Chapter 1 – An Overview of Managerial Finance – Notes

What is Finance?
 Finance is concerned with decisions about money, or more appropriately, cash flows.
 To make rational financial decisions, you must understand three general, yet reasonable,
concepts: Everything else equal,
1. More value is preferred to less.
2. The sooner cash is received, the more valuable it is.
3. Less risky assets are more valuable than (preferred to) riskier assets.

General Areas of Finance

1. Financial markets and institutions:
 Include banks, insurance companies, savings and loans, and credit unions.
 Are an integral part of the general financial services marketplace.
2. Investments:
 Focuses on the decisions made by businesses and individuals as they choose securities for their
investment portfolios.
 The major functions in the investments area are (1) determining the values, risks, and returns
associated with such financial assets as stocks and bonds and (2) determining the optimal mix of
securities that should be held in a portfolio of investments.
3. Financial services:
 Refers to functions provided by organizations that operate in the finance industry.
 Deals with the management of money.
 Helps individuals (and companies) determine how to invest money to achieve such goals as
home purchase, retirement, financial stability and sustainability, budgeting, and related
activities.
4. Managerial finance:
 Deals with decisions that all firms make concerning their cash flows.
 Managerial finance is important in all types of businesses, whether they are public or private,
deal with financial services, or manufacture products.
 Duties range from making decisions about plant expansions to choosing what types of securities
to issue to finance such expansions.
 Financial managers also have the responsibility for deciding the credit terms under which
customers can buy, how much inventory the firm should carry, how much cash to keep on hand,
whether to acquire other firms (merger analysis), and how much of the firm’s earnings to
reinvest in the business and how much to pay out as dividends.

Importance of Finance in Non-Finance Areas

1. Management:
 Involves personnel decisions and employee relations, strategic planning, and the general
operations of the firm.
 Strategic planning, which is one of the most important activities of management, cannot be
accomplished without considering how such plans impact the overall financial well-being of the
firm (setting salaries, hiring new staff, and paying bonuses).
2. Marketing:
 The 4 Ps of marketing (product, price, place, and promotion) determine the success of products
that are manufactured and sold by companies.
 The price that should be charged for a product and the amount of advertising a firm can afford
for the product must be determined in consultation with financial managers because the firm
will lose money if the price of the product is too low or too much is spent on advertising.
3. Accounting:
 In many firms (especially small ones), it is difficult to distinguish between the finance function
and the accounting function.
 Financial managers rely heavily on accounting information because making decisions about the
future requires information about the past.
 Accountants must understand how financial managers use accounting information in planning
and decision making so that it can be provided in an accurate and timely fashion.
4. Information Systems:
 Businesses thrive by effectively collecting and using information, which must be reliable and
available when needed for making decisions. Without appropriate information, decisions
relating to finance, management, marketing, and accounting could prove disastrous.
 Different types of information require different information systems, so information system
specialists work with financial managers to determine what information is needed, how it
should be stored, how it should be delivered, and how information management will affect the
profitability of the firm.
5. Economics:
 Most noticeable difference between finance and economics is that financial managers evaluate
information and make decisions about cash flows associated with a particular firm or a small
group of firms, whereas economists analyze information and forecast changes in activities
associated with entire industries and the economy as a whole.
 It is important that financial managers understand economics and that economists understand
finance - economic activity and policy impact financial decisions, and vice versa.

Finance in the Organizational Structure of the Firm

 Chief financial officer (CFO; often called the vice president of finance) - reports to the president.
 The financial vice president’s key subordinates are the treasurer and the controller.
 In most firms, the treasurer has direct responsibility for managing the firm’s cash and marketable
securities, planning how the firm is financed and when funds are raised, managing risk, and
overseeing the corporate pension fund. Also supervises the credit manager, the inventory
manager, and the director of capital budgeting, who analyzes decisions related to investments in
fixed assets.
 The controller is responsible for the activities of the accounting and tax departments.
Alternative Forms of Business Organization
Proprietorship
 An unincorporated business owned by one individual.
 Starting a proprietorship is fairly easy - just begin business operations.
 Three important advantages:
1. It is easily and inexpensively formed.
2. It is subject to few government regulations. Large firms that potentially threaten competition
are much more heavily regulated than small ‘‘mom-and-pop’’ businesses.
3. It is taxed like an individual, not a corporation; thus, earnings are taxed only once.
 Four important limitations:
1. The proprietor has unlimited personal liability for business debts. With unlimited personal
liability, the proprietor (owner) can potentially lose all of his or her personal assets, even those
assets not invested in the business; thus, losses can far exceed the money that he or she has
invested in the company.
2. A proprietorship’s life is limited to the time the individual who created it owns the business.
When a new owner takes over the business, technically the firm becomes a new proprietorship
(even if the name of the business does not change).
3. Transferring ownership is somewhat difficult. Disposing of the business is similar to selling a
house in that the proprietor must seek out and negotiate with a potential buyer.
4. It is difficult for a proprietorship to obtain large sums of capital because the firm’s financial
strength generally is based on the financial strength of the sole owner.
 Most large businesses start out as proprietorships and then convert to corporations when their
growth causes the disadvantages of being a proprietorship - namely, unlimited personal liability -
to outweigh the advantages.

Partnership
 An unincorporated business owned by two or more people.
 Partnerships can operate under different degrees of formality, ranging from informal, oral
understandings to formal agreements filed with the secretary of the state in which the
partnership does business.
 Most legal experts recommend that partnership agreements be put in writing.
 The advantages of a partnership are the same as for a proprietorship:
1. Formation is easy and relatively inexpensive.
2. It is subject to few government regulations.
3. It is taxed like an individual, not a corporation.
 The disadvantages are also similar to those associated with proprietorships:
1. Owners have unlimited personal liability.
2. The life of the organization is limited.
3. Transferring ownership is difficult.
4. Raising large amounts of capital is difficult (reason why growth companies eventually change to
corporations).
 Under partnership law, each partner is liable for the debts of the business.
 If any partner is unable to meet his or her pro rata claim in the event the partnership goes
bankrupt, the remaining partners must make good on the unsatisfied claims, drawing on their
personal assets if necessary.
Corporations
 A legal entity created by a state, separate and distinct from its owners and managers, having
unlimited life, easy transferability of ownership, and limited liability.
 Four major advantages:
1. A corporation can continue after its original owners and managers no longer have a
relationship with the business; thus it has an unlimited life.
2. Ownership interests can be divided into shares of stock, which in turn can be transferred far
more easily than can proprietorship or partnership interests.
3. A corporation offers its owners limited liability.
4. The first three factors - unlimited life, easy transferability of ownership interest, and limited
liability - make it much easier for corporations than for proprietorships or partnerships to raise
money in the financial markets.
 Two major disadvantages:
1. Setting up a corporation, as well as subsequent filings of required state and federal reports, is
more complex and time consuming than for a proprietorship or a partnership. When a
corporation is created, (a) a corporate charter must be filed with the secretary of the state in
which the firm incorporates; (b) a set of rules, called bylaws, must be drawn up by the founder.
2. Corporate earnings are subject to double taxation - the earnings of the corporation are taxed at
the corporate level, and then any earnings paid out as dividends are again taxed as income to
stockholders.
 Corporate Charter - A document filed with the secretary of the state in which a business is
incorporated that provides information about the company, including its name, address, directors,
and amount of capital stock.
 Bylaws - A set of rules drawn up by the founders of the corporation that indicate how the
company is to be governed; includes procedures for electing directors, the rights of the
stockholders, and how to change the bylaws when necessary.

Hybrid Business Forms - LLP, LLC, and S Corporation

Alternative business forms that include some of the advantages, as well as avoid some of the
disadvantages, of the three major forms of business have evolved over time.
Limited Liability Partnership (LLP)
 A partnership wherein one (or more) partner is designated the general partner(s) with unlimited
personal financial liability and the other partners are limited partners whose liability is limited to
amounts they invest in the firm.
 Only the general partners can participate in the management of the business. If a limited partner
becomes involved in the day-to-day management of the firm, then he or she no longer has the
protection of limited personal liability.

Limited Liability Company (LLC)

 Offers the limited personal liability associated with a corporation, but the company’s income is
taxed like a partnership (taxed only once through owners).
 The structure of the LLC is fairly flexible - owners generally can divide liability, management
responsibilities, ownership shares, and control of the business any way they please.
 Like a corporation, paperwork (articles of organization) must be filed with the state in which the
business is set up, and there are certain financial reporting requirements after the formation of an
LLC.
S Corporation
 A corporation with no more than 75 stockholders that elects to be taxed the same as
proprietorships and partnerships so that business income is taxed only once.
 The major differences between an S corporation and an LLC is that an LLC can have more than 75
stockholders and more than one type of stock.
 For the following reasons, the value of any business will be maximized if it is organized as a
corporation:
1. Limited liability reduces the risks borne by investors. Other things held constant, the lower the
firm’s risk, the higher its market value.
2. A firm’s current value is related to its future growth opportunities, and corporations can attract
funds more easily than can unincorporated businesses to take advantage of growth
opportunities.
3. Corporate ownership can be transferred more easily than ownership of either a proprietorship
or a partnership. Therefore, all else equal, investors would be willing to pay more for a
corporation than a proprietorship or partnership, which means that the corporate form of
organization can enhance the value of a business.

What Goal(s) Should Businesses Pursue?

 In general, every business owner wants the value of his or her investment in the firm to increase.
 Investors purchase the stock of a corporation because they expect to earn an acceptable return
on the money they invest.
 Managers should behave in a manner that is consistent with enhancing the firm’s value.
 Stockholder Wealth Maximization:
 The appropriate goal for management decisions; considers the risk and timing associated with
expected cash flows to maximize the price of the firm’s common stock.
 Requires efficient, low-cost plants that produce high quality goods and services that are sold at
the lowest possible prices.
 Requires the development of products that consumers want and need, so the profit motive
leads to new technology, new products, and new jobs.
 Necessitates efficient and courteous service, adequate stocks of merchandise, and well-located
business establishments.
 Managers who make the actual decisions are interested in their own personal satisfaction, in their
employees’ welfare, and in the good of the community and of society at large, BUT, stock price
maximization is the most important goal of most corporations.
 Aside from such illegal actions as attempting to form monopolies, violating safety codes, and
failing to meet pollution control requirements, the same actions that maximize stock prices also
benefit society.

Managerial Actions to Maximize Shareholder Wealth

 The value of any investment, such as a stock, is based on the amount of cash flows the asset is
expected to generate during its life.
 Investors prefer to receive a particular cash flow sooner rather than later.
 Investors generally are risk averse, which means that they are willing to pay more for investments
with more certain future cash flows than investments with less certain, or riskier, cash flows,
everything else equal.
 Managers can increase the value of a firm by making decisions that increase the firm’s expected
future cash flows, generate the expected cash flows sooner, increase the certainty of the
expected cash flows, or produce any combination of these actions.
 Managerial Decisions:
1. Capital Structure Decisions - Decisions about how much and what types of debt and equity
should be used to finance the firm.
2. Capital Budgeting Decisions - Decisions as to what types of assets should be purchased to help
generate future cash flows.
3. Dividend Policy Decisions - Decisions concerning how much of current earnings to pay out as
dividends rather than retain for reinvestment in the firm.
 Although managerial actions affect the value of a firm’s stock, external factors also influence stock
prices (legal constraints, the general level of economic activity, tax laws, and conditions in the
financial markets).
 Value - The present, or current, value of the cash flows an asset is expected to generate in the
future.

Should Earnings Per Share (EPS) Be Maximized?

 Profit Maximization - Maximization of the firm’s net income.
 Earnings Per Share (EPS) - Net income divided by the number of shares of common stock
outstanding.
 Many investors use EPS to gauge the value of a stock.
 EPS can be used as a barometer for measuring the firm’s potential for generating future cash
flows.
 Financial managers who attempt to maximize earnings might not maximize value because
earnings maximization is a shortsighted goal.
 Timing is an important reason to concentrate on wealth as measured by the price of the stock
rather than on earnings alone.
 The firm’s stock price, and thus its value, is dependent on:
1. The cash flows the firm is expected to provide in the future.
2. When these cash flows are expected to occur.
3. The risk associated with these cash flows.

Managers’ Roles as Agents of Stockholders

 Since stockholders are not involved in the day-to-day operations, they ‘‘permit’’ (empower) the
managers to make decisions as to how the firms are run.
 At times, managers’ interests can potentially conflict with stockholders’ interests.
 An Agency Relationship exists when one or more individuals, who are called the principals, hire
another person, the agent, to perform a service and delegate decision making authority to that
agent.
 Agency Problem - A potential conflict of interest between outside shareholders (owners) and
managers who make decisions about how to operate the firm.
 The potential for agency problems is greatest in large corporations with widely dispersed
ownership because individual stockholders own very small proportions of the companies and
managers have little, if any, of their own wealth tied up in these companies.
 Managers might be more concerned about pursuing their own agendas, such as increased job
security, higher salary, or more power, than maximizing shareholder wealth.
 Several mechanisms are used to motivate managers to act in the shareholders’ best interests:
1. Managerial compensation (incentives). A common method used to motivate managers to
operate in a manner consistent with stock price maximization is to tie managers’
compensation to the company’s performance. Often the reward that managers receive is the
stock of the company. If managers own stock in the company, they are motivated to make
decisions that will increase the firm’s value and thus the value of the stock they own. All
incentive compensation plans are designed to accomplish two things: (a) provide
inducements to executives to act on those factors under their control in a manner that will
contribute to stock price maximization and (b) attract and retain top-level executives.
2. Shareholder intervention. Many institutional investors routinely monitor top corporations to
ensure that managers pursue the goal of wealth maximization. When action is needed to
‘‘realign’’ management decisions with the interests of investors, these institutional investors
exercise their influence by suggesting possible remedies to management or by sponsoring
proposals that must be voted on by stockholders at the annual meeting. In situations where
large blocks of the stock are owned by a relatively few large institutions, such as pension
funds and mutual funds, and they have enough clout to influence a firm’s operations, these
institutional owners often have enough voting power to overthrow management teams that
do not act in the best interests of stockholders.
3. Threat of takeover. Hostile takeovers, instances in which management does not want the firm
to be taken over, are most likely to occur when a firm’s stock is undervalued relative to its
potential, which often is caused by poor management. In a hostile takeover, the managers of
the acquired firm generally are fired, and those who do stay on typically lose the power they
had prior to the acquisition.
 Wealth maximization is a long-term goal, not a short-term goal.
 When executives are rewarded for maximizing the price of the firm’s stock, the reward should be
based on the long-run performance of the stock.

Business Ethics
 Business Ethics are a company’s attitude and conduct toward its stakeholders - employees,
customers, stockholders, and so forth; ethical behavior requires fair and honest treatment of all
parties.
 Ethics – standards of conduct/moral behavior.
 High standards of ethical behavior demand that a firm treat each party with which it deals in a fair
and honest manner.
 A firm’s commitment to business ethics can be measured by the tendency of the firm and its
employees to adhere to laws and regulations relating to such factors as product safety and
quality, fair employment practices, fair marketing and selling practices, the use of confidential
information for personal gain, community involvement, bribery, and illegal payments to foreign
governments to obtain business.
 Congress passed the Sarbanes-Oxley Act of 2002 because investors felt that executives were
pursuing interests that too often resulted in large gains for themselves and large losses for
stockholders.
 Ethical behavior:
1. Prevents fines and legal expenses.
2. Builds public trust.
3. Attracts business from customers who appreciate and support ethical policies.
4. Attracts and keeps employees of the highest caliber.
5. Supports the economic viability of the communities where these firms operate.
Sarbanes-Oxley Act
 Established standards for accountability and responsibility of reporting financial information for
major corporations.
 The act provides that a corporation must:
1. Have a committee that consists of outside directors to oversee the firm’s audits.
2. Hire an external auditing firm that will render an unbiased (independent) opinion concerning
the firm’s financial statements.
3. Provide additional information about the procedures used to construct and report financial
statements.
 The firm’s CEO and CFO must certify financial reports submitted to the Securities and Exchange
Commission.
 The act also stiffens the criminal penalties that can be imposed for producing fraudulent financial
information and provides regulatory bodies with greater authority to enact prosecution for such
actions.

Corporate Governance
 Corporate Governance - The ‘‘set of rules’’ that a firm follows when conducting business; these
rules identify who is accountable for major financial decisions.
 It is important for a firm to clearly specify its corporate governance structure so that individuals
and entities that have an interest in the well-being of the business understand how their interests
will be pursued.
 Stakeholders - Those who are associated with a business; stakeholders include mangers,
employees, customers, suppliers, creditors, stockholders, and other parties with an interest in the
firm.
 Good corporate governance includes a board of directors with members that are independent of
the company’s management.
 An independent board generally serves as a ‘‘checks and balances’’ system that monitors
important management decisions, including executive compensation.
 It has also been shown that firms that develop governance structures that make it easier to
identify and correct accounting problems and potentially unethical or fraudulent practices
perform better than firms that have poor governance policies (internal controls).

Multinational Corporations
 A firm that operates in two or more countries.
 Multinational firms make direct investments in fully integrated operations, with worldwide
entities controlling all phases of the production process, from extraction of raw materials, through
the manufacturing process, to distribution to consumers throughout the world. Thus controlling a
large and growing share of the world’s technological, marketing, and productive resources.
 Advantages:
1. To seek new markets. After saturated markets at home, growth opportunities often are better
in foreign markets.
2. To seek raw materials.
3. To seek new technology. No single nation holds a commanding advantage in all technologies,
so companies scour the globe for leading scientific and design ideas.
4. To seek production efficiency. Companies in countries where production costs are high tend to
shift production to low-cost countries.
5. To avoid political and regulatory hurdles.
Multinational versus Domestic Managerial Finance
 Exchange Rates - The prices at which the currency from one country can be converted into the
currency of another country.
 Six major factors distinguish managerial finance as practiced by firms operating entirely within a
single country from management by firms that operate in several different countries:
1. Different currency denominations. Cash flows in various parts of a multinational corporate
system often are denominated in different currencies. Hence, an analysis of exchange rates
and the effects of fluctuating currency values must be included in all financial analyses.
2. Economic and legal ramifications. Each country in which the firm operates has its own unique
political and economic institutions, and institutional differences among countries can cause
significant problems when a firm tries to coordinate and control the worldwide operations of
its subsidiaries. Also, differences in legal systems of host nations complicate many matters,
from the simple recording of a business transaction to the role played by the judiciary in
resolving conflicts. Such differences can restrict multinational corporations’ flexibility to deploy
resources as they wish and can even make procedures illegal in one part of the company that
are required in another part. These differences also make it difficult for executives trained in
one country to operate effectively in another.
3. Language differences. The ability to communicate is critical in all business transactions.
4. Cultural differences. Even within geographic regions long considered fairly homogeneous,
different countries have unique cultural heritages that shape values and influence the role of
business in the society. Multinational corporations find that such matters as defining the
appropriate goals of the firm, attitudes toward risk taking, dealing with employees, and the
ability to curtail unprofitable operations can vary dramatically from one country to the next.
5. Role of governments. Most traditional models in finance assume the existence of a competitive
marketplace in which the terms of trade are determined by the participants. The government,
through its power to establish basic ground rules, is involved in this process, but its
participation is minimal. Thus, the market provides both the primary barometer of success and
the indicator of the actions that must be taken to remain competitive. Frequently, the terms
under which companies compete, the actions that must be taken or avoided, and the terms of
trade on various transactions are determined not in the marketplace but by direct negotiation
between the host government and the multinational corporation.
6. Political risk. The distinguishing characteristic that differentiates a nation from a multinational
corporation is that the nation exercises sovereignty over the people and property in its
territory. Hence, a nation is free to place constraints on the transfer of corporate resources and
even to expropriate the assets of a firm without compensation. This is political risk, and it tends
to be largely a given rather than a variable that can be changed by negotiation. Political risk
varies from country to country, and it must be addressed explicitly in any financial analysis.