Chapter 1

The Role of
Managerial
Finance
• Q1: What is Finance?
• Q2: What is Financial Management
• Q3: What are the Different legal forms of business
org?
• Q4: What is the goal of the firm (goal of financial
managers)?
• Q5: What is the managerial finance function
• Q6: What is the relationship between MF and
Economics?
• What is the relationship between MF and accounting?
• What is Agency Problem?

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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:
• how firms raise money from investors
• how firms invest money in an attempt to earn a profit
• how firms decide whether to reinvest profits in the
business or distribute them back to investors.

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Career 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 governments.
• Career opportunities include:
• banking
• personal financial planning
• Investments
• real estate
• insurance

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Career Opportunities in Finance:
Managerial Finance

• Managerial finance is concerned with the duties

of the financial manager working in a business.
• Financial managers administer the financial
affairs of all types of businesses—private and
public, large and small, profit-seeking and not-for-
profit. Tasks include:
• developing a financial plan or budget
• extending credit to customers
• evaluating proposed large expenditures
• raising money to fund the firm’s operations.

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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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Matter of Fact

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Figure 1.1 Corporate Organization

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Table 1.2 Career Opportunities in
Managerial Finance

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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 1.2 Share Price Maximization Financial decisions
and share 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 (timing)
2. Profits do not necessarily result in cash flows available to
stockholders (Amount)
3. Profit maximization fails to account for risk (Uncertainty)

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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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The Role of Business Ethics: 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

enhancement of long-term value and a positive
effect on share price

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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).

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Figure 1.1 Corporate Organization

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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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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 (MCBA) 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.

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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.

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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)

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

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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):

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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

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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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Figure 1.1 Corporate Organization

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5.1 Agency Relationship (Principal - Agent
Relationship)
 Agency relationship exists when one or more
persons (known as the principal) contracts with
one or more persons (the agent) to make decisions
on their behalf.
 In a corporation, the managers are the agents and
the stockholders are the principal.

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 5.1 Agency Relationship
(Principal - Agent Relationship)

 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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Canada Inc. 1-31
1-31
5.1 Agency Relationship (Principal
- Agent Relationship)

 An agency relationship = when a principal

hires an agent to act on their behalf
 Within corporations, agency relationships exist
between Stockholders and managers

32
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Stockholders and Managers

Owners

Manager
s

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5.1.2 Agency Problem

• Agency problem arise when managers place personal goals ahead of the
goals of shareholders, which lead to conflict of interest between the
stockholders and the managers.

• The source of agency problems is the separation of (owners’) control and

management.
– This occurs in a corporate setting whenever the agents do not hold 100% of the firm’s shares.

• Examples:Not pursuing risky project for fear of losing jobs, stealing, expensive perks.

• All else equal, agency problems will reduce the firm

value.

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5.1.3.1 Agency Problem

– A profitable project that is risky may benefit owners, but may put the
manager’s job at risk (risk Avoidance)

• If manager does not take on project  Cost to

owner
– Managers may create ways to pay themselves great deals of money
(accounting or other)

– Entering into unprofitable acquisitions (empire building)

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Agency Costs (AC)

• Two Factors- Market forces and Agency Costs- serve to

prevent or minimize agency problems.

A. Market Forces : Institutional Investors & Threat of Takeovers

B. Agency Costs: Costs of maintaining a corporate governance

structure that monitors management behavior, ensures
against dishonest acts of management, and gives managers
the financial incentives to maximize share price.

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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 (LITTLE INFLUENCE)
• 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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The Agency Issue:
Management Compensation (Incentive)
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.

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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
(increase its stock price) by restructuring its
management, operations, and financing, can
provide a strong source of external corporate
governance.

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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 (SOX) 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.

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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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The Agency Issue:
Management Compensation Plans (MCPs)

• Incentive plans (IPs) are management

compensation plans that tie management
compensation to share price; one example involves
the granting of stock options.

• Performance plans (PPs) 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.

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Matter of Fact—Forbes.com
CEO Performance vs. Pay

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