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Chapter One

Overview of

Managerial Finance

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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 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?

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 f ixed 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

ABC CompanyBalance Sheet

As of December 31, 2003

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 Views

Accounting 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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The Modern Corporation

There exists a SEPARATION between owners and managers.

Modern Corporation

Shareholders Management

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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.

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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.

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