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.

© Pearson Education Limited, 2015. 1-2

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.

© Pearson Education Limited, 2015. 1-3

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.

© Pearson Education Limited, 2015. 1-4

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

© Pearson Education Limited, 2015. 1-5

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.

© Pearson Education Limited, 2015. 1-6

Career Opportunities in Finance:
Managerial Finance (cont.)

• The recent global financial crisis and subsequent

responses by governmental regulators, increased
global competition, and rapid technological change
also increase the importance and complexity of the
financial manager’s duties.
• Increasing globalization has increased demand for
financial experts who can manage cash flows in
different currencies and protect against the risks
that naturally arise from international transactions.

© Pearson Education Limited, 2015. 1-7

Focus on Practice

• Professional Certifications in Finance:

– Chartered Financial Analyst (CFA) – Offered by the CFA
Institute, the CFA program is a graduate-level course of
study focused primarily on the investments side of finance.
– Certified Treasury Professional (CTP) – The CTP program
requires students to pass a single exam that is focused on
the knowledge and skills needed for those working in a
corporate treasury department.
– Certified Financial Planner (CFP) – To obtain CFP status,
students must pass a ten-hour exam covering a wide range
of topics related to personal financial planning.

© Pearson Education Limited, 2015. 1-8

Focus on Practice (cont.)

• Professional Certifications in Finance:

– American Academy of Financial Management (AAFM) – The
AAFM administers certifications including the Charter
Portfolio Manager, Chartered Asset Manager, Certified Risk
Analyst, Certified Cost Accountant, and Certified Credit
Analyst.
– Professional Certifications in Accounting –Professional
certifications in accounting include the Certified Public
Accountant (CPA), Certified Management Accountant
(CMA), and Certified Internal Auditor (CIA).

© Pearson Education Limited, 2015. 1-9

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.

© Pearson Education Limited, 2015. 1-10

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

© Pearson Education Limited, 2015. 1-11

Matter of Fact

© Pearson Education Limited, 2015. 1-12

Figure 1.1 Corporate Organization

© Pearson Education Limited, 2015. 1-13

Table 1.2 Career Opportunities in
Managerial Finance

© Pearson Education Limited, 2015. 1-14

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

© Pearson Education Limited, 2015. 1-15

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

© Pearson Education Limited, 2015. 1-16

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."

© Pearson Education Limited, 2015. 1-17

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

© Pearson Education Limited, 2015. 1-18

The Role of Business Ethics: Considering
Ethics

• Robert A. Cooke, a noted ethicist, suggests that the

following questions be used to assess the ethical
viability of a proposed action:
– Is the action arbitrary or capricious? Does the action
unfairly single out an individual or group?
– Does the action affect the morals, or legal rights of any
individual or group?
– Does the action conform to accepted moral standards?
– Are there alternative courses of action that are less likely
to cause actual or potential harm?

© Pearson Education Limited, 2015. 1-19

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 to
positively affect the firm’s share price.

© Pearson Education Limited, 2015. 1-20

Focus on Ethics

• The Case of Google Glass

– Computer that users wear like a pair of eyeglasses has
raised concerns over privacy.
– 2004 “Owner’s Manual” states that Google’s ultimate goal
“is to develop services that significantly improve the lives
of as many people as possible.”
– Corporate motto “Don’t Be Evil” conveys willingness to do
the right thing at the expense of short-term profits.
– Share price has increased 700% from 2004 to 2013.

© Pearson Education Limited, 2015. 1-21

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).

© Pearson Education Limited, 2015. 1-22

Figure 1.1 Corporate Organization

© Pearson Education Limited, 2015. 1-23

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.

© Pearson Education Limited, 2015. 1-24

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.

© Pearson Education Limited, 2015. 1-25

Managerial Finance Function:
Relationship to Economics (cont.)

Nord Department Stores is applying marginal-cost

benefit analysis to decide whether to replace a
computer:

© Pearson Education Limited, 2015. 1-26

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.

© Pearson Education Limited, 2015. 1-27

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.

© Pearson Education Limited, 2015. 1-28

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)

© Pearson Education Limited, 2015. 1-29

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):

© Pearson Education Limited, 2015. 1-30

Personal Finance Example

Net cash flow = -$215!

© Pearson Education Limited, 2015. 1-31

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.

© Pearson Education Limited, 2015. 1-32

Figure 1.3
Financial Activities

© Pearson Education Limited, 2015. 1-33

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.

© Pearson Education Limited, 2015. 1-34

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.
© Pearson Education Limited, 2015. 1-35
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.

© Pearson Education Limited, 2015. 1-36

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.
© Pearson Education Limited, 2015. 1-37
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.

© Pearson Education Limited, 2015. 1-38

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.

© Pearson Education Limited, 2015. 1-39

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.

© Pearson Education Limited, 2015. 1-40

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

© Pearson Education Limited, 2015. 1-41

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.

© Pearson Education Limited, 2015. 1-42