Principles of Managerial Finance Chapter 1 PDF

Chapter 1 The Role of Managerial Finance 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 bu...

Chapter 1 The Role of Managerial Finance 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. © Pearson Education Limited, 2015. 1-2 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. © Pearson Education Limited, 2015. 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 how they invest their savings In a business context, finance involves: how firms raise money from investors how firms invest money in an attempt to earn a profit how firms decide whether to reinvest profits in the business or distribute them back to investors. © Pearson Education Limited, 2015. 1-4 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 insurance © Pearson Education Limited, 2015. 1-5 Career Opportunities in Finance: Managerial Finance Managerial finance is concerned with the duties of the financial manager working in a business. Financial managers administer the financial affairs of all types of businesses—private and public, large and small, profit-seeking and not-for- profit. Tasks include: developing a financial plan or budget extending credit to customers evaluating proposed large expenditures raising money to fund the firm’s operations. © Pearson Education Limited, 2015. 1-6 Career Opportunities in Finance: Managerial Finance (cont.) The recent global financial crisis and subsequent responses by governmental regulators, increased global competition, and rapid technological change also increase the importance and complexity of the financial manager’s duties. Increasing globalization has increased demand for financial experts who can manage cash flows in different currencies and protect against the risks that naturally arise from international transactions. © Pearson Education Limited, 2015. 1-7 Focus on Practice Professional Certifications in Finance: – Chartered Financial Analyst (CFA) – Offered by the CFA Institute, the CFA program is a graduate-level course of study focused primarily on the investments side of finance. – Certified Treasury Professional (CTP) – The CTP program requires students to pass a single exam that is focused on the knowledge and skills needed for those working in a corporate treasury department. – Certified Financial Planner (CFP) – To obtain CFP status, students must pass a ten-hour exam covering a wide range of topics related to personal financial planning. © Pearson Education Limited, 2015. 1-8 Focus on Practice (cont.) Professional Certifications in Finance: – American Academy of Financial Management (AAFM) – The AAFM administers certifications including the Charter Portfolio Manager, Chartered Asset Manager, Certified Risk Analyst, Certified Cost Accountant, and Certified Credit Analyst. – Professional Certifications in Accounting –Professional certifications in accounting include the Certified Public Accountant (CPA), Certified Management Accountant (CMA), and Certified Internal Auditor (CIA). © Pearson Education Limited, 2015. 1-9 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. © Pearson Education Limited, 2015. 1-10 Table 1.1 Strengths and Weaknesses of the Common Legal Forms of Business Organization © Pearson Education Limited, 2015. 1-11 Matter of Fact © Pearson Education Limited, 2015. 1-12 Figure 1.1 Corporate Organization © Pearson Education Limited, 2015. 1-13 Table 1.2 Career Opportunities in Managerial Finance © Pearson Education Limited, 2015. 1-14 Goal of the Firm: Maximize Shareholder Wealth Decision rule for managers: only take actions that are expected to increase the share price. Figure 1.2 Share Price Maximization Financial decisions and share price © Pearson Education Limited, 2015. 1-15 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 © Pearson Education Limited, 2015. 1-16 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." © Pearson Education Limited, 2015. 1-17 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 © Pearson Education Limited, 2015. 1-18 The Role of Business Ethics: Considering Ethics Robert A. Cooke, a noted ethicist, suggests that the following questions be used to assess the ethical viability of a proposed action: – Is the action arbitrary or capricious? Does the action unfairly single out an individual or group? – Does the action affect the morals, or legal rights of any individual or group? – Does the action conform to accepted moral standards? – Are there alternative courses of action that are less likely to cause actual or potential harm? © Pearson Education Limited, 2015. 1-19 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. © Pearson Education Limited, 2015. 1-20 Focus on Ethics The Case of Google Glass – Computer that users wear like a pair of eyeglasses has raised concerns over privacy. – 2004 “Owner’s Manual” states that Google’s ultimate goal “is to develop services that significantly improve the lives of as many people as possible.” – Corporate motto “Don’t Be Evil” conveys willingness to do the right thing at the expense of short-term profits. – Share price has increased 700% from 2004 to 2013. © Pearson Education Limited, 2015. 1-21 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). © Pearson Education Limited, 2015. 1-22 Figure 1.1 Corporate Organization © Pearson Education Limited, 2015. 1-23 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. © Pearson Education Limited, 2015. 1-24 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. © Pearson Education Limited, 2015. 1-25 Managerial Finance Function: Relationship to Economics (cont.) Nord Department Stores is applying marginal-cost benefit analysis to decide whether to replace a computer: © Pearson Education Limited, 2015. 1-26 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. © Pearson Education Limited, 2015. 1-27 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. © Pearson Education Limited, 2015. 1-28 Managerial Finance Function: Relationship to Accounting (cont.) 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) © Pearson Education Limited, 2015. 1-29 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): © Pearson Education Limited, 2015. 1-30 Personal Finance Example Net cash flow = -$215! © Pearson Education Limited, 2015. 1-31 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. © Pearson Education Limited, 2015. 1-32 Figure 1.3 Financial Activities © Pearson Education Limited, 2015. 1-33 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. © Pearson Education Limited, 2015. 1-34 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. © Pearson Education Limited, 2015. 1-35 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. © Pearson Education Limited, 2015. 1-36 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. © Pearson Education Limited, 2015. 1-37 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. © Pearson Education Limited, 2015. 1-38 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. © Pearson Education Limited, 2015. 1-39 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. © Pearson Education Limited, 2015. 1-40 Matter of Fact—Forbes.com CEO Performance vs. Pay © Pearson Education Limited, 2015. 1-41 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. © Pearson Education Limited, 2015. 1-42 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. © Pearson Education Limited, 2015. 1-43 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. © Pearson Education Limited, 2015. 1-44 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. The 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. © Pearson Education Limited, 2015. 1-45 Chapter Resources on MyFinanceLab Chapter Cases Group Exercises Critical Thinking Problems © Pearson Education Limited, 2015. 1-46