The Role of Managerial Finance Legal Forms of Business Organization

1.1 Finance and Business The three most common legal forms of
business organization are sole proprietorship,
The field of finance is broad and
partnership, and corporation. More businesses
dynamic. Finance influences everything that
are organized as sole proprietorships than any
firms do, from hiring personnel to building
other legal form. However, the largest
factories to launching new advertising
businesses are almost always organized as
campaigns.
corporations. Even so, each type of organization
What is Finance?
has its advantages and disadvantages.
Finance can be defined as the science
1. Sole Proprietorship – a business owned by one
and art of managing money. In a business
person who operates it for his or her own profit.
context, finance involves the same types of
The typical sole proprietorship is small, such as a
decisions: how firms raise money from investors,
bike shop, personal trainer, or plumber. The
how firms invest money in an attempt to earn a
majority of sole proprietorships operate in the
profit, and how they decide whether to reinvest
wholesale, retail, service, and construction
profits in the business or distribute them back to
industries.
investors.
Typically, the owner (proprietor), along
Career Opportunities in Finance with a few employees, operates the
Careers in finance typically fall into one proprietorship. The proprietor raises capital from
of two broad categories: (1) financial services personal resources or by borrowing, and he or
and (2) managerial finance. Workers in both she is responsible for all business decisions. As a
areas rely on a common analytical “tool kit,” but result, this form of organization appeals to
the types of problems to which that tool kit is entrepreneurs who enjoy working independently.
applied vary a great deal from one career path A major drawback to the sole
to the other. proprietorship is unlimited liability, which means
1.) Financial Services – is the area of finance that the liabilities of the business are the
concerned with the design and delivery entrepreneur’s responsibility, and creditors can
of advice and financial products to make claims against the entrepreneur’s
individuals, businesses, and personal assets if the business fails to pay its
governments. It involves a variety of debts.
interesting career opportunities within 2. Partnership – consists of two or more owners
the areas of banking, personal financial doing business together for profit. Partnerships
planning, investments, real estate, and account for about 7 percent of all businesses,
insurance. and they are typically larger than sole
2.) Managerial Finance – is concerned with proprietorships. Partnerships are common in the
the duties of the financial manager finance, insurance, and real estate industries.
working in a business. Financial Public accounting and law partnerships often
Managers administer the financial affairs have large numbers of partners.
of all types of businesses—private and Most partnerships are established by a
public, large and small, profit-seeking written contract known as articles of partnership.
and not-for-profit. They perform such In a general (or regular) partnership, all partners
varied tasks as developing a financial have unlimited liability, and each partner is
plan or budget, extending credit to legally liable for all of the debts of the
customers, evaluating proposed large partnership.
expenditures, and raising money to fund
3. Corporation – is an entity created by law. A
the firm’s operations.
corporation has the legal powers of an
individual in that it can sue and be sued, make described previously. What they have in
and be a party to contracts, and acquire common is that their owners enjoy limited
property in its own name. liability, and they typically have fewer than 100
The owners of a corporation are its owners.
stockholders, whose ownership, or 1.2 Goal of the Firm
equity takes the form of either common stock or
preferred stock. Unlike the owners of sole Maximize Shareholder Wealth

proprietorships or partnerships, stockholders of Finance teaches that managers’ primary

a corporation enjoy limited liability, meaning goal should be to maximize the wealth of the
that they are not personally liable for the firm’s firm’s owners—the stockholders. The simplest
debts. Their losses are limited to the amount and best measure of stockholder wealth is the
they invested in the firm when they purchased firm’s share price.
shares of stock. Common stock is the purest and The goal of the firm, and also of
most basic form of corporate ownership. managers, should be to maximize the wealth of
Stockholders expect to earn a return by the owners for whom it is being operated, or
receiving dividends—periodic distributions of equivalently, to maximize the stock price. This
cash—or by realizing gains through increases in goal translates into a straightforward decision
share price. Because the money to pay rule for managers—only take actions that are
dividends generally comes from the profits that expected to increase the share price. Although
a firm earns, stockholders are sometimes that goal sounds simple, implementing it is not
referred to as residual claimants, meaning that always easy. To determine whether a particular
stockholders are paid last—after employees, course of action will increase or decrease a
suppliers, tax authorities, and lenders receive firm’s share price, managers have to assess
what they are owed. If the firm does not what return (that is, cash inflows net of cash
generate enough cash to pay everyone else, outflows) the action will bring and how risky that
there is nothing available for stockholders return might be. In fact, we can say that the key
The stockholders (owners) vote variables that managers must consider when
periodically to elect members of the board of making business decisions are return (cash
directors and to decide other issues such as flows) and risk.
amending the corporate charter. The board of Maximize Profit
directors is typically responsible for approving Corporations commonly measure profits
strategic goals and plans, setting general policy, in terms of earnings per share (EPS), which
guiding corporate affairs, and approving major represents the amount earned during the period
expenditures. on behalf of each outstanding share of common
The president or chief executive officer stock. EPS is calculated by dividing the period’s
(CEO) is responsible for managing day-to-day total earnings available for the firm’s common
operations and carrying out the policies stockholders by the number of shares of
established by the board of directors. The CEO common stock outstanding.
reports periodically to the firm’s directors. But does profit maximization lead to the
4. Other Limited Liability Organizations – a highest possible share price? For at least three
number of other organizational forms provide reasons the answer is often no.
owners with limited liability. The most popular 1. Timing - because the firm can earn a return on
are limited partnership (LP), S corporation (S funds it receives, the receipt of funds sooner
corp), limited liability company (LLC), and rather than later is preferred.
limited liability partnership (LLP). Each
2. Cash Flows – profits do not necessarily result
represents a specialized form or blending of the
in cash flows available to the stockholders. There
characteristics of the organizational forms
is no guarantee that the board of directors will insider trading, fraud, excessive executive
increase dividends when profits increase. In compensation, options backdating, bribery, and
addition, the accounting assumptions and kickbacks.
techniques that a firm adopts can sometimes 1. Considering Ethics – considering such
allow a firm to show a positive profit even when questions before taking an action can help to
its cash outflows exceed its cash inflows. ensure its ethical viability.
3. Risk – profit maximization also fails to account 2. Ethics and Share Price – An effective ethics
for risk—the chance that actual outcomes may program can enhance corporate value by
differ from those expected. A basic premise in producing a number of positive benefits. It can
managerial finance is that a trade-off exists reduce potential litigation and judgment costs,
between return (cash flow) and risk. Return and maintain a positive corporate image, build
risk are, in fact, the key determinants of share shareholder confidence, and gain the loyalty,
price, which represents the wealth of the commitment, and respect of the firm’s
owners in the firm. stakeholders.
Simply put, the increased risk reduced 1.3 Managerial Finance Function
the firm’s share price. In general, stockholders
are risk averse—that is, they must be Organization of the Finance Function

compensated for bearing risk. In other words, The size and importance of the
investors expect to earn higher returns on riskier managerial finance function depend on the size
investments, and they will accept lower returns of the firm. In small firms, the finance function is
on relatively safe investments. generally performed by the accounting
department. As a firm grows, the finance
What About Stakeholders?
function typically evolves into a separate
Although maximization of shareholder
department linked directly to the company
wealth is the primary goal, many firms broaden
president or CEO through the chief financial
their focus to include the interests of
officer (CFO).
stakeholders as well as shareholders.
Reporting to the CFO is the treasurer and
Stakeholders are groups such as employees,
the controller. The treasurer (the chief financial
customers, suppliers, creditors, owners, and
manager) typically manages the firm’s cash,
others who have a direct economic link to the
investing surplus funds when available and
firm. A firm with a stakeholder focus consciously
securing outside financing when needed. The
avoids actions that would prove detrimental to
treasurer also oversees a firm’s pension plans
stakeholders. The goal is not to maximize
and manages critical risks related to
stakeholder well-being but to preserve it.
movements in foreign currency values, interest
The stakeholder view does not alter the
rates, and commodity prices. The controller (the
goal of maximizing shareholder wealth. Such a
chief accountant) typically handles the
view is often considered part of the firm’s “social
accounting activities, such as corporate
responsibility.” It is expected to provide long-run
accounting, tax management, financial
benefit to shareholders by maintaining positive
accounting, and cost accounting. The
relationships with stakeholders.
treasurer’s focus tends to be more external,
The Role of Business Ethics whereas the controller’s focus is more internal.
Business ethics are the standards of If international sales or purchases are
conduct or moral judgment that apply to important to a firm, it may well employ one or
persons engaged in commerce. Violations of more finance professionals whose job is to
these standards in finance involve a variety of monitor and manage the firm’s exposure to
actions: “creative accounting,” earnings losses from currency fluctuations. These foreign
management, misleading financial forecasts,
exchange managers typically report to the firm’s expenses only with respect to actual inflows and
treasurer. outflows of cash. Whether a firm earns a profit or

Relationship to Economics experiences a loss, it must have a sufficient flow

of cash to meet its obligations as they come
Financial managers must understand the
due.
economic framework and be alert to the
consequences of varying levels of economic 2. Decision Making – the second major
activity and changes in economic policy. They difference between finance and accounting has
must also be able to use economic theories as to do with decision-making. Accountants devote
guidelines for efficient business operations. most of their attention to the collection and
Examples include supply-and-demand analysis, presentation of financial data. Financial
profit-maximizing strategies, and price theory. managers evaluate the accounting statements,
The primary economic principle used in develop additional data, and make decisions on
managerial finance is marginal cost-benefit the basis of their assessment of the associated
analysis, the principle that financial decisions returns and risks.
should be made and actions taken only when Primary Activities of the Financial Manager
the added benefits exceed the added costs. The financial manager’s primary
Relationship to Accounting activities are making investments and financing
The firm’s finance and accounting decisions. Investment decisions determine what
activities are closely related and generally types of assets the firm holds. Financing
overlap. In small firms, accountants often carry decisions determine how the firm raises money
out the finance function, and in large firms, to pay for the assets in which it invests.
financial analysts often help compile
accounting information. However, there are two
basic differences between finance and
accounting; one is related to the emphasis on
cash flows and the other to decision-making.

1. Emphasis on Cash Flows - the accountant’s 1.4 Governance and Agency

primary function is to develop and report data Corporate Governance

for measuring the performance of the firm,
Corporate governance refers to the rules,
assess its financial position, comply with and file
processes, and laws by which companies are
reports required by securities regulators, and file
operated, controlled, and regulated. It defines
and pay taxes. Using generally accepted
the rights and responsibilities of the corporate
accounting principles, the accountant prepares
participants such as the shareholders, board of
financial statements that recognize revenue at
directors, officers and managers, and other
the time of sale (whether payment has been
stakeholders, as well as the rules and
received or not) and recognize expenses when
procedures for making corporate decisions.
they are incurred. This approach is referred to as
A firm’s corporate governance is
the accrual basis.
influenced by both internal factors such as
The financial manager, on the other
the shareholders, board of directors, and officers
hand, places primary emphasis on cash flows,
as well as external forces such as clients,
the intake and outgo of cash. He or she
creditors, suppliers, competitors, and
maintains the firm’s solvency by planning the
government regulations.
cash flows necessary to satisfy its obligations
and to acquire assets needed to achieve the Two Broad Classes of Owners
firm’s goals. The financial manager uses this 1. Individual Investors – own relatively small
cash basis to recognize the revenues and quantities of shares and as a result do
 not typically have sufficient means to principal-agent relationship. This arrangement
directly influence a firm’s corporate works well when the agent makes decisions that
governance. In order to influence the are in the principal’s best interest but doesn’t
firm, individual investors often find it work well when the interests of the principal and
necessary to act as a group by voting agent differ.
collectively on corporate matters. The The Agency Problem
most important corporate matter
This arises when managers deviate from
individual investors vote on is the election
the goal of maximizing shareholder wealth by
of the firm’s board of directors. The
placing their personal goals ahead of the goals
corporate board’s first responsibility is
of shareholders. These problems in turn give rise
with the shareholders.
to agency costs. Agency costs are costs borne
2. Institutional Investors – are investment
by shareholders due to the presence or
professionals who are paid to manage
avoidance of agency problems, and in either
and hold large quantities of securities on
case, represent a loss of shareholder wealth.
behalf of individuals, businesses, and
Management Compensation Price
governments. Institutional investors
include banks, insurance companies, corporate governance can be

mutual funds, and pension funds. strengthened by ensuring that managers’

interests are aligned with those of shareholders.
Government Regulation
A common approach is to structure
Government regulation generally shapes
management compensation to correspond with
the corporate governance of all firms. The
firm performance. In addition to combating
misdeeds are derived from two main types of
agency problems, the resulting performance-
issues: (1) false disclosures in financial reporting
based compensation packages allow firms to
and other material information releases and (2)
compete for and hire the best managers
undisclosed conflicts of interest between
available. The two key types of managerial
corporations and their analysts, auditors, and
compensation plans are incentive plans and
attorneys and between corporate directors,
performance plans.
officers, and shareholders.
1. Incentive Plans – tie management
Sarbanes-Oxley Act of 2002 (SOX) is
compensation to share price. One
intended to eliminate many of the disclosure
incentive plan grants stock options to
and conflict of interest problems that can arise
management. If the firm’s stock price
when corporate managers are not held
rises over time, managers will be
personally accountable for their firm’s financial
rewarded by being able to purchase
decisions and disclosures.
stock at the market price in effect at the
The Agency Issues time of the grant and then to resell the
We know that the duty of the financial shares at the prevailing higher market
manager is to maximize the wealth of the price.

firm’s owners. Shareholders give managers 2. Performance Plans – tie management

decision-making authority over the firm; thus, compensation to performance measures

managers can be viewed as the agents of the such as earnings per share (EPS) or

firm’s shareholders. Technically, any manager growth in EPS. Compensation under

who owns less than 100 percent of the firm is an these plans is often in the form of

agent acting on behalf of other owners. performance shares or cash bonuses.

Principal-agent relationship, where the Performance shares are shares of stock

shareholders are the principals. In general, a given to management as a result of

contract is used to specify the terms of a meeting the stated performance goals,
 whereas cash bonuses are cash cannot exist for very long. Given that
payments tied to the achievement of somewhat bleak scenario, how can
certain performance goals. managers find good projects – that is,

The Threat of Takeover projects that provide more than their

expected rate of return given their risk
When a firm’s internal corporate
level.
governance structure is unable to keep agency
6. Efficient Capital Markets – the markets
problems in check, it is likely that rival managers
are quick, and the prices are right.
will try to gain control of the firm. Because
7. The Agency Problem – managers won’t
agency problems represent a misuse of the
work for owners unless it’s in their best
firm’s resources and impose agency costs on
interest.
the firm’s shareholders, the firm’s stock is
8. Taxes bias Business Decisions – hardly
generally depressed, making the firm an
any decision is made by the financial
attractive takeover target. The threat of takeover
manager without considering the impact
by another firm that believes it can enhance the
of taxes.
troubled firm’s value by restructuring its
9. All Risks are not Equal – some risks can
management, operations, and financing can
be diversified away, and some cannot.
provide a strong source of external corporate
“Don’t put all of your eggs in one basket”.
governance. The constant threat of a takeover
Diversification allows good and bad
tends to motivate management to act in the
events to cancel each other out and thus
best interests of the firm’s owners.
reduce risk.
Principles of Financial Management
10. Ethical Behavior is doing the right thing,
Financial management is crucial for the and ethical dilemmas are everywhere in
success and stability of any organization. It’s finance. – the problem is that each
more than just managing finances; it’s about person has his or her own set of values,
making strategic choices that promote growth which forms the basis for their personal
and guarantee long-term viability. judgments about what is right and what
1. The Risk-Return Trade-off– we won’t take is wrong. However, every society adopts a
on additional risk unless we expect to be set of rules or laws that prescribe what
compensated with additional return. ‘doing the right thing’ involves.
2. Principle of Time Value of Money - this
principle states that a dollar today is
worth more than a dollar in the future
due to its potential earning capacity.
3. Cash – not profit – is king - when
measuring wealth or value, cash flows,
not accounting profits, are generally
used/recognized as a measurement tool.
4. Incremental Cash Flows – it’s only what
changes that counts. Incremental cash
flows is an additional operating cash that
a company earns when accepting a new
project.
5. The Curse of Competitiveness Markets –
why it’s hard to find exceptionally
valuable projects. In competitive
markets, extremely large profits simply