Chapter OneOverview of Managerial Finance

Principles of Managerial Finance

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Learning Goals

LG1 – Define finance and describe its three major areas and career opportunities.

LG2 – Review basic forms of business organization, their strengths and weaknesses.

LG3 – Describe managerial finance function and differentiate from economics and accounting.

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Learning Goals (continued)

LG4 – Identify key activities of financial manager within the firm.

LG5 – Explain why wealth maximization is firm’s goal.

LG6 – Explain how EVA, stakeholder focus, and ethical behaviour relate to firm’s goal.

LG7 – Discuss agency issue as it relates to owner wealth maximization.

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What is Finance?

• At the macro level, finance is the study of financial institutions and financial markets and how they operate within the financial system in both the Canadian and global economies.

• At the micro level, finance is the study of financial planning, asset management, and fund raising for businesses and financial institutions.

• Financial management can be described in brief using the following balance sheet.

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What is Finance?

Assets: Liabilities & Equity:

Current Assets Current Liabilities

Cash & M.S. Accounts payable

Accounts receivable Notes Payable

Inventory Total Current Liabilities

Total Current Assets Long-Term Liabilities

Fixed Assets: Total Liabilities

Gross f ixed assets Equity:

Less: Accumulated dep. Common Stock

Goodw ill Paid-in-capital

Other long-term assets Retained Earnings

Total Fixed Assets Total Equity

Total Assets Total Liabilities & Equity

WorkingCapital

WorkingCapital

InvestmentDecisions

FinancingDecisions

Macro Finance

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What is Finance?• A well-developed financial system is a hallmark and

essential characterpistic of any modern developed nation.

• Financial markets, financial intermediaries, and financial management are the important components.

• Financial markets and financial intermediaries facilitate the flow of funds from borrowers to savers.

• Financial management involves the efficient use of financial resources in the production of goods.

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Areas of Specialization in Finance

• Financial Markets– Markets of users and savers of funds.

• Financial Services– Design and delivery of financial advice and

products to individuals, businesses, government.

• Managerial Finance– Financial management of business firms.

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Areas of Employment in Finance

• Financial Analyst

• Capital budgeting analyst/manager

• Project finance manager

• Cash manager

• Credit analyst/manager

• Pension fund manager

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Basic Forms of Business Organization

• Sole Proprietorship– Owned by one person, operated for personal profit.

• Partnerships– Owned by two or more people, operated for joint

profit.

• Corporations– “Legal entity”, owned by individuals, operated for

joint profit.

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Sole Proprietorship

STRENGTHS:• Low organizational cost• Income taxed once as

personal income• Independence• Secrecy• Ease of dissolution

WEAKNESSES:• Unlimited liability• Limited funding• Proprietor must be all• Difficult to develop staff

career opportunities• Lack of continuity on

death of proprietor

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Partnerships

STRENGTHS:• Improved funding

sources• Increased managerial

talent• Income split by

partnership contract, taxed as personal income

WEAKNESSES:• Unlimited liability to

all partners• Partnership dissolved

upon death of partner• Difficult to liquidate

or transfer ownership

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Corporations

STRENGTHS:• Owners’ liability limited• Large capitalization

possible, greater funding• Ownership readily

transferable• Indefinite life• Professional management

WEAKNESSES:• Higher tax rates• Expensive organization• Greater government

regulation• When publicly traded,

lacks secrecy

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Corporate Organization Chart

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Organization of Finance Functions

• CFO – Chief Financial Officer

• Treasurer responsibilities:– Financial planning, fund raising, capital

expenditure decisions, cash and credit management.

• Controller responsibilities:– Corporate accounting, cost accounting, and tax

management.

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Relationship to Economics

Fundamental Economic Principle:

• Marginal Analysis– Financial decisions should be made and actions

taken only when the added benefits exceed the added costs.

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Relationship to Accounting

• Cash Flows– Accrual Basis: recognizes sales revenue and

expenses incurred to make sale at time of sale.– Cash Basis: recognizes revenues and expenses

as they occur.

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Accounting vs. Financial ViewsAccounting View(Accrual Basis)

Income StatementPeakes Quay, Inc.

For year ended 12/31

Financial View(Cash Basis)

Cash Flow StatementPeakes Quay, Inc.

For year ended 12/31

Sales revenue $100,000Less: Costs 80,000Net Profit $ 20,000

Cash inflow $ 0Less: Cash outflow 80,000Net cash flow ($80,000)

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Financial Manager–Key Activities

Balance Sheet

CurrentAssets

_______________FixedAssets

CurrentLiabilities

_______________Long-Term Funds(Debt & Equity)

Financial Analysis & Planning

MakingInvestmentDecisions

MakingFinancingDecisions

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Should Firms Maximize Profit?

• Corporations commonly define profit as “Earnings per Share” (EPS).– A measure of total earnings divided by total

number of ownership shares.

• EPS ignores critical factors of– the timing of the returns.– cash flows available to common shareholders.– risk factors facing the firm.

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Or Should Firms Maximize Shareholder Wealth?

• Evaluating Shareholder Wealth addresses factors of timing, cash flows and risk ignored by the EPS.

• Therefore, Maximizing Shareholder Wealth is a more comprehensive goal for the firm, its managers and employees.

• This can be explored through “economic valued added” and a focus on stakeholders.

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Economic Value Added – EVA®

• EVA measures whether an investment contributes to shareholder wealth.

• EVA is calculated by subtracting cost of funds used from after-tax operating profits.

• While popular, EVA is essentially derived from the concept of “net present value.”

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What about Stakeholders?

• Stakeholders include groups that have direct economic links to the firm.

• Stakeholders include not only owners, but also employees, customers, suppliers, and creditors.

• Maintaining positive stakeholder relationships helps maximize long-term benefits to shareholders.

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Importance of EthicsThe standards of conduct or moral judgment:• Honesty, trustworthiness, fair dealing are

foundations of sustainable business relations:– With customers,– With suppliers,– With creditors,– With employees,– With owners.

• Ethical behaviour is necessary to achieve the goal of maximizing shareholder wealth.

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Internal Ethical Review

• Are rights of stakeholders being violated?• Does firm have extra duties to stakeholders?• Will a decision unfairly discriminate benefits

among stakeholders?• If stakeholders are harmed, should this be

remedied? How?• What is the relationship between shareholders

and stakeholders?

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Financial Goals of a Company

• Maximize sales.• Maximize cash flow.• Maximize market

share.• Maximize profit.• Minimize costs.

• Maximize return on sales, investment, equity.

• Ensure earnings stability.

• Achieve target goals for sales, profits, market share or return.

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Agency Issues: The Principal-Agent Problem

• Whenever ownership is independent of management there exists potential problem of conflicts.

• The owner’s goals for the firm are best described as maximizing shareholder wealth.

• Managers are also concerned with personal wealth, job security, lifestyle, and benefits. These concerns may conflict with shareholder interests.

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Resolving the Agency Problem

• Good corporate governance by the Board of Directors is the heart of any resolution.

• Agency Costs – the costs of this governance:– Monitoring costs,– Bonding costs,– Structuring compensation costs.

• Market forces, such as the potential for hostile takeover provide some deterrence.

• Legal forces, fraud, and fiduciary misconduct laws aim to act as deterrents as well.

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Current View on Incentive Plans

• Executive compensation packages generally include incentive plans that grant stock options, performance based shares, or cash bonuses upon meeting or exceeding corporate goals.

• Such packages may also include long-term benefits that can protect the manager against poor corporate performance.