Chapter 1

The Role of
Managerial
Finance

Copyright © 2012 Pearson Education.

 Learning Goals

LG1 Define finance and the managerial finance function.

LG2 Describe the legal forms of business organization.

LG3 Describe the goal of the firm, and explain why

maximizing the value of the firm is an appropriate
goal for a business.

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 Learning Goals (cont.)

LG4 Describe how the managerial finance function is

related to economics and accounting.

LG5 Identify the primary activities of the financial

manager.

LG6 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.

© 2012 Pearson Education 1-3

 What is Finance?

• Finance can be defined as the science and art of managing

money.
• At the personal level, finance is concerned with
individuals’ decisions about how much of their earnings
they 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, how
firms invest money in an attempt to earn a profit, and how
they decide whether to reinvest profits in the business or
distribute them back to investors.
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 Career Opportunities in
Finance: Financial Services
• Financial Services is 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 financial
planning, investments, real estate, and insurance.

© 2012 Pearson Education 1-5

 Legal Forms of Business
Organization
• A sole proprietorship is a business owned by one person
and operated for his or her own profit.
• A partnership is a business owned by two or more
people and operated for profit.
• A corporation is an entity created by law. Corporations
have the legal powers of an individual in that it can sue
and be sued, make and be party to contracts, and acquire
property in its own name.

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 Table 1.1 Strengths and Weaknesses of the
Common Legal Forms of Business Organization

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 Matter of Fact

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 Figure 1.1 Corporate
Organization

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 Goal of the Firm:
Maximize Shareholder Wealth
Decision rule for managers: only take actions that are
expected to increase the share price.

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 Goal of the Firm:
Maximize Profit?
Which Investment is Preferred?

Profit maximization may not lead to the highest possible share price for at least three reasons:
1. Timing is important—the 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

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 Goal of the Firm:
What About Stakeholders?
• Stakeholders are groups such as employees, customers,
suppliers, creditors, owners, and others who have a direct
economic link to the firm.
• A firm with a stakeholder focus consciously avoids
actions 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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 The Role of Business Ethics

• Business ethics are the standards of conduct or moral

judgment that apply to persons engaged in commerce.
• Violations of these standards in finance involve a variety
of actions: “creative accounting,” earnings management,
misleading financial forecasts, insider trading, fraud,
excessive executive compensation, options backdating,
bribery, and kickbacks.
• Negative publicity often leads to negative impacts on a
firm

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 The Role of Business Ethics:
Ethics and Share Price
Ethics programs seek to:
– reduce litigation and judgment costs
– maintain a positive corporate image
– build shareholder confidence
– gain the loyalty and respect of all stakeholders
The expected result of such programs is to positively affect
the firm’s share price.

© 2012 Pearson Education 1-14

 Focus on Ethics

Will Google Live Up to Its Motto?

– In January 2010, Google announced that the Gmail accounts of
Chinese human-rights activists and a number of technology,
financial, and defense companies had been hacked.
– The company threatened to pull out of China unless an
agreement on uncensored search results could be reached.
– Is the goal of maximization of shareholder wealth necessarily
ethical or unethical?
– How can Google justify its actions in the short run to its long
run investors?

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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)

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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 economic
policy.
• 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 cost–benefit 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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 Managerial Finance Function:
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 firm’s 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 help
compile accounting information.
• One major difference in perspective and emphasis
between finance and accounting is that accountants
generally use the accrual method while in finance, the
focus is on cash flows.

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 Managerial Finance Function:
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 using the
following simple example.
• The Nassau Corporation experienced the following activity last
year:

Sales $100,000 (1 yacht sold, 100% still

uncollected)
Costs $ 80,000 (all paid in full under supplier
terms)

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 Managerial Finance Function:
Relationship to Accounting (cont.)
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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 Managerial Finance Function:
Relationship to Accounting (cont.)
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 decisions on the basis of their
assessment of the associated returns and risks.

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 Personal Finance Example

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 Figure 1.3
Financial Activities

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 Governance and Agency:
Corporate Governance
• Corporate governance refers to the rules, processes, and
laws by which companies are operated, controlled, and
regulated.
• It defines the rights and responsibilities of the corporate
participants 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 investors are investors who own relatively small

quantities of shares so as to meet personal investment goals.
• Institutional investors are 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 firm’s corporate governance by exerting pressure
on management to perform or communicating their concerns to the
firm’s 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-profile
corporate scandals involving abuse of corporate power
and, in some cases, alleged criminal activity by corporate
officers.

© 2012 Pearson Education 1-28

 Governance and Agency:
Government Regulation
The Sarbanes-Oxley Act of 2002:
• established an oversight board to monitor the accounting industry;
• tightened audit regulations and controls;
• toughened penalties against executives who commit corporate fraud;
• strengthened accounting disclosure requirements and ethical guidelines for
corporate officers;
• established corporate board structure and membership guidelines;
• established guidelines with regard to analyst conflicts of interest;
• mandated instant disclosure of stock sales by corporate executives;
• increased securities regulation authority and budgets for auditors and
investigators.

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 Governance and Agency:
The Agency Issue
• A principal-agent relationship is 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 problems arise when managers place personal
goals ahead of the goals of shareholders.
• Agency costs arise from agency problems that are borne
by shareholders and represent a loss of shareholder
wealth.

© 2012 Pearson Education 1-30

 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 managers’ interests are aligned with those of
shareholders.
• A common approach is to structure management
compensation to correspond with firm performance.

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 The Agency Issue:
Management Compensation Plans
• Incentive plans are management compensation plans that
tie management compensation to share price; one
example involves the granting of stock options.
• Performance plans tie management compensation to
measures 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 Fact—Forbes.com
CEO Performance vs. Pay

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 The Agency Issue: The Threat
of Takeover
• When a firm’s 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 it
can enhance the troubled firm’s value by restructuring its
management, operations, and financing, can provide a
strong source of external corporate governance.

© 2012 Pearson Education 1-34

 Review of Learning Goals

LG1 Define finance and the managerial finance function.

– Finance is the science and art of managing money. Managerial finance
is concerned with the duties of the financial manager working in a
business.
LG2 Describe the legal forms of business organization.
– The legal forms of business organization are the sole proprietorship, the
partnership, and the corporation.
LG3 Describe the goal of the firm, and explain why maximizing the
value of the firm is an appropriate goal for a business.
– The goal of the firm is maximize its value, and therefore the wealth of
its shareholders. Maximizing the value of the firm means running the
business in the interest of those who own it—the shareholders.

© 2012 Pearson Education 1-35

 Review of Learning Goals
(cont.)
LG4 Describe how the managerial finance function is related to
economics and accounting.
– The financial manager must understand the economic environment and
rely heavily on the economic principle of marginal cost–benefit analysis
to make financial decisions. Financial managers use accounting but
concentrate on cash flows and decision making.
LG5 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 investment
decisions and making financing decisions.

© 2012 Pearson Education 1-36

 Review of Learning Goals
(cont.)
LG6 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.
– This separation of owners and managers of the typical firm is
representative of the classic principal-agent relationship, where the
shareholders are the principles and mangers are the agents. A firm’s
corporate governance structure is intended to help ensure that managers
act in the best interests of the firm’s shareholders, and other
stakeholders, and it is usually influenced by both internal and external
factors.

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 THANK
YOU
© 2012 Pearson Education 1-38