Chapter 1

THE ROLE AND ENVIRONMENT OF

MANAGERIAL FINANCE

1.1 FINANCE AND BUSINESS

FINANCE-the art and science of managing

money

FINANCIAL SERVICES-design and delivery of

advice and financial products to individuals,

business, and government

MANAGERIAL FINANCE- duties of the

financial manager in the business firms

manage the financial

affairs of any type of

business - financial and nonfinancial

LEGAL FORMS OF BUSINESS ORGANIZATION

• owned by one person who operates it for his or her own profit.

SOLE PROPRIETORSHIP

• consists of two or more owners doing business together for profit.

PARTNERSHIP

• artificial being created by law• often called as “legal entity” and has the powers of an

individual that it can sue and be sued, make and be party to contracts, and acquire property in its own name.

CORPORATION

PROPRIETOR

PARTNERS Articles of partnership

stock

non-stock

STOCKHOLDERS

MEMBERS

preferred

common

TABLE 1.1a STRENGTHS OF THE COMMON LEGAL FORMS OF BUSINESS ORGANIZATION

SOLE PROPRIETORSHIP

owner receives all profits (sustains all

losses)

low organizational costs

income included and taxed on proprietor’s personal tax return

independence

secrecy

ease of dissolution

PARTNERSHIP

can raise more funds than sole

proprietorship

borrowing power enhanced by more powers

more available brain power and managerial skill

income included and taxed on partner’s personal tax

return

CORPORATION

owners have limited liability

can achieve large size via sale of ownership (stock)

ownership is transferrable

long life of firm

can hire professional managers

Has better access to financing

Can offer attractive retirement plans

Table 1.1b WEAKNESSES OF THE COMMON LEGAL FORMS OF BUSINESS ORGANIZATION

SOLE PROPRIETORSHIP

Owner has unlimited liability – total wealth can be taken to

satisfy debts

limited fund-raising power tends to inhibit growth

proprietor must be jack-of-all trades

Difficult to give employees run career opportunities

lacks continuity when proprietor dies

PARTNERSHIP

Owners have unlimited liability

Partnership is dissolved when a partner dies

Difficult to liquidate or transfer partnership

CORPORATION

taxes generally higher, dividends are taxed at a

maximum of 15%

more expensive to organize

Subject to greater government regulation

Lacks secrecy (stockholders must receive

FS)

Stockholders

Figure 1.1 CORPORATE ORGANIZATION

elect

Board of Directors

hires

President (CEO)

VP Human Resource VP Manufacturing VP Finance

(CFO) VP Marketing VP Info Resources

Treasurer Controller

Financial Planning & Fund Raising

Manager

Capital Expendit

ure Manager

Cash Manager

Credit Manager

Pension Fund

Manager

FOREX Manager

Corporate Accounting Manager

Tax Manager

Financial Accounting Manager

Cost Accounting Manager

OWNERS

MANAGERS

Why study Managerial Finance?

Because most business decisions are measured in

“financial” terms!!!!

FINANCIAL MANAGER

CAREER OPPORTUNITIES IN MANAGERIAL FINANCE

• Prepares financial plans and budgets• Financial forecasting, financial comparisons, working

closely with accounting.FINANCIAL ANALYST

• Involved in the financial aspects of implementing approved investments.

CAPITAL EXPENDITURE MANAGER

• Arranges financing for approved asset investments.• Coordinates consultants, investment bankers, and

legal counsel.

PROJECT FINANCE MANAGER

CAREER OPPORTUNITIES IN MANAGERIAL FINANCE

• Maintains and controls the firm’s daily cash balance.CASH MANAGER

• Administers credit policy by evaluating credit application, extending credit, and monitoring and collecting A/R.

CREDIT ANALYST/ MANAGER

• Oversees the assets and liabilities of the employees’ pension fund.

PENSION FUND MANAGER

CAREER OPPORTUNITIES IN MANAGERIAL FINANCE

• Manages specific foreign and the firm’s exposure to fluctuations.

FOREIGN EXCHANGE MANAGER

1.2 THE MANAGERIAL FINANCE FUNCTION

VP FINANCE (CFO)

PRESIDENT

TREASURER

“Financial Manager”

external

CONTROLLER

“Chief Accountant”

internal

RELATIONSHIP OF FINANCIAL MANAGEMENT TO OTHER FIELDS OF BUSINESS

ECONOMICS – efficient allocation of scarce means of production toward the satisfaction of human needs and

wants.

“Marginal cost-benefit

analysis”- The financial

decisions should be made and actions taken only when

the added benefits exceed the added

costs.

Example: Decide whether to replace the old with a new computer using the following data:

NEW COMPUTER – purchase would require cash outlay of $80,000 but will have benefits of $100,000.

OLD COMPUTER – can be sold to net of $28,000 and will have benefits of $35,000 if still be used.

Benefits with new computer $ 100,000

Less: Benefit with old computer 35,000

(1) Marginal (added) benefits $ 65,000

Cost of new computer $ 80,000

Less: Proceeds from sale of old computer 28,000

(2) Marginal (added) costs 52,000

Net benefit [(1) – (2)] $ 13,000

Applying the marginal cost-benefit analysis…..

Since the marginal added benefits of $65,000 exceed the

marginal added costs of $52,000, the firm should

purchase the new computer and experience a net benefit of

$13,000!!!!!

• ACCOUNTING – a service activity whose function is to provide quantitative information, primarily financial in nature, about

economic entities, that is to be useful in making economic decisions.

Basic difference between

FINANCE and ACCOUNTING

Emphasis on CASH

FLOW

“accrual basis” in accounting. - recognizes revenue when earned and expenses when incurred.

“cash basis” in financial management.- recognizes revenue and expenses only with respect to inflows and outflows of cash.

DECISION MAKING

In accounting, accountants focus on collection and presentation of financial data.

In financial management, financial managers evaluate accounting statements, develop data, and make decisions on the basis of their assessment of the associated “returns and risks”.

Figure 1.2 PRIMARY ACTIVITIES OF A FINACIAL MANAGER

Current Asset

Current Liabilities

Fixed Asset

Long-Term Funds

BALANCE SHEET

Making Investment Decisions

Making Financing Decisions

1.3 GOAL OF THE FIRMWe need to “maximize profit”

by means of increasing the earnings per share!!!

Total earnings available to common stockholders number of common shares outstanding

No way! Our objective should be to “maximize shareholder wealth” !!!

What should I do?

Sample case: A financial manager is choosing between two investments with expected

earnings per share as shown below:

Earnings per share

Investment Year 1 Year 2 Year 3 Total

ROTOR $ 1.40 $ 1.00 $ 0.40 $ 2.80

VALVE 0.60 1.00 1.40 3.00

If answered on the point of view of “profit

maximization” the choice would be

VALVE.

Yahoo!!! My answer is correct!

But if answered on the point of view of “shareholder wealth maximization” the choice would be

ROTOR.

Of course! !!I have the

correct answer!

Hey!!! I’m the finance manager

here! Now I’m confused! Which is

correct?...

Is “profit maximization” a reasonable goal?No! It fails for the following reasons: (1) timing

of returns, (2) cash flows available to stockholders, and (3) risk.

TIMING. The receipt of funds sooner than later is preferred. Though the total earnings of ROTOR is

lower than VALVE, still, ROTOR has larger returns in year 1 and therefore could be reinvested to provide

greater future earnings.

CASH FLOWS. Earnings or Profits does not necessarily means cash inflow to

stockholders.RISK. Actual outcomes may differ from those expected. There must be a trade-off

between return (cash flow) and risk.

Therefore, I should definitely invest in ROTOR using the

point of view of “shareholder wealth maximization”!!!

The correct answer should be “shareholder wealth maximization”.

Financial managers should accept only those actions that are expected to increase “share price”

Figure 1.3 Share Price Maximization

Financial Managers

Financial Decision

Alternatives

Return?Risk?

Increase the Share

Price?

Yes Accept

NoReject

Other concerns of financial management:

1. Focus also on the “stakeholders” wealth.employees, customers,

suppliers, creditors, owners, and others who have a

direct economic link to the firm.

2. Establish good “corporate governance” The system used to direct and control a corporation. Defines the rights and

responsibilities of key corporate participants, decision making procedures,

and the way in which the firm will set, achieve, and monitor its objectives.

The board’s first responsibility is to the shareholders with broad classes of:a. Individual investors – who buy

relatively small quantities of shares.b. Institutional investors – investment

professionals such as insurance companies, mutual funds, and pension funds, that are paid to manage other people’s money.

has greater influence over

corporate governance

Issues arose from numerous corporate misdeeds:(1) false disclosures in financial reporting and other information releases(2) undisclosed conflicts of interests [between corporations and their analysts, auditors, and attorneys and between corporate directors, officers and shareholders.]

SARBANES-OXLEY ACT

OF 2002 (SOX)

An act aimed at eliminating corporate disclosure and conflict of interest problems.

Other concerns of financial management:

3. Considering the role of ethics.Standards of conduct or

moral judgment.

Example of cases wherein the ethics became a major media issue:

- when energy company Enron Corp’s key executives failed to disclose to employees and shareholders of its bankruptcy.

- when auditing firm KPMG failed in their audit work with a company Lernout and Hauspie Speech Products that forced the auditing firm to pay $115 million to settle a shareholder lawsuit.

Develop an effective ethics program

Other concerns of financial management:

4. Solving the “agency issue”.There must be a clear cut indication of separation of

the “owners” and “managers”

The Agency Problem is the likelihood that managers may place personal goals ahead of corporate goals.

Factors that serve to prevent or minimize agency problems:

Market Forces- some large “institutional investors” tend to exercise their voting rights to influence the management.

Agency Costs- costs borne by stockholders to maintain a governance structure

Agency costs explained…

Structure management compensation

the objective was to give managers

incentives to act in the best

interests of the owners.

Incentive plans – tend to tie management compensations to share price; the most popular incentive plan involves the grant of stock options.

Performance plan – plans tie management to measures such as EPS, growth in EPS, and other ratios of return.

Cash bonuses – cash paid to management for achieving certain performance goals.

1.4 FINANCIAL INSTITUTIONS AND MARKETS

FINANCIAL INSTITUTIONS FINANCIAL MARKETS

serve as intermediaries by channeling the savings of individuals, businesses, and governments into loans or investments

forums in which suppliers of funds and demanders of funds can transact business directly.

Money market

Capital market

Money Market vs. Capital Market

marketable securities bonds

money market

stocks

capital market

SHORT-TERM DEBT INSTRUMENTS

LONG-TERM DEBT INSTRUMENTS

HOW TO RAISE MONEY THROUGH THE FINANCIAL MARKETS?...

Securities Exchanges – provide the marketplace in which firms can raise funds through the sale of new securities and purchases of securities can easily resell them when necessary. The two key types of securities exchanges are:

ORGANIZED SECURITIES EXCHANGE – tangible organizations that act as secondary markets where outstanding securities are resold.Example: New York Stock Exchange

OVER-THE-COUNTER EXCHANGES– an intangible market for the purchase and sale of securities not listed by the organized exchanges. OTC traders, known as dealers, are linked with the purchasers and sellers of securities through the National Association of Securities Dealers Automated Quotation (Nasdaq) system.