Managerial Finance Chapter 1

Chapter 1: The Role of Managerial Finance

• Managerial finance is the science and art of managing money.
• Finance at a personal level involves decisions about spending, saving, and investing earnings.
• In a business context, finance involves raising money from investors, investing money to earn a profit, and deciding whether to reinvest profits or distribute them to investors.
• A firm sells goods or services.
• Investors seek risky investment opportunities.

Learning Goals

• LG 1: Define finance and its managerial function.
• LG 2: Describe the goal of a firm and why maximizing firm value is an appropriate goal
• LG 3: Identify the primary activities of a financial manager.
• LG 4: Explain the key principles that financial managers use when making decisions.
• LG 5: Describe the legal forms of business organization.
• LG 6: Describe the nature of the principal-agent relationship and how various corporate governance mechanisms manage agency problems.

1.1 Finance and The Firm

• Finance is defined as the science and art of managing money.
• At a personal level, it involves decisions about earnings, saving and investments.
• In business, it involves: raising capital, investing that capital to earn a profit, and deciding among payouts and reinvestment.
• A business, or firm is an organization selling goods or services.
• Firms exist because investors are seeking risky investment opportunities.

1.1 Goal of the Firm

• The primary aim of managers should be to maximize firm owners' wealth.
• This often means maximizing stock prices.
• Profit maximization does not always lead to the highest possible share price, mainly due to timing, cash flows and risk.
• Some stakeholders, besides shareholders are employees, suppliers, customers, and local community members.

1.1 Example 1.1

• Investment decisions are crucial.
• Choosing between investments (example: Rotor and Valve).
• Highest total earnings per share over three years is the most beneficial investment and profit maximizing choice.

1.1 Role of Business Ethics

• Business ethics are standards of conduct for business professionals and commercial activities.
• These ethics aim to motivate compliance with laws and regulations and professional standards.
• Application of moral judgment and the guiding principles of ethical guidelines to ensure correct and appropriate action.

1.1 Example 1.2

• Apply marginal cost-benefit analysis for decisions.
• Benefits compared to costs (example: new vs. old computer servers for business).
• Decision is to invest in a new, more profitable computer system given positive $1,000 net benefit calculation.

1.2 Managing the Firm

• Financial Managers' Key Decisions:
  • Investment decisions (capital budgeting)
  • Financing decisions
  • Capital structure decisions (raising capital)
  • Working capital decisions (managing short-term resources - cash, receivables, inventory, and payables)
• Relationship to economics:
  • Marginal cost-benefit analysis. Actions taken when marginal benefits exceed marginal costs.
• Relationship to accounting:
  • Emphasis on cash flows.
  • Accrual basis vs. cash basis accounting methods

1.3 Organizational Forms, Taxation, and the Principal-Agent Relationship

• Sole Proprietorships: Owned and operated by one person; unlimited liability.
• Partnerships: Owned by two or more people; unlimited liability; articles of partnership as written contract.
• Corporations: Separate legal entities with stockholders; limited liability; dividends distributed to stockholders. Stock, board of directors, and president (CEO) aspects.
• Principal-Agent Problem: Difference in interests between owners (principals) and managers (agents) in a corporation. Corporate governance mechanisms aim at aligning interests.

1.3 Other Legal Forms

• Limited partnership (LP)
• S corporation (S corp)
• Limited liability company (LLC)
• Limited liability partnership (LLP)

1.3 Business Organizational Forms & Taxation

• Prior to Tax Cuts and Jobs Act of 2017, sole proprietorships and partnerships were taxed at same progressive rates as individuals. Corporations were taxed according to a separate structure.
• As of 2018, sole proprietorships and partnerships are taxed at a modified progressive rate. Corporations are taxed at a flat 21%.
• Ordinary income: Revenue from business operations.
• Capital gains: Income from selling assets at higher value.

1.3 Example 1.5

• Calculating tax for individual sole proprietor from business income ($80,000).
• Applying income tax brackets to determine tax liability using Table 1.2.
• Total tax due.

1.3 Example 1.6

• Calculating tax liability of a partner ($300,000 taxable income).
• Demonstrating marginal vs. average tax rate calculation.
• Illustrating the potential effect of corporate governance structure on taxes.

1.3 Example 1.7

• Showing total tax liability difference between a partnership and a corporation.
• Assessing the impact of corporate structure on the tax burden of shareholders.

1.3 Corporate Governance

• Stock Options: Allow managers to buy company stock at a fixed price.
• Restricted Stock: Part of a compensation package not fully transferred to the investor/employee until conditions met.
• External Corporate Governance Mechanisms:
  • Individual versus institutional investors.
  • Activist investors.
• Government Regulations: Sarbanes-Oxley Act (2002) - aimed at eliminating corporate disclosure and conflict of interest problems.

1.4 Developing Skills for Your Careers

• Critical thinking
• Communication and collaboration
• Financial computing skills

This quiz covers the foundational concepts of managerial finance, including its definition, goals, and essential activities of financial managers. Students will explore the principles guiding financial decisions and the implications of various business organizations. Dive into the core components that ensure effective financial management in both personal and business contexts.