Ch1 Financial Management Gitman 97 to 4

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Chapter OneIntroduction to Managerial Finance

Md. Rizvy Ahmed

Lecturer

Faculty of Business Administration

Eastern University

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Learning Goals

LG1 – Define finance and describe its major areas and career opportunities.

LG2 – Review basic forms of business organization, their strengths and weaknesses.

LG3 – Describe managerial finance function and differentiate from economics and accounting.

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Learning Goals (continued)

LG4 – Identify key activities of financial manager within the firm.

LG5 – Explain why wealth maximization is firm’s goal.

LG6 – Explain how EVA, stakeholder focus, and ethical behavior relate to firm’s goal.

LG7 – Discuss agency issue as it relates to owner wealth maximization.

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What is Finance?• Finance is concerned with the process, institutions,

market and instruments involved in the transfer of money among individuals, business and governments.

• Financial markets, financial intermediaries, and financial management are the important components.

• Financial markets and financial intermediaries facilitate the flow of funds from borrowers to savers.

• Financial management involves the efficient use of financial resources in the production of goods.

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What is Finance?

• At the macro level, finance is the study of financial institutions and financial markets and how they operate within the financial system in global economies.

• At the micro level, finance is the study of financial planning, asset management, and fund raising for businesses and financial institutions.

• Financial management can be described in brief using the following balance sheet.

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What is Finance?

Assets: Liabilities & Equity:

Current Assets Current Liabilities

Cash & M.S. Accounts payable

Accounts receivable Notes Payable

Inventory Total Current Liabilities

Total Current Assets Long-Term Liabilities

Fixed Assets: Total Liabilities

Gross f ixed assets Equity:

Less: Accumulated dep. Common Stock

Goodw ill Paid-in-capital

Other long-term assets Retained Earnings

Total Fixed Assets Total Equity

Total Assets Total Liabilities & Equity

WorkingCapital

WorkingCapital

InvestmentDecisions

FinancingDecisions

Macro Finance

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Areas of Specialization in Finance

• Financial Markets– Markets of users and savers of funds.

• Financial Services– Design and delivery of financial advice and

products to individuals, businesses, government.

• Managerial Finance– Financial management of business firms.

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Areas of Employment in Finance

• Financial Analyst

• Capital budgeting analyst/manager

• Project finance manager

• Cash manager

• Credit analyst/manager

• Pension fund manager

© 2005 Pearson Education Canada Inc. 1-9

Basic Forms of Business Organization

• Sole Proprietorship– Owned by one person, operated for personal profit.

• Partnerships– Owned by two or more people, operated for joint

profit.

• Corporations– “Legal entity”, owned by individuals, operated for

joint profit.

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Sole Proprietorship

STRENGTHS:• Low organizational cost• Income taxed once as

personal income• Independence• Secrecy• Ease of dissolution

WEAKNESSES:• Unlimited liability• Limited funding• Proprietor must be all• Difficult to develop staff

career opportunities• Lack of continuity on

death of proprietor

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Partnerships

STRENGTHS:• Improved funding sources

than sole proprietorship• Borrowing power enhanced

by more owner• Increased managerial talent• Income split by partnership

contract, taxed as personal income

WEAKNESSES:

• Unlimited liability to all partners

• Partnership dissolved upon death of partner

• Difficult to liquidate or transfer ownership

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Corporations

STRENGTHS:

• Owners own liability

• Large capitalization possible, greater funding

• Ownership readily transferable

• Indefinite life

• Professional management

• Receive tax advantage and has better access to finance.

WEAKNESSES:

• Higher corporate tax rates as well as dividend paid is also taxed.

• More expensive to organization than other business forms

• Greater government regulation

• When publicly traded, lacks secrecy

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Corporate Organization Chart

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Organization of Finance Functions• The importance of managerial finance function depends on the size of the firm.• CFO – Chief Financial Officer• Treasurer responsibilities:

– Financial planning, fund raising, capital expenditure decisions, cash and credit management.

– The treasurer’s focus tends to be more external, the controller’s focus more internal.

• Controller responsibilities:– Corporate accounting, cost accounting, and tax management.

•Foreign Exchange manager

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Relationship to Economics

Economic theories:

– Supply and Demand analysis

– Profit maximizing Strategies

Fundamental Economic Principle:

• Marginal Analysis

– Financial decisions should be made and actions taken only when the added benefits exceed the added costs.

Example• Jamie Teng is a financial manager for Nord Department

Stores, a large chain of upscale department stores operating primarily in the western United States. She is currently trying to decide whether to replace one of the firm’s online computers with a new, more sophisticated one that would both speed processing and handle a larger volume of transactions. The new computer would require a cash outlay of $80,000, and the old computer could be sold to net $28,000. The total benefits from the new computer (measured in today’s dollars) would be $100,000. The benefits over a similar time period from the old computer (measured in today’s dollars) would be $35,000.

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Example Benefit with new computer

1,00,000

Less: Benefit with old computer

35,000

Marginal benefit 65,000

Cost of new computer

80,000

Less: Proceed from sale of old computer

28,000

Marginal Added cost 52,000

Net Benefit 13,000

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Relationship to Accounting

• Cash Flows– Accrual Basis: recognizes sales revenue and

expenses incurred to make sale at time of sale.– Cash Basis: recognizes revenues and expenses

as they occur.

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Accounting vs. Financial ViewsAccounting View(Accrual Basis)

Income StatementPeakes Quay, Inc.

For year ended 12/31

Financial View(Cash Basis)

Cash Flow StatementPeakes Quay, Inc.

For year ended 12/31

Sales revenue $100,000Less: Costs 80,000Net Profit $ 20,000

Cash inflow $ 0Less: Cash outflow 80,000Net cash flow ($80,000)

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Financial Manager–Key Activities

Balance Sheet

CurrentAssets

_______________FixedAssets

CurrentLiabilities

_______________Long-Term Funds(Debt & Equity)

Financial Analysis & Planning

MakingInvestmentDecisions

MakingFinancingDecisions

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Goal of the Firm: Should Firms Maximize Profit?

• Corporations commonly define profit as “Earnings per Share” (EPS).– A measure of total available earnings for shareholder

by total number of ownership shares.

• Profit Maximization goal fails for 3 critical factors– the timing of the returns.– Future cash flows , ex- may have higher earnings by

reducing R&D expenditure– risk factors facing the firm.

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Or Should Firms Maximize Shareholder Wealth?

• Evaluating Shareholder Wealth addresses factors of timing, cash flows and risk ignored by the EPS.

• Therefore, Maximizing Shareholder Wealth is a more comprehensive goal for the firm, its managers and employees.

• This can be explored through “economic valued added” and a focus on stakeholders.

Two important issues related to maximize share price

1. EVA

2. Focus on stakeholder

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1. Economic Value Added – EVA®

• EVA measures whether an investment contributes to shareholder wealth.

• EVA is calculated by subtracting cost of funds used from after-tax operating profits.

• While popular, EVA is essentially derived from the concept of “net present value.”

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2. What about Stakeholders?• Stakeholders include groups that have direct

economic links to the firm.• Wealth maximization cant be possible as

long as other stakeholder has got conflict.• Maintaining positive stakeholder

relationships helps maximize long-term benefits to shareholders and the goal is not to maximize it rather preserve it.

• Example: CSR

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Importance of EthicsThe standards of conduct or moral judgment:• Honesty, trustworthiness, fair dealing are

foundations of sustainable business relations:– With customers,– With suppliers,– With creditors,– With employees,– With owners.

• Ethical behaviour is necessary to achieve the goal of maximizing shareholder wealth.

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Internal Ethical Review

• Are rights of stakeholders being violated?• Does firm have extra duties to stakeholders?• Will a decision unfairly discriminate benefits

among stakeholders?• If stakeholders are harmed, should this be

remedied? How?• What is the relationship between shareholders

and stakeholders?

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Financial Goals of a Company

• Maximize sales.• Maximize cash flow.• Maximize market

share.• Maximize profit.• Minimize costs.

• Maximize return on sales, investment, equity.

• Ensure earnings stability.

• Achieve target goals for sales, profits, market share or return.

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Agency Issues: The Principal-Agent Problem

• 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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Resolving the Agency Problem

• Good corporate governance by the Board of Directors is the heart of any resolution.

• Agency Costs – the costs of this governance:– Monitoring costs,– Bonding costs,– Structuring compensation costs.

• Market forces, such as the potential for hostile takeover provide some prevention

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Current View on Incentive Plans

• Executive compensation packages generally include incentive plans that grant stock options, performance-based shares, or cash bonuses upon meeting or exceeding corporate goals.

• Such packages may also include long-term benefits that can protect the manager against poor corporate performance.

Financial Institutions and Market• Financial institution: An intermediary that

channels the savings of individuals, businesses, and governments into loans or investments.

• Key customers of Financial Institutions:– Individuals– Businesses – Government

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Major Financial Institutions

• Commercial Banks

• NBFI’s

• Insurance Companies

• Pension funds

• Mutual Fund

• Credit Union & Savings Banks

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Financial Markets

• Financial markets are forums in which suppliers of funds and demanders of funds can transact business directly.

• Two key markets are– Money market– Capital market

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Money market

• Transactions in short-term debt instruments, or marketable securities, take place in the money market.

• marketable securities means Short-term debt instruments, such as U.S. Treasury bills, commercial paper, and negotiable certificates of deposit issued by government, business, and financial institutions, respectively.

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Capital market

• Long-term securities—bonds and stocks—are traded in the capital market.

• In Capital market to raise money, firms can use either – private placements or – public offerings.

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Capital market

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Some key Concept

• Eurocurrency Market• LIBOR• Bond• Preferred stock• SEC• OTC market• Eurobond Market• Foreign Bond and International Equity Market

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Eurocurrency Market• The international equivalent of the domestic

money market is called the Eurocurrency market. • This is a market for short-term bank deposits

denominated in U.S. dollars or other easily convertible currencies.

• Historically, the Eurocurrency market has been centered in London, but it has evolved into a truly global market.

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Eurobond Market

• The market in which corporations and governments typically issue bonds denominated in dollars and sell them to investors located outside the United States.

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Foreign Bond

• Bond that is issued by a foreign corporation or government and is denominated in the investor’s home currency and sold in the investor’s home market.

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