Chapter One
Overview of Managerial Finance
Principles of Managerial
Finance
Learning Goals
– 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.
LG1
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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?
Macro Finance
Assets:
Liabilities & Equity:
Current Assets
Current Liabilities
Cash & M.S.
Accounts payable
Accounts receivable
Notes Payable
Inventory
Working
Capital
Investment
Decisions
Total Current Assets
Fixed Assets:
Gross fixed assets
Total Current Liabilities
Long-Term Liabilities
Total Liabilities
Equity:
Less: Accumulated dep.
Common Stock
Goodw ill
Paid-in-capital
Other long-term assets
Retained Earnings
Total Fixed Assets
Total Assets
Total Equity
Total Liabilities & Equity
Working
Capital
Financing
Decisions
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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 Views
Accounting View
(Accrual Basis)
Income Statement
Peakes Quay, Inc.
For year ended 12/31
Sales revenue
Less: Costs
Net Profit
$100,000
80,000
$ 20,000
Financial View
(Cash Basis)
Cash Flow Statement
Peakes Quay, Inc.
For year ended 12/31
Cash inflow
$
0
Less: Cash outflow 80,000
Net cash flow
($80,000)
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Financial Manager–Key Activities
Financial Analysis & Planning
Balance Sheet
Making
Investment
Decisions
Current
Current
Assets
Liabilities
Making
_______________ _______________ Financing
Fixed
Long-Term Funds Decisions
Assets
(Debt & Equity)
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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 Ethics
The 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.
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