Managerial Finance Chapter 1

Chapter 1: The Role of Managerial Finance

• Managerial finance is the science and art of managing money.
• At a personal level, finance concerns individual decisions about spending, saving, and investing.
• In a business context, finance involves raising capital from investors, investing to earn a profit, and deciding whether to reinvest profits or distribute them back to investors.

Learning Goals

• LG1: Define finance and the managerial finance function.
• LG2: Describe the legal forms of business organization. These include sole proprietorships, partnerships, and corporations.
• LG3: Describe the goal of the firm and explain why maximizing firm value is an appropriate goal. The goal is to maximize shareholder wealth.
• LG4: Describe how managerial finance relates to economics and accounting. Finance is interrelated with economics and accounting.
• LG5: Identify the primary activities of the financial manager. These include developing financial plans, extending credit, evaluating large expenditures, and raising funds.
• LG6: Describe the nature of the principle-agent relationship in corporations and explain how corporate governance mechanisms attempt to manage agency problems.

Legal Forms of Business Organization

• Sole Proprietorship: Owned and operated by one person for profit. Simplest form, low organizational costs, income is taxed on owner's personal return, and owner has complete control.
• Partnership: Owned by two or more people for profit. Borrowing power enhanced by multiple owners, and it offers more brainpower. Owners have unlimited liability, and if one partner does something wrong, the others can be held responsible.
• Corporation: An entity created by law, with the legal powers of an individual. Offers liability protection to owners, but is more complex to organize than other forms. Ownership is transferable, and they can raise large sums of money.

Career Opportunities in Finance

• Financial Services: Deals with the design and delivery of financial products and advice. Includes banking, personal financial planning, investments, real estate, and insurance.
• Managerial Finance: The duties of a financial manager in any type of business. Includes developing a financial plan, extending credit, evaluating large expenditures, raising capital for operations for profit-seeking and not-for-profit, large or small businesses

Matter of Fact

• Sole proprietorships comprise 61% of all U.S. firms.
• Corporations receive 80% of total receipts.

Corporate Organization

• Figure 1.1 depicts the structure of a corporation, showing the relationships between stockholders, the board of directors, the president (CEO), managers (various vice presidents, treasurer, controller, etc.), and other stakeholders.

Career Opportunities in Managerial Finance

• Table 1.2 lists various positions and their corresponding roles/responsibilities in financial management

Goal of the Firm: Maximize Shareholder Wealth

• Managers will make decisions that are expected to increase the share price. The diagram in Figure 1.2 illustrates a decision-making process based on the idea of maximizing shareholder wealth.

Goal of the Firm: Maximize Profit?

• Profit maximization may not lead to the highest share price. This is because timing of funds and risk aren't taken into account.

What About Stakeholders?

• Stakeholders include employees, customers, suppliers, creditors, owners, and others with economic ties to the firm.
• A firm with a stakeholder focus avoids actions detrimental to stakeholders.

The Role of Business Ethics

• Business ethics encompasses standards of conduct or moral judgment.
• Violations can include creative accounting, misreporting, fraud, excessive compensation, insider trading, bribery, kickbacks that affect the firm's image and share price.

Business Ethics: Considering Ethics

• Key ethical questions to ask when evaluating an action include if it is arbitrary, affects anyone unfairly, complies with standards, and if there are better alternatives.

Ethics and Share Price

• Ethics programs aim to reduce litigation costs, enhance corporate image, and build shareholder confidence.
• The goal is to favorably affect a firm's share price.

The Case of Google Glass

• Google Glass, a wearable computer, raised privacy concerns.
• Google's corporate motto, 'Don't be Evil', shows its commitment to ethical behavior.
• Google's share price increased significantly.

Managerial Finance Function

• The size and importance of financial management depend on the size of the firm.
• Small firms often use their accounting function for all financial activity.
• Larger firms will use a distinct financial department reporting to the CFO.

Managerial Finance Function: Relationship to Economics

• Finance is closely linked to economics.
• Financial managers need to understand the economic framework, be alert to economic fluctuations and policy changes, and use economic theories to guide business operations.
• Marginal cost-benefit analysis helps evaluate financial decisions.

Managerial Finance Function: Relationship to Accounting

• Finance and accounting activities overlap significantly.
• In small firms the accounting department often handles finance functions.
• In large firms separate financial analysts and teams assist the accounting department.
• Accounting uses the accrual method, while finance focuses on cash flows and decision-making.

Personal Finance Example

• Cash inflows and outflows are key to personal finance decisions.

Managerial Finance Function: Relationship to Accounting (cont.)

• A firm needs a sufficient cash flow to meet obligations, regardless of profit or loss.

Governance and Agency: Corporate Governance

• Corporate governance is the rules, processes, and laws by which companies operate, controlled, and regulated. It defines the rights and responsibilities of participants like shareholders, directors, managers, and other stakeholders, and outlines procedures for corporate decision-making.

Governance and Agency: Individual Versus Institutional Investors

• Individual investors hold small quantities of shares for personal investment goals. Institutional investors (banks, insurance companies, mutual funds, pension funds), manage large quantities of assets for others. Institutional investors often actively monitor governance and exert pressure on management.

Governance and Agency: Government Regulation

• Government regulation influences corporate governance.
• Scandals highlighting corporate abuse have prompted stricter regulation, such as the Sarbanes-Oxley Act of 2002. This act strengthens corporate governance, tightens penalties for fraud, improves accounting disclosures.

Governance and Agency: The Agency Issue

• Principal-agent relationships exist when shareholders (principals) hire managers (agents) to act on behalf of the shareholders.
• Agency problems arise when managers prioritize their personal goals over shareholder goals.
• Agency costs represent the loss of shareholder wealth due to agency problems.

Governance and Agency: Management Compensation Plans

• Incentive plans tie management compensation to stock price. Performance plans relate compensation to firm performance metrics (e.g., EPS, growth in EPS).

The Agency Issue: The Threat of Takeover

• A firm's internal governance structure failing to manage agency problems can trigger takeover attempts by rival firms.
• Takeovers can provide external corporate governance pressures for improving firm performance.

Review of Learning Goals

• LG1: Finance is the function of managing money. Managerial finance is a subset of finance applying to business.
• LG2: Sole proprietorships, partnerships, and corporations are common legal business structures.
• LG3: Maximizing firm value, which is reflected in share price, is the central goal.
• LG4: Finance relies on economic principles like marginal analysis and considering impacts of economic factors. Accounting provides data to use in this, but finance focuses on cash flows.
• LG5: Financial managers focus on investment and financing decisions.
• LG6: The principal-agent problem is inherent in corporations; managers are agents acting on behalf of shareholders (principals). Corporate governance tries to align incentives (e.g., compensation) to mitigate potential issues.

Chapter Resources on MyFinanceLab

• MyFinanceLab provides chapter cases, group exercises, and critical thinking problems, for added practice.