MANAGERIAL FINANCE 410 (Rev Sp15)
STUDENT LECTURE NOTE 1
I. Financial Management Overview
A. The ____ primary areas and opportunities in Finance:
1. Capital Markets and Institutions: Potential employment opportunities with banks, insurance companies, mutual funds and investment banks.
2. Investments: Probably the most obvious job
opportunity is to work for a ________ firm either in
sales or as a security analyst. Could also do similar
work for banks, mutual funds or insurance
companies in analyzing or managing investment
portfolios.
3. Corporate financial management: Presents the
greatest number of different job opportunities as it is
important in all types of businesses. Different types
of decisions made by financial managers:
 Asset acquisition or sale, including mergers
 Plant expansion or contraction
 Management of current assets and liabilities
 How to _______ investment projects
 How to raise _______ _________
 Payment of dividends versus retaining earnings
 Which customers merit credit and the credit
terms extended
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B. Forms of Business Organization
1. Traditional Sole Proprietorships
a. Simple and inexpensive to organize
b. _________ liability for owner
c. Subject to few government regulations
d. Difficult to obtain large sums of capital
e. Business ______ corporate income taxes
f. Life is limited to the life of the individual who
created it
2. Limited Liability Corporation: an Alternative to
Traditional Sole Proprietorships1
a. LLCs are permitted in most states.
b. The LLC gives its owners, like those of S Corps,
_______ liability and taxation as a partnership.
c. Unlike an S Corp, the LLC can own more than
80% of another corporation, and corporations,
partnerships, or non-U.S. residents can own LLC
shares.
d. LLCs work well for corporate _____ ventures or
projects developed through a subsidiary.
3. Traditional Partnerships
a. Can arise formally or informally
b. ___ cost and ease of formation
c. Unlimited liability for all partnership debts, and all
partners are ______ for the business debts
d. Difficult to liquidate or sell a partner’s share
1
Source: L.J. Gitman (2006), Principals of Managerial Finance, Brief, 4th Edition, (as well as the
information on LLPs and S Corps).
2
e. Limited partners possible but at least ___ partner
must have unlimited liability
f. Tax treatment same as sole proprietorship
g. Difficulty in raising large amounts of capital
means that at some point, the founders of a sole
proprietorship or partnership may incorporate.
4. Limited Liability Partnership: an Alternative to
Traditional Partnerships
a. LLPs are permitted in many states; governing
statutes vary by state.
b. All LLP partners have _______ liability.
c. They are liable for their own acts of malpractice,
not for those of other partners.
d. The LLP is taxed as a ___________.
e. LLPs are frequently used by legal and accounting
professionals.
f. In recent years this organizational form has begun
to
replace
professional
corporations-corporations formed by groups of professionals
such as attorneys and accountants that provide
limited liability except for that related to
malpractice--because of the tax advantages it
offers.
5. Corporations (C Corps)
a. A company is a ________ legal entity created by
the state, separate and distinct from its owners.
b. Has unlimited life
c. Shareholders have no personal liability for debts,
i.e., liability is _______.
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d. More expensive to setup and operate as it subject
to greater governmental regulations.
e. Transfer of ownership is ____ as shares can be
readily issued and traded.
f. Can draw upon more sources of capital, it can offer
debenture securities and shares of stock.
g. Corporate income is subject to double taxation.
6. Sub-chapter S Corporations (S Corps): an
Alternative to C Corps
a. A tax-reporting entity that (under Subchapter S of
the Internal Revenue Code) allows certain
corporations with 75 or fewer stockholders to
choose to be taxed as ____________.
b. Its stockholders receive the organizational benefits
of a corporation and the tax advantages of a
partnership.
c. But S Corps lose certain tax advantages related to
_______ plans.
C. THE Most Important Concepts in Finance
1. 1st Fundamental Concept: Manage the Risk/Return
Tradeoff
a. The Financial Manager’s overall goal is to ensure
the firm’s competitiveness and to avoid risk—in
essence to manage the Risk/Return Tradeoff.
b. Statement of the Risk/Return Tradeoff
“An investor can not expect to earn _____average returns unless they accept ______-than4
average risk. Conversely, investments with _____than-average risk may be expected to yield _____than-average returns.”
2. 2nd Fundamental Concept: The Goal of the Finance
Function
a. The goal of the Finance function is to ________
welfare (wealth) of the firm’s owners (shareholders).
b. Managers should help to do so—although since
they don’t always do this, there is a need to monitor
them.  This is the essence of the Agency Problem
as described in the next lecture.
c. It has been argued that sometimes management
tries to maximize firm ___, rather than firm ____.
By creating a large, rapidly growing firm,
managers may:
 Increase their job security, as chances of a hostile
takeover may be reduced;
 Increase their own power, status and salaries; and
 Create more opportunities for their lower- and
middle-level employees.
d. The goal expressed above translates
Maximization of the firm’s share price.
 Total Value of Firm Equity 
Share Price  
.
Number
of
Equity
Shares


e. What about Profit Maximization as Goal?
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into:
(1.1)
The proper goal must consider:
i. Timing of Returns; (Ex. 1.1 below)
ii. Riskiness of Returns; and (Ex. 1.2 below)
iii. Adopt a Long-Run Viewpoint. (Ex. 1.3 below)
f. It can be proven that welfare maximization is a
________ objective because it correctly considers
all three factors above, whereas profit
maximization may not.
3. Maximization of Share Price and Corporate
Scandals2
a. Enron, ImClone, WorldCom, Tyco, Sunbeam,
Adelphia, etc. … the list of corporate scandals
seems to suggest that maximization of share price is
not a ____ choice for the goal of the finance
function.
b. Given resulting lowered stock values for these
firms, or in some cases bankruptcies, it would seem
that if share-price maximization was the goal then
these firms’ managements did an extremely ____
job of achieving this objective.
c. The exact reasons for these managements’ failures
vary from firm to firm. However, some common
problems emerge.
i. First, management compensation packages were
______ designed. Specifically, stock option and
stock grant plans were linked to short-term stock
2
This discussion draws upon E.F. Brigham and P.R. Daves (2010), Intermediate Financial Management,
10th Edition, pg. 8.
6
price performance which provided management
with the incentive to manipulate short-term
earnings without regard to the firm’s long run
viability.
ii. Second, it is extremely _________ for firms to
take actions that legally drive up short-term stock
prices but harm it in the long-term.
 This is because firm value is based on the
discounted _______ value of both short- and
long-term cash flows.
 Since old-fashioned _____ activities to drive
up stock price (like increasing sales, reducing
capital requirements and cutting costs) were
not available to these firms, management
began engaging in questionable (irregular)
accounting practices.
iii. Third, as these managers found that they seemed
to getting away with irregular account-ting
practices they apparently developed a mindset
that the (legal accounting) rules did not apply to
them or that they would not get caught. Thus,
they began breaking even more rules, until they
finally did get caught.
d. Abraham Lincoln once observed that “You can’t
fool ___ of the people, ___ of the time.” Stock
prices for these firms did rise, at least temporarily.
As the evidence about these firms’ illegal activities
became known, Lincoln’s assertion was proven
correct. These firms’ stock prices fell precipitously
even to the extent of firm ruination.
e. Lessons to be Learned from the Scandals
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i. First, since people respond to incentives, even
poorly-designed ones, it is extremely critical that
incentive-based compensation is designed to
ensure a proper ____-term focus.
ii. Second, managers should not be allowed to
commit even small ethical violations. Clearly,
evidence from these companies shows that small
violations lead to large ones.
iii. Third, top financial managers (CEO and/or
CFO) should not be allowed to take shortcuts
(allow irregularities). The internal and external
auditors, as well as other managers ______
overlook anything that doesn’t conform to the
FASB or POASCB accounting rules.
4. Corporate Citizenship and the Stakeholder View
of the Firm3
a. Maximizing the wealth of shareholders should be
the major goal of the financial manager.
b. However, there are many interested parties who
believe that companies have a ______
responsibility to society at large to improve how
their firms are both perceived, recognized and
actually providing real benefits beyond those
accruing to shareholders.
c. Stakeholders are those people or groups that a firm
affects or is affected by their decisions.
3
This section draws upon Chapter 11 in Corporate Governance, 3rd. Edition (2010) by K.A. Kim, J.R.
Nofsinger and D.J. Mohr.
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 The primary stakeholders would include:
stockholders, employees, creditors, suppliers and
customers.
 The secondary stakeholders would include: the
community,
society,
the
environment,
competitors and the government.
d. Under a stakeholder view the objective of
management is to ________ sustainable
organizational wealth (the utility of both primary
and secondary stakeholders) by optimizing these
relationships.
e. Corporate Social Responsibility (CSR): Archie
Carroll4 has suggested four levels of CSR in order
of decreasing priority.
i. Level I: ________˗most importantly a firm must
survive by producing goods and/or services at a
profit.
ii. Level II: _____˗firms are expected to operate
according to the applicable laws.
iii. Level III: _______˗beyond even the legal code,
society expects firms to act within societal norms
and customs. An example might be expectations
that firm decisions will not hurt the environment.
iv. Level IV: Philanthropy˗corporate contributions
of time (community service) and money
(charitable donations) are increasingly desired by
stakeholders.
4
A.B. Carroll (1979), “A Three-Dimensional Conceptual Model of Corporate Performance,” Academy of
Management Review Vol. 4: pp. 497-505 and A.B. Carroll (1999), “Corporate Social Responsibility:
Evolution of a Definitional Construct,” Business & Society Vol. 38, No. 4: pp. 268-295.
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5. 3rd Fundamental Concept: The Time Value of
Money  A dollar received today is worth ____
than that same dollar received at some point in the
future, because today’s dollar can be invested now
and will earn interest in the interim.
Ex. 1.1
Consider the two mutually-exclusive investment projects
described below. Answer the following questions.
Assume that the return you require on either project is
7.5%.
Project A: After-tax profit of $500,000 is received at
the end of Year 10.
Project B: After-tax profits of $50,000 are received at
the end of each of the next 10 years.
a) What is the average annual profit on each project?
Which project do you prefer on this basis?
b) Calculate the present values of the two projects.
Which project do you prefer?
c) Compare the two projects on the basis of their future
values at the end of year ten, which do you prefer?
A1.1a) Average annual profit equals ______ for both
projects, so on this basis you are indifferent.
A1.1b) Note: Refer to Time Value formulas at the end of
this LN for a refresher as necessary.
PVProject A
= $500,000 * (PVIF 7.5%/1, 10*1)
10




1

= $500,000 * 
   .075 10*1 
 1  
 
   1  
= $500,000 * (0.4851939)
=$
.
Numerical Approach - Calculator Sequence:
0.075 [] 1 [=] [+] 1[=] [yx] [(] 10 [x] 1 [)] [=] [1/x] [x]
500000 [=]
PVProject B
= $50,000 * (PVIFA 7.5%/1, 10*1)
 

1

1  
10*1  
(1  (0.075 / 1))  
= $50,000 *  


 0.075 




1 



= $50,000 * (6.8640809)
=$
.
Numerical Approach - Calculator Sequence:
.075 [÷] 1 [=] [+] 1 [=] [yx] [(] 10 [x] 1 [)] [=] [1/x] [+/-]
[+] 1 [=] [÷] [(] .075 [÷] 1 [)] [=] [x] 50000
Conclusion: The comparison of the present values shows
that the PV of Project B exceeds that of Project A, by a
substantial amount, thus Project ___ is preferred.
A1.1c) FVProject A = $500,000, because this is already a
future value.
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FVProject B
= $50,000 * (FVIFA 7.5%/1, 10*1)


 (1  (0.075 / 1))10*1  1
= $50,000 * 

(0.075 / 1)


= $50,000 * (14.147087)
=$
.
Numerical Approach - Calculator Sequence:
0.075 [] 1 [=] [+] 1 [=] [yx] [(] 10 [x] 1 [)] [=] [-] 1 [=] []
[(] .075 [] 1 [)] [=] [x] 50000 [=]
Conclusion: Not surprisingly, the comparison of the
future values also shows that the FV of Project B exceeds
that of Project A, by a substantial amount, thus Project
___ is preferred.
Ex. 1.2
Suppose you have $1000 to invest. You are going to
invest it in one of two possible investments described
below which will yield the gain described at the end of
one year. Use this information to answer the following
questions. Base your answers on the percentage return
on investment.
Investment 1): A sure gain of $500 more; or
Investment 2): A gamble that offers a 50% chance of
earning a $1000 gain and a 50% chance of an additional
gain of zero.
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a) Determine which investment you would prefer if you
are not taking risk into account? Hint: Compare
expected returns.
b) If risk is considered does that change your answer?
Hint: Compare standard deviations.
 $1500  
A1.2a) E(R1) = 
  1 *1.00 = ____ = ____.
$
1000
 

 $2000  
 $1000  
E(R2) = 
  1 * 0.50 + 
  1 * 0.50
$
1000
$
1000
 
 


= (100% * 0.50) + (0% * 0.50) = ____.
Conclusion: The expected returns on the two projects are
equal, thus you would be ___________ between the two
investments if risk is not considered.
A1.2b) σ2(R1) = [(0.50 – 0.50)2 * 1.00] = __.
σ(R1) = 0 = ___.
σ2(R2) = [[(1.00 – 0.50)2 * 0.50] + [[(0 – 0.50)2 * 0.50]]
= ____.
σ(R2) =
0.25 = ___.
Conclusion: Although the expected returns on the two
projects are equal, clearly, the standard deviations of
returns are different. Investment 1 is riskless so it is
preferred.
Ex. 1.3
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On October 17, 1973, following the 1973 Yom Kippur
War the Organization of Petroleum Exporting Companies
(OPEC) imposed an oil embargo on the United States.
This led to a severe recession in much of the Western
World, including the U.S. Between 10/17/73 and the end
of November the Dow Jones index fell 15%. Gasoline
prices went from 30 cents per gallon to $1.20 and gasoline
lines snaked their way around city blocks.
a) In 1973 what kind of gas mileage do you suppose an
average American car was getting?
b) Can you think of any cars generally that were both
more fuel efficient and also more dependable?
c) Speculate on the results of this quadrupling in gas
prices on demand for U.S. vehicles vis-à-vis their
more efficient foreign competitors.
d) What is the implication for the long-term outlook of
U.S. automakers?
A1.3a) A guess would be about 8-10 mpg. Less for big,
luxury cars like Cadillacs, Continentals, etc.
A1.3b) Obviously, foreign autos, especially ________
imports.
A1.3c) U.S. automakers lost market share to the Japanese
imports big-time, and they still have not regained it.
A1.3d) U.S. automakers did not see any long-term trend
away from the big, fuel inefficient cars they
expected to be able to build forever. Certainly, they
did not foresee the huge increase in gas prices.
Failing to adopt a long-run viewpoint cost them lots
of lost sales and loyal customers.
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Future Value of a Single Payment:
  r   t*m 
FVt = PV0  1      = PV0 * FVIFr%/m,t*m.
  m   
Present Value of a Single Payment:


1
PV0 = FVt  
= FVt * PVIFr%/m,t*m.
t*m 
 (1(r/m)) 
Future Value of an Annuity:
 (1  (r/m)) t*m  1
FVA = A  
 = A * FVIFA r%/m,t*m.
(r/m)


Present Value of an Annuity:
  1

1

  (1  ( r/m)) t*m  
PVA = R 
 = R * PVIFA r%/m,t*m.
(r/m)




Where: r = annual interest rate,
t = number of years, and
m = number of compounding periods per
year.
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