholder focusconsciously avoidsactions 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."


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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 CorporateOrganization


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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 of varying

levels of economic activity and changes in economicpolicy.

They must also be able to use economic theories as

guidelines for efficient business operation.


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Managerial Finance Function:

Relationship to Economics (cont.)

Marginal costbenefit 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.


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Relationship to Economics (cont.)

Nord Department Stores is applying marginal-cost benefit

analysis to decide whether to replace a computer:


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Managerial Finance Function:Relationship to Accounting

The firms 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 helpcompile 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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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 usingthe following simple example.


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The Nassau Corporation experienced the following activity

last year:

Sales $100,000 (1 yacht sold, 100% stilluncollected)

Costs $ 80,000 (all paid in full under supplierterms)


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Now contrast the differences in performance under the

accounting method (accrual basis) versus the financial view

(cash basis):

Income Statement Summary

Accrual basis Cash basis

Sales $100,000 $ 0

Less: Costs (80,000) (80,000)

Net Profit/(Loss) $ 20,000 $(80,000)


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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 decisionson the basis of their

assessment of the associated returns and risks.


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Personal Finance Example


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Figure 1.3Financial Activities


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Governance and Agency:Corporate Governance

Corporate governancerefers to the rules, processes, and

laws by which companies are operated, controlled, and

regulated.

It defines the rights and responsibilities of the corporateparticipants 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.


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Governance and Agency:Individual versus Institutional Investors

Individual investorsare investors who own relatively smallquantities of shares so as to meet personal investment goals.

Institutional investorsare 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 firms corporate governance by exerting pressure

on management to perform or communicating their concerns to the

firms board.


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Governance and Agency: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-profilecorporate scandals involving abuse of corporate power

and, in some cases, alleged criminal activity by corporate

officers.


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Governance and Agency:The Agency Issue

A principal-agent relationshipis 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 problemsarise when managers place personal

goals ahead of the goals of shareholders.

Agency costsarise from agency problems that are borne

by shareholders and represent a loss of shareholder

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 by ensuring

that managersinterests are aligned with those ofshareholders.

A common approach is to structure management

compensation to correspond with firm performance.


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The Agency Issue:

Management Compensation Plans

Incentive plansare management compensation plans that

tie management compensation to share price; one example

involves the granting of stock options.

Performance planstie management compensation tomeasures such as EPS or growth in EPS. Performance

shares and/or cash bonuses are used as compensation

under these plans.


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Matter of FactForbes.comCEO Performance vs. Pay


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The Agency Issue: The Threatof Takeover

When a firms internal corporate governance structure is

unable to keep agency problems in check, it is likely that

rival managers will try to gain control of the firm.

The threat of takeover by another firm, which believes itcan enhance the troubled firms value by restructuring its

management, operations, and financing, can provide a

strong source of external corporate governance.


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Review of Learning Goals

LG1 Definefinanceand the managerial finance function.

Financeis the science and art of managing money.Managerial financeis concerned with the duties of thefinancial manager working in a business.

LG2 Describe the goal of the firm, and explain whymaximizing the value of the firm is an appropriategoal for a business.

The goal of the firm is maximize its value, and therefore thewealth of its shareholders. Maximizing the value of the firmmeans running the business in the interest of those who ownitthe shareholders.


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Review of Learning Goals(cont.)

LG3 Describe how the managerial finance function is related toeconomics and accounting.

The financial manager must understand the economic environment and

rely heavily on the economic principle of marginal costbenefit analysis

to make financial decisions. Financial managers use accounting butconcentrate on cash flows and decision making.

LG4 Identify the primary activities of the financial manager.

The primary activities of the financial manager, in addition to ongoing

involvement in financial analysis and planning, are making investmentdecisions and making financing decisions.


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Review of Learning Goals(cont.)

LG5 Describe the nature of the principle-agent relationship betweenthe owners and managers of a corporation, and explain how

various corporate governance mechanisms attempt to manage

agency problems.

This separation of owners and managers of the typical firm isrepresentative of the classic principal-agent relationship, where the

shareholders are the principles and mangers are the agents. A firms

corporate governance structure is intended to help ensure that managers

act in the best interests of the firms shareholders, and other

stakeholders, and it is usually influenced by both internal and externalfactors.

Ch R


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Chapter Resources onMyFinanceLab

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Critical Thinking Problems

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