Overview of Managerial Finance

1. 1
Chapter One
Overview
of
Managerial Finance

2. 2
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.

3. 3
What is Finance?
ABC Company
Balance Sheet
As of December 31, 2003
Assets: Liabilities & Equity:
Current Assets Current Liabi l i ties
Cash & M.S. Accounts payable
Accounts receivable Notes Payable
Inventory Total Current Liabilities
Total Current Assets Long-Term Liabilities
Fixed Assets: Total Liabi l i ties
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
Working
Capital
Working
Capital
Investment
Decisions
Financing
Decisions
Macro Finance

4. 4
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.

5. Areas of Specialization in Finance
5
 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.

6. 6
Areas of Employment in Finance
 Financial Analyst
 Capital budgeting analyst/manager
 Project finance manager
 Cash manager
 Credit analyst/manager
 Pension fund manager

7. 7
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.

8. 8
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

9. 9
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

10. 10
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

11. 11
Corporate Organization Chart

12. Organization of Finance Functions
12
 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.

13. 13
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.

14. 14
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.

15. Accounting vs. Financial Views
15
Accounting View
(Accrual Basis)
Income Statement
Peakes Quay, Inc.
For year ended 12/31
Financial View
(Cash Basis)
Cash Flow Statement
Peakes Quay, Inc.
For year ended 12/31
Sales revenue $100,000
Less: Costs 80,000
Net Profit $ 20,000
Cash inflow $ 0
Less: Cash outflow 80,000
Net cash flow ($80,000)

16. Financial Manager–Key Activities
16
Financial Analysis & Planning
Balance Sheet
Current
Assets
_______________
Fixed
Assets
Current
Liabilities
_______________
Long-Term Funds
(Debt & Equity)
Making
Investment
Decisions
Making
Financing
Decisions

17. Should Firms Maximize Profit?
 Corporations commonly define profit as
“Earnings per Share” (EPS).
• A measure of total earnings divided by total
17
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.

18. 18
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.

19. 19
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.”

20. 20
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.

21. 21
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.

22. 22
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?

23. Financial Goals of a Company
23
 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.

24. Modern Corporation
Shareholders Management
24
The Modern Corporation
There exists a SEPARATION between
owners and managers.

25. Management acts as an agent
for the owners (shareholders)
25
Role of Management
of the firm.
 An agent is an individual authorized by
another person, called the principal, to
act in the latter’s behalf.

26. Jensen and Meckling developed
a theory of the firm based on
agency theory.
26
Agency Theory
 Agency Theory is a branch of economics
relating to the behavior of principals and
their agents.

27. 27
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.

28. Resolving the Agency Problem
 Good corporate governance by the Board of
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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.

29. 29
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.

30. 30
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.