© Pearson Education 2013
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Principles of Managerial Finance
Arab World Edition
Gitman, Zutter, Elali, Al Roubaie
Chapter 1:
The Role and
Environment of
Managerial Finance
Lecturer: [Insert your name here]
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Learning Goals
LG1: Define finance, its major areas and opportunities
available in this field, and the legal forms of business
organization.
LG2: Describe the managerial finance function and its
relationship to economics and accounting.
LG3: Identify the primary activities of the financial manager.
LG4: Explain the goal of the firm, corporate governance, the
role of ethics, and the agency issue.
LG5: Understand financial institutions and markets, and the
role they play in managerial finance.
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What is Finance?
Finance can be defined as the art and science 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, and how they invest their savings.
• In a business context, finance involves the same types of
decisions: how firms raise money from investors, how firms
invest money in an attempt to earn a profit, and how they
decide whether to reinvest profits in the business or
distribute them back to investors.
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Major Areas & 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 government.
•
Career opportunities include banking, personal financial
planning, investments, real estate, and insurance.
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Major Areas & Opportunities in Finance:
Managerial Finance
•
Managerial finance is concerned with the duties of the
financial manager in the business firm.
•
The financial manager actively manages the financial
affairs of any type of business, whether private or public,
large or small, profit-seeking or not-for-profit.
•
They are also more involved in developing corporate
strategy and improving the firm’s competitive position.
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Major Areas & Opportunities in Finance:
Managerial Finance (cont’d)
•
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 the need for financial
managers who can actively manage a balance sheet, find
the cash to sustain a company through a downturn, reduce
risk, and seek out the growth opportunities that remain.
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Legal Forms of Business Organization
One of the most basic decisions that all businesses confront is
how to choose a legal form of organization.
The three most common legal forms of business organization
are:
•
Sole proprietorship
•
Partnership
•
Corporation
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Legal Forms of Business Organization:
Corporations
•
A corporation is an entity created by law. It has the legal
powers of an individual in that it can sue and be sued, make
and be party to contracts, and acquire property.
•
Stockholders are the owners of a corporation, whose
ownership, or equity, is evidenced by either common stock
or preferred stock.
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Legal Forms of Business Organization:
Corporations
Figure 1.1
Corporate
Organization
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Why Study Managerial Finance?
Table 1.1 Career
Opportunities in
Managerial Finance
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The Managerial Finance Function
•
The size and importance of the managerial finance function
depends on the size of the firm.
•
In small companies, the finance function may be performed
by the company president or accounting department.
•
As the business expands, finance typically evolves into a
separate department linked to the president as was
previously described in Figure 1.1.
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The 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.
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The Managerial Finance Function:
Relationship to Economics (cont.)
•
The primary economic principal used by financial managers
is marginal cost-benefit analysis which says that
financial decisions should be implemented only when added
benefits exceed added costs.
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The Managerial Finance Function:
Relationship to Accounting
•
The firm’s finance (treasurer) and accounting (controller)
functions are closely-related and overlapping.
•
In smaller firms, the financial manager generally performs
both functions.
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The Managerial Finance Function:
Relationship to Accounting (cont.)
•
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.
•
The significance of this difference can be illustrated using
the following simple example.
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The Managerial Finance Function:
Relationship to Accounting (cont.)
•
•
The Nassima Corporation experienced the following activity
last year:
Sales
US$100,000 (1 yacht sold, 100% still uncollected)
Costs
US$80,000 (all paid in full under supplier terms)
Now contrast the differences in performance under the
accounting method versus the cash method.
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The Managerial Finance Function:
Relationship to Accounting (cont.)
INCOME STATEMENT SUMMARY
ACCRUAL
Sales
Less: Costs
Net Profit/(Loss)
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US$100,000
CASH
US$
0
(80,000)
(80,000)
US$ 20,000
US$(80,000)
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The Managerial Finance Function:
Relationship to Accounting (cont.)
•
Finance and accounting also differ with respect to
decision-making.
•
While accounting is primarily concerned with the
presentation of financial data, the financial manager is
primarily concerned with analyzing and interpreting
this information for decision-making purposes.
•
The financial manager uses this data as a vital tool for
making decisions about the financial aspects of the firm.
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The Managerial Finance Function:
Primary Activities of the Financial Manager
Figure 1.2
Financial Activities
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Goal of the Firm:
Maximize Shareholder Wealth
Decision rule for managers: only take actions that are expected
to increase the share price.
Figure 1.3
Share Price Maximization
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Goal of the Firm:
Maximize Shareholder Wealth
•
Why?
•
Because maximizing shareholder wealth properly
considers cash flows, the timing of these cash flows,
and the risk of these cash flows
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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.
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Goal of the Firm:
What About Other 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."
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Goal of the Firm:
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.
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Goal of the Firm:
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.
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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.
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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.
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Governance and Agency:
Government Regulation
•
Government regulation generally shapes the corporate
governance of all firms.
•
During the past decade, corporate governance has received
increased attention due to several high-profile corporate
scandals.
•
Recent corporate governance codes have been introduced in
many countries internationally, including in the Arab region
in Saudi Arabia, Bahrain, the U.A.E., Oman, and Qatar.
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The Agency Issue:
The Agency Problem
•
•
•
•
Managers can be viewed as agents of the owners who have
hired them.
Technically, any manager who owns less than 100% of the
firm’s equity is to some degree an agent of other owners.
In theory, managers would agree with shareholder wealth
maximization. However, managers are also concerned with
their personal interests.
This potential conflict of owner and personal goals is called the
agency problem.
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The Agency Issue:
Resolving the Problem
•
Market Forces such as major shareholders and the threat
of a hostile takeover act to keep managers in check.
•
Agency Costs are the costs borne by stockholders to
maintain a corporate governance structure that minimizes
agency problems and contributes to the maximization of
shareholder wealth.
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The Agency Issue:
Resolving the Problem (cont.)
•
Incentive plans are management compensation plans that
tie management compensation to share price; one example
involves the granting of stock options.
•
A stock option is an incentive allowing managers to
purchase stock at the market price set at the time of the
grant.
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The Agency Issue:
Resolving the Problem (cont.)
•
Performance plans tie management compensation to
measures such as EPS growth; performance shares and/or
cash bonuses are used as compensation under these plans.
•
Recent studies have failed to find a strong relationship
between CEO compensation and share price.
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Financial Institutions & Markets
Firms that require funds from external sources can obtain them
in three ways:
•
through a bank or other financial institution
•
through financial markets
•
through private placements
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Financial Institutions & Markets:
Financial Institutions
•
Financial institutions are intermediaries that channel the
savings of individuals, businesses, and governments into
loans or investments.
•
The key suppliers and demanders of funds are individuals,
businesses, and governments.
•
In general, individuals are net suppliers of funds, while
businesses and governments are net demanders of funds.
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Financial Institutions & Markets:
Financial Markets
•
Financial markets provide a forum in which suppliers of
funds and demanders of funds can transact business
directly.
•
The two key financial markets are the money market and
the capital market.
•
Transactions in short term marketable securities take place
in the money market, while transactions in long-term
securities take place in the capital market.
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Financial Institutions & Markets:
Financial Markets (cont.)
•
All securities are initially issued through the primary
market.
•
The primary market is the only one in which a corporation
or government is directly involved in and receives the
proceeds from the transaction.
•
Once issued, securities then trade on the secondary
markets such as the New York Stock Exchange or Tadawul.
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Financial Institutions & Markets:
Relationship Between Institutions & Markets
Figure 1.4 Flow of Funds
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The Money Market
•
The money market is created by a financial relationship
between suppliers and demanders of short-term funds
(those having a maturity of a year or less).
•
Most money market transactions are made in marketable
securities which are short-term debt instruments such as
government Treasury bills and commercial paper.
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The Capital Market
•
Capital markets are the markets for long-term debt and
corporate stocks. The best-known stock market is the New
York Stock Exchange.
•
In the Arab world capital markets have grown rapidly in the
past few years, but are relatively small.
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The Capital Market
•
The key capital market securities are bonds (long-term
debt) and both common and preferred stock (equity).
•
Bonds are long-term debt instruments used by businesses
and government to raise large sums of money or capital.
•
Common stock are units of ownership interest or equity in a
corporation.
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The Capital Market:
The Role of Capital Markets
•
The capital market creates continuous liquid markets in
which firms can obtain needed financing.
•
It also creates efficient markets that allocate funds to
their most appropriate uses.
•
The price of an individual security is determined by the
demand for and supply of the security.
•
Figure 1.5 (next slide) shows the interaction of the forces of
demand and supply for a given security.
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The Capital Market:
The Role of Capital Markets
Figure 1.5
Supply and
Demand
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