Chapter 1
The Role of
Managerial
Finance
Copyright © 2012 Pearson Prentice Hall.
All rights reserved.
Learning Goals
LG1 Define finance and the managerial finance function.
LG2 Describe the goal of the firm, and explain why
maximizing the value of the firm is an appropriate
goal for a business.
1-2
Learning Goals (cont.)
LG3 Describe how the managerial finance
function is related to economics and
accounting.
LG4 Identify the primary activities of the
financial manager.
LG5 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. 1-3
What is Finance?
Resource
Utilization
Individuals and firms
(Production agent)
Finance
1-4
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, 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.
1-5
What is Finance? (Cont.)
Sources/Raising Fund Utilization/Uses of Fund
Attaining Goal of Firm
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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.
1-7
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
1-8
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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Managerial Finance Function
• The size and importance of the managerial finance
function depends on the size of the firm.
• In small firms, the finance function is generally performed
by the accounting department.
• As a firm grows, the finance function typically evolves
into a separate department linked directly to the company
president or CEO through the chief financial officer
(CFO) (see Figure 1.1)
1-10
Managerial Finance Function:
Organization of finance function
1-11
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.
1-12
Managerial Finance Function:
Relationship to Economics (cont.)
• Marginal cost–benefit analysis is the economic principle
that states that financial decisions should be made and
actions taken only when the added benefits exceed the
added costs
• Marginal cost-benefit analysis can be illustrated using the
following simple example.
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Managerial Finance Function:
Relationship to Economics (cont.)
Nord Department Stores is applying marginal-cost benefit
analysis to decide whether to replace a computer:
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Managerial Finance Function:
Relationship to Accounting
• The firm’s finance and accounting activities are closely-
related and generally overlap.
• In small firms accountants often carry out the finance
function, and in large firms financial analysts often
help compile accounting information.
• 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.
1-15
Managerial Finance Function:
Relationship to Accounting (cont.)
• Whether a firm earns a profit or experiences a loss, it must
have a sufficient flow of cash to meet its obligations as
they come due.
• The significance of this difference can be illustrated using
the following simple example.
1-16
Managerial Finance Function:
Relationship to Accounting (cont.)
The Nassau Corporation experienced the following activity
last year:
Sales $100,000 (1 yacht sold, 100% still uncollected)
$ 80,000 (all paid in full under supplier terms)
Costs
1-17
Managerial Finance Function:
Relationship to Accounting (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) $ $(80,000)
20,000
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Managerial Finance Function:
Relationship to Accounting (cont.)
Finance and accounting also differ with respect to decision-
making:
– Accountants devote most of their attention to the collection and
presentation of financial data.
– Financial managers evaluate the accounting statements, develop
additional data, and make decisions on the basis of their
assessment of the associated returns and risks.
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Figure 1.3
Financial Activities
-Investment Decision
-Financing Decision
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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.
1-22
Governance and Agency:
Government Regulation
• Government regulation generally shapes the corporate
governance of all firms.
• During the recent decade, corporate governance has
received increased attention due to several high-profile
corporate scandals involving abuse of corporate power
and, in some cases, alleged criminal activity by corporate
officers.
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Governance and Agency:
Government Regulation
The Sarbanes-Oxley Act of 2002:
• established an oversight board to monitor the accounting industry;
• tightened audit regulations and controls;
• toughened penalties against executives who commit corporate fraud;
• strengthened accounting disclosure requirements and ethical guidelines for
corporate officers;
• established corporate board structure and membership guidelines;
• established guidelines with regard to analyst conflicts of interest;
• mandated instant disclosure of stock sales by corporate executives;
• increased securities regulation authority and budgets for auditors
and investigators.
1-24
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.
1-25
The Agency Issue:
Management Compensation Plans
• In addition to the roles played by corporate boards,
institutional investors, and government regulations,
corporate governance can be strengthened by ensuring
that managers’ interests are aligned with those of
shareholders.
• A common approach is to structure management
compensation to correspond with firm performance.
1-26
The Agency Issue:
Management Compensation Plans
• Incentive plans are management compensation plans that
tie management compensation to share price; one example
involves the granting of stock options.
• Performance plans tie management compensation to
measures such as EPS or growth in EPS. Performance
shares and/or cash bonuses are used as compensation
under these plans.
1-27
Matter of Fact—Forbes.com
CEO Performance vs. Pay
1-28
The Agency Issue: The Threat of
Takeover
• When a firm’s internal corporate governance structure is
unable to keep agency problems in check, it is likely
that rival managers will try to gain control of the firm.
• The threat of takeover by another firm, which believes it
can enhance the troubled firm’s value by restructuring its
management, operations, and financing, can provide a
strong source of external corporate governance.
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