chapter 1 the role and environment of managerial finance
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Chapter 1
THE ROLE AND ENVIRONMENT OF
MANAGERIAL FINANCE
1.1 FINANCE AND BUSINESS
FINANCE-the art and science of managing
money
FINANCIAL SERVICES-design and delivery of
advice and financial products to individuals,
business, and government
MANAGERIAL FINANCE- duties of the
financial manager in the business firms
manage the financial
affairs of any type of
business - financial and nonfinancial
LEGAL FORMS OF BUSINESS ORGANIZATION
• owned by one person who operates it for his or her own profit.
SOLE PROPRIETORSHIP
• consists of two or more owners doing business together for profit.
PARTNERSHIP
• artificial being created by law• often called as “legal entity” and has the powers of an
individual that it can sue and be sued, make and be party to contracts, and acquire property in its own name.
CORPORATION
PROPRIETOR
PARTNERS Articles of partnership
stock
non-stock
STOCKHOLDERS
MEMBERS
preferred
common
TABLE 1.1a STRENGTHS OF THE COMMON LEGAL FORMS OF BUSINESS ORGANIZATION
SOLE PROPRIETORSHIP
owner receives all profits (sustains all
losses)
low organizational costs
income included and taxed on proprietor’s personal tax return
independence
secrecy
ease of dissolution
PARTNERSHIP
can raise more funds than sole
proprietorship
borrowing power enhanced by more powers
more available brain power and managerial skill
income included and taxed on partner’s personal tax
return
CORPORATION
owners have limited liability
can achieve large size via sale of ownership (stock)
ownership is transferrable
long life of firm
can hire professional managers
Has better access to financing
Can offer attractive retirement plans
Table 1.1b WEAKNESSES OF THE COMMON LEGAL FORMS OF BUSINESS ORGANIZATION
SOLE PROPRIETORSHIP
Owner has unlimited liability – total wealth can be taken to
satisfy debts
limited fund-raising power tends to inhibit growth
proprietor must be jack-of-all trades
Difficult to give employees run career opportunities
lacks continuity when proprietor dies
PARTNERSHIP
Owners have unlimited liability
Partnership is dissolved when a partner dies
Difficult to liquidate or transfer partnership
CORPORATION
taxes generally higher, dividends are taxed at a
maximum of 15%
more expensive to organize
Subject to greater government regulation
Lacks secrecy (stockholders must receive
FS)
Stockholders
Figure 1.1 CORPORATE ORGANIZATION
elect
Board of Directors
hires
President (CEO)
VP Human Resource VP Manufacturing VP Finance
(CFO) VP Marketing VP Info Resources
Treasurer Controller
Financial Planning & Fund Raising
Manager
Capital Expendit
ure Manager
Cash Manager
Credit Manager
Pension Fund
Manager
FOREX Manager
Corporate Accounting Manager
Tax Manager
Financial Accounting Manager
Cost Accounting Manager
OWNERS
MANAGERS
Why study Managerial Finance?
Because most business decisions are measured in
“financial” terms!!!!
FINANCIAL MANAGER
CAREER OPPORTUNITIES IN MANAGERIAL FINANCE
• Prepares financial plans and budgets• Financial forecasting, financial comparisons, working
closely with accounting.FINANCIAL ANALYST
• Involved in the financial aspects of implementing approved investments.
CAPITAL EXPENDITURE MANAGER
• Arranges financing for approved asset investments.• Coordinates consultants, investment bankers, and
legal counsel.
PROJECT FINANCE MANAGER
CAREER OPPORTUNITIES IN MANAGERIAL FINANCE
• Maintains and controls the firm’s daily cash balance.CASH MANAGER
• Administers credit policy by evaluating credit application, extending credit, and monitoring and collecting A/R.
CREDIT ANALYST/ MANAGER
• Oversees the assets and liabilities of the employees’ pension fund.
PENSION FUND MANAGER
CAREER OPPORTUNITIES IN MANAGERIAL FINANCE
• Manages specific foreign and the firm’s exposure to fluctuations.
FOREIGN EXCHANGE MANAGER
1.2 THE MANAGERIAL FINANCE FUNCTION
VP FINANCE (CFO)
PRESIDENT
TREASURER
“Financial Manager”
external
CONTROLLER
“Chief Accountant”
internal
RELATIONSHIP OF FINANCIAL MANAGEMENT TO OTHER FIELDS OF BUSINESS
ECONOMICS – efficient allocation of scarce means of production toward the satisfaction of human needs and
wants.
“Marginal cost-benefit
analysis”- The financial
decisions should be made and actions taken only when
the added benefits exceed the added
costs.
Example: Decide whether to replace the old with a new computer using the following data:
NEW COMPUTER – purchase would require cash outlay of $80,000 but will have benefits of $100,000.
OLD COMPUTER – can be sold to net of $28,000 and will have benefits of $35,000 if still be used.
Benefits with new computer $ 100,000
Less: Benefit with old computer 35,000
(1) Marginal (added) benefits $ 65,000
Cost of new computer $ 80,000
Less: Proceeds from sale of old computer 28,000
(2) Marginal (added) costs 52,000
Net benefit [(1) – (2)] $ 13,000
Applying the marginal cost-benefit analysis…..
Since the marginal added benefits of $65,000 exceed the
marginal added costs of $52,000, the firm should
purchase the new computer and experience a net benefit of
$13,000!!!!!
• ACCOUNTING – a service activity whose function is to provide quantitative information, primarily financial in nature, about
economic entities, that is to be useful in making economic decisions.
Basic difference between
FINANCE and ACCOUNTING
Emphasis on CASH
FLOW
“accrual basis” in accounting. - recognizes revenue when earned and expenses when incurred.
“cash basis” in financial management.- recognizes revenue and expenses only with respect to inflows and outflows of cash.
DECISION MAKING
In accounting, accountants focus on collection and presentation of financial data.
In financial management, financial managers evaluate accounting statements, develop data, and make decisions on the basis of their assessment of the associated “returns and risks”.
Figure 1.2 PRIMARY ACTIVITIES OF A FINACIAL MANAGER
Current Asset
Current Liabilities
Fixed Asset
Long-Term Funds
BALANCE SHEET
Making Investment Decisions
Making Financing Decisions
1.3 GOAL OF THE FIRMWe need to “maximize profit”
by means of increasing the earnings per share!!!
Total earnings available to common stockholders number of common shares outstanding
No way! Our objective should be to “maximize shareholder wealth” !!!
What should I do?
Sample case: A financial manager is choosing between two investments with expected
earnings per share as shown below:
Earnings per share
Investment Year 1 Year 2 Year 3 Total
ROTOR $ 1.40 $ 1.00 $ 0.40 $ 2.80
VALVE 0.60 1.00 1.40 3.00
If answered on the point of view of “profit
maximization” the choice would be
VALVE.
Yahoo!!! My answer is correct!
But if answered on the point of view of “shareholder wealth maximization” the choice would be
ROTOR.
Of course! !!I have the
correct answer!
Hey!!! I’m the finance manager
here! Now I’m confused! Which is
correct?...
Is “profit maximization” a reasonable goal?No! It fails for the following reasons: (1) timing
of returns, (2) cash flows available to stockholders, and (3) risk.
TIMING. The receipt of funds sooner than later is preferred. Though the total earnings of ROTOR is
lower than VALVE, still, ROTOR has larger returns in year 1 and therefore could be reinvested to provide
greater future earnings.
CASH FLOWS. Earnings or Profits does not necessarily means cash inflow to
stockholders.RISK. Actual outcomes may differ from those expected. There must be a trade-off
between return (cash flow) and risk.
Therefore, I should definitely invest in ROTOR using the
point of view of “shareholder wealth maximization”!!!
The correct answer should be “shareholder wealth maximization”.
Financial managers should accept only those actions that are expected to increase “share price”
Figure 1.3 Share Price Maximization
Financial Managers
Financial Decision
Alternatives
Return?Risk?
Increase the Share
Price?
Yes Accept
NoReject
Other concerns of financial management:
1. Focus also on the “stakeholders” wealth.employees, customers,
suppliers, creditors, owners, and others who have a
direct economic link to the firm.
2. Establish good “corporate governance” The system used to direct and control a corporation. Defines the rights and
responsibilities of key corporate participants, decision making procedures,
and the way in which the firm will set, achieve, and monitor its objectives.
The board’s first responsibility is to the shareholders with broad classes of:a. Individual investors – who buy
relatively small quantities of shares.b. Institutional investors – investment
professionals such as insurance companies, mutual funds, and pension funds, that are paid to manage other people’s money.
has greater influence over
corporate governance
Issues arose from numerous corporate misdeeds:(1) false disclosures in financial reporting and other information releases(2) undisclosed conflicts of interests [between corporations and their analysts, auditors, and attorneys and between corporate directors, officers and shareholders.]
SARBANES-OXLEY ACT
OF 2002 (SOX)
An act aimed at eliminating corporate disclosure and conflict of interest problems.
Other concerns of financial management:
3. Considering the role of ethics.Standards of conduct or
moral judgment.
Example of cases wherein the ethics became a major media issue:
- when energy company Enron Corp’s key executives failed to disclose to employees and shareholders of its bankruptcy.
- when auditing firm KPMG failed in their audit work with a company Lernout and Hauspie Speech Products that forced the auditing firm to pay $115 million to settle a shareholder lawsuit.
Develop an effective ethics program
Other concerns of financial management:
4. Solving the “agency issue”.There must be a clear cut indication of separation of
the “owners” and “managers”
The Agency Problem is the likelihood that managers may place personal goals ahead of corporate goals.
Factors that serve to prevent or minimize agency problems:
Market Forces- some large “institutional investors” tend to exercise their voting rights to influence the management.
Agency Costs- costs borne by stockholders to maintain a governance structure
Agency costs explained…
Structure management compensation
the objective was to give managers
incentives to act in the best
interests of the owners.
Incentive plans – tend to tie management compensations to share price; the most popular incentive plan involves the grant of stock options.
Performance plan – plans tie management to measures such as EPS, growth in EPS, and other ratios of return.
Cash bonuses – cash paid to management for achieving certain performance goals.
1.4 FINANCIAL INSTITUTIONS AND MARKETS
FINANCIAL INSTITUTIONS FINANCIAL MARKETS
serve as intermediaries by channeling the savings of individuals, businesses, and governments into loans or investments
forums in which suppliers of funds and demanders of funds can transact business directly.
Money market
Capital market
Money Market vs. Capital Market
marketable securities bonds
money market
stocks
capital market
SHORT-TERM DEBT INSTRUMENTS
LONG-TERM DEBT INSTRUMENTS
HOW TO RAISE MONEY THROUGH THE FINANCIAL MARKETS?...
Securities Exchanges – provide the marketplace in which firms can raise funds through the sale of new securities and purchases of securities can easily resell them when necessary. The two key types of securities exchanges are:
ORGANIZED SECURITIES EXCHANGE – tangible organizations that act as secondary markets where outstanding securities are resold.Example: New York Stock Exchange
OVER-THE-COUNTER EXCHANGES– an intangible market for the purchase and sale of securities not listed by the organized exchanges. OTC traders, known as dealers, are linked with the purchasers and sellers of securities through the National Association of Securities Dealers Automated Quotation (Nasdaq) system.