Chapter 1

The Role of
Managerial
Finance
Learning Goals

LG1 Define finance and the managerial finance function.

LG2 Describe the legal forms of business organization.

LG3 Describe the goal of the firm, and explain why

maximizing the value of the firm is an appropriate
goal for a business.

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Learning Goals (cont.)

LG4 Describe how the managerial finance function

is related to economics and accounting.

LG5 Identify the primary activities of the financial

manager.

LG6 Describe the nature of the principle-agent

relationship between the owners and managers of a
corporation, and explain how various corporate
governance mechanisms attempt to manage agency
problems.
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What is Finance?
• Finance can be defined as the science and art 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,
• 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,
• how they decide whether to reinvest profits in the business or distribute
them back to investors.
 Managerial finance is concerned with the duties of the financial
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manager working in a business.
Legal Forms of Business
Organization
• A sole proprietorship is a business owned by one person
and operated for his or her own profit.
• A partnership is a business owned by two or more
people and operated for profit.
• A corporation is an entity created by law. Corporations
have the legal powers of an individual in that it can sue
and be sued, make and be party to contracts, and acquire
property in its own name.

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Table 1.1 Strengths and Weaknesses of the
Common Legal Forms of Business Organization

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Finance Within The Organization

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Goal of Corporation

 Because the ownership and management are separate in a corporation

thus the goals of corporation are different from those of proprietorship
and partnership.

 The primary goal for managers of publicly owned corporation implies that
decisions should be made to maximize the long-run value of the firm’s
shares/stocks, within some constraints.

 The primary financial goal is shareholder wealth

maximization, which translates to maximizing stock price.

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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 (Ex-Accounting profit or Cash flow)
3. Profit maximization fails to account for risk

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Accounting profit or Cash flow

The Nassau Corporation experienced the following activity

last year:

Sales $100,000 (1 yacht sold, 100% still

uncollected)
Costs $ 80,000 (all paid in full under supplier
terms)

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Accounting profit or Cash flow (cont.)

Now contrast the differences in performance under the

accounting method (accrual basis) versus the financial view
(cash basis):

Income Statement Summary

Accrual basis Cash basis
Sales $100,000 $ 0
Less: Costs (80,000) (80,000)
Net Profit/(Loss) $ 20,000 $(80,000)

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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.

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Factors that affect stock price

 Projected cash
flows to
shareholders
 Timing of the cash
flow stream
 Riskiness of the
cash flows
Factors that Affect the Level and
Riskiness of Cash Flows
 Important Decisions made by financial managers:
 Investment decisions
 Financing decisions (the relative use of debt financing)
 Dividend policy decisions

 The external environment

• 9/11 Terrorist Attack
• Global financial crisis of 2008
• National distress
• Economic slowdown
• Government legislation
Goal of the Firm:
What About 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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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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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.

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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:
The Agency Issue
• A principal-agent relationship is an arrangement in
which an agent acts on the behalf of a principal. For
example, shareholders of a company (principals) elect
management (agents) to act on their behalf.
• Agency problems arise when managers place personal
goals ahead of the goals of shareholders.
• Agency costs arise from agency problems that are borne
by shareholders and represent a loss of shareholder
wealth.

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Shareholders versus Managers

Managers are naturally inclined to act in their

own best interests.
Ex- Tyco CEO Dennis Konzlowski (who was in jail) spent more than $1million of the
company's money on his wife’s birthday.

But the following factors affect managerial

behavior:
– Managerial compensation plans
– Direct intervention by shareholders
– The threat of firing
– The threat of takeover
Matter of Fact—Forbes.com
CEO Performance vs. Pay

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Shareholders versus Bondholders

Stockholders are more likely to prefer riskier projects, because

they receive more of the upside if the project succeeds. By
contrast, bondholders receiving fixed payments are more
interested in limiting risk.
Bondholders are particularly concerned about the use of
additional debt.
Bondholders attempt to protect themselves by including
covenants in bond agreements that limit the use of additional
debt and constrain managers’ actions.
Managerial Finance Function:
Relationship to Economics &
Accounting
The financial manager must understand the
economic environment and rely heavily on the
economic principle of marginal cost–benefit
analysis to make financial decisions.
Financial managers use accounting but concentrate
on cash flows and decision making.

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Table 1.2 Career Opportunities
in Managerial Finance

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Review of Learning Goals

LG1 Define finance and the managerial finance function.

– Finance is the science and art of managing money. Managerial finance
is concerned with the duties of the financial manager working in a
business.
LG2 Describe the legal forms of business organization.
– The legal forms of business organization are the sole proprietorship, the
partnership, and the corporation.
LG3 Describe the goal of the firm, and explain why maximizing the
value of the firm is an appropriate goal for a business.
– The goal of the firm is maximize its value, and therefore the wealth of
its shareholders. Maximizing the value of the firm means running the
business in the interest of those who own it—the shareholders.

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Review of Learning Goals
(cont.)
LG4 Describe how the managerial finance function is related to
economics and accounting.
– The financial manager must understand the economic environment and
rely heavily on the economic principle of marginal cost–benefit analysis
to make financial decisions. Financial managers use accounting but
concentrate on cash flows and decision making.
LG5 Identify the primary activities of the financial manager.
– The primary activities of the financial manager, in addition to ongoing
involvement in financial analysis and planning, are making investment
decisions and making financing decisions.

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Review of Learning Goals
(cont.)
LG6 Describe the nature of the principle-agent relationship between
the owners and managers of a corporation, and explain how
various corporate governance mechanisms attempt to manage
agency problems.
– This separation of owners and managers of the typical firm is
representative of the classic principal-agent relationship, where the
shareholders are the principles and mangers are the agents. A firm’s
corporate governance structure is intended to help ensure that managers
act in the best interests of the firm’s shareholders, and other
stakeholders, and it is usually influenced by both internal and external
factors.

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Other Resources

 Wall Street Journal

 Investopedia
 CFA Institute
 www.dsebd.org
 Yahoo Finance
 Bloomberg

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