Managerial Finance FIN 745

Professor Dr Catherine S F Ho AC 5019 55445544-4792 catherine@salam.uitm.edu.my

Dr Catherine S F Ho

The Scope of Managerial Finance

Dr Catherine S F Ho

Learning Goals
1. Define finance and its major areas. 2. Describe the managerial finance function and its relationship to economics and accounting. 3. Identify the primary activities of the financial manager. 4. Explain the goal of the firm, corporate governance, the role of ethics, and the agency issue.

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What is Finance?
Finance can be defined as the art and science of managing money. Finance is concerned with the process, institutions, markets, and instruments involved in the transfer of money among individuals, businesses, and governments. Enable managers to make effective financial decisions
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Major Areas & 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 government. Career opportunities include banking, personal financial planning, investments, real estate, and insurance.
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Major Areas & Opportunities in Finance: Managerial Finance

Managerial finance is concerned with the duties of the financial manager in the business firm. The financial manager actively manages the financial affairs of any type of business, whether private or public, large or small, profit-seeking or profitnot-fornot-for-profit. They are also more involved in developing corporate strategy and improving the firms competitive position.
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Major Areas & 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 managers duties. Increasing globalization has complicated the financial management function by requiring them to be proficient in managing cash flows in different currencies and protecting against the risks inherent in international transactions. Changing economic and regulatory conditions also complicate the financial management function.
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Legal Forms of Business Organization

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Corporate Organization

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Other Limited Liability Organizations

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The Managerial Finance Function

The size and importance of the managerial finance function depends on the size of the firm. In small companies, the finance function may be performed by the company president or accounting department. As the business expands, finance typically evolves into a separate department linked to the president as was previously described in Figure 1.1.
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Major Functional Areas of Financial Management

Planning and Forecasting - appropriate goals,
objectives, and strategies

Controlling and Coordinating - analyzing financial

statements, cash flows, causes of problems and responsibilities

Investment and Financing Decisions appropriate mix of assets and liabilities

Understanding Financial Markets understand

the external financial environment to negotiate efficiently and effectively

Managing Price Risk - diversification and hedging

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The 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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The Managerial Finance Function: Relationship to Economics (cont.)

The primary economic principal used by financial managers is marginal costcostbenefit analysis which says that financial decisions should be implemented only when added benefits exceed added costs.

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Nord Department Stores is applying marginalmarginalcost benefit analysis to decide whether to replace a computer:

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The Managerial Finance Function: Relationship to Accounting

The firms finance (treasurer) and accounting (controller) functions are closelyclosely-related and overlapping. In smaller firms, the financial manager generally performs both functions.

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The Managerial Finance Function: Relationship to Accounting (cont.)

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. flows. The significance of this difference can be illustrated using the following simple example.
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The Managerial Finance Function: Relationship to Accounting (cont.)

The Nassau Corporation experienced the following activity last year:
Sales Costs $100,000 (1 yacht sold, 100% still uncollected) $ 80,000 (all paid in full under supplier terms)

Now contrast the differences in performance under the accounting method versus the cash method.
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The 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):

INCOME STATEMENT SUMMARY ACCRUAL Sales Less: Costs Net Profit/(Loss) $100,000 (80,000) $ 20,000
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CASH $ 0 (80,000) $(80,000)

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The Managerial Finance Function: Relationship to Accounting (cont.)

Finance and accounting also differ with respect to decision-making. decision-making. While accounting is primarily concerned with the presentation of financial data, the financial manager is primarily concerned with analyzing and interpreting this information for decisiondecisionmaking purposes. The financial manager uses this data as a vital tool for making decisions about the financial aspects of the firm.
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Finance and accounting also differ with respect to decision-making: decisionAccountants 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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Primary Activities of the Financial Manager

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Goal of the Firm: Maximize Profit?

Which Investment is Preferred?
Earnings per share (EPS) Investment Rotor Valve $ $ Year 1 1.40 0.60 $ $ Year 2 1.00 1.00 $ $ Year 3 0.40 1.40 $ $ Total (years 1-3) 2.80 3.00

Profit maximization fails to account for differences in the level of cash flows (as opposed to profits), the timing of these cash flows, and the risk of these cash flows.
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Goal of the Firm: Maximize Shareholder Wealth!

Why? Because maximizing shareholder wealth properly considers cash flows, the timing of these cash flows, and the risk of these cash flows. This can be illustrated using the following simple stock valuation equation: level & timing
of cash flows

Share Price = Future Dividends Required Return

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risk of cash flows

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Goal of the Firm: Maximize Shareholder Wealth! (cont.)

The process of shareholder wealth maximization can be described using the following flow chart:

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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.

2.

3.

Timing is importantthe receipt of funds sooner rather than later important is preferred Profits do not necessarily result in cash flows available to stockholders Profit maximization fails to account for risk
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Goal of the Firm: What About Other Stakeholders?

Stakeholders include all groups of individuals who have a direct economic link to the firm including employees, customers, suppliers, creditors, owners, and others who have a direct economic link to the firm. The "Stakeholder View" prescribes that the firm make a conscious effort to avoid actions that could be detrimental to the wealth position of its stakeholders. Such a view is considered to be "socially responsible."
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Corporate Governance
Corporate Governance is the system used to direct and control a corporation. It defines the rights and responsibilities of key corporate participants such as shareholders, the board of directors, officers and managers, and other stakeholders and and rules and procedures for making corporate decisions. Board of Directors sets policies that specify ethical practices and protect stakeholder interests. interests. Presence of institutional investors exert greater influence on CG through ability to affect stock prices

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Individual versus Institutional Investors

Individual investors are investors who purchase relatively small quantities of shares in order to earn a return on idle funds, build a source of retirement income, or provide financial security. Institutional investors are investment professionals who are paid to manage other peoples money. They hold and trade large quantities of securities for individuals, businesses, and governments and tend to have a much greater impact on corporate governance. Unlike individual investors, institutional investors often monitor and directly influence a firms corporate governance by exerting pressure on management to perform or communicating their concerns to the firmsCatherine S F Ho board. Dr 29

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 highcorporate scandals involving abuse of corporate power and, in some cases, alleged criminal activity by corporate officers.
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The Role of Ethics: Ethics Defined

Ethics is the standards of conduct or moral judgmenthave become an judgment overriding issue in both our society and the financial community Ethical violations attract widespread publicity Negative publicity often leads to negative impacts on a firm
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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 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:
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?
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The Role of Ethics: Ethics & 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. Ethical behaviour is necessary to achieve the goal of shareholder wealth maximization.
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The Agency Problem

Conflict of interest between owners and managers Agent person given decision-making power on behalf decisionof principal. Manager as agent of owners. Whenever a manager owns less than 100% of the firms equity, a potential agency problem exists. In theory, managers would agree with shareholder wealth maximization. However, managers are also concerned with their personal wealth, job security, fringe benefits, and lifestyle. This would cause managers to act in ways that do not always benefit the firm shareholders.
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A principal-agent relationship is an arrangement in principalwhich 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. 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 Dr Catherine with 36 compensation to correspond S F Ho firm performance

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. When a firms 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 firms value by restructuring its management, operations, and financing, can provide a strong source of external corporate governance.
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The Agency Issue: Resolving the Problem

Market Forces such as major shareholders and the threat of a hostile takeover act to keep managers in check. Agency Costs are the costs borne by stockholders to maintain a corporate governance structure that minimizes agency problems and contributes to the maximization of shareholder wealth.
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Institutional investors Market Forces Agency Issue: Resolving the Problem Agency Costs External Audit Costs Threat of takeovers

Management Compensation

Incentive Plans
Performance Plans

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Agency Relationship
Firms incur agency costs to prevent or minimize agency problems. It is unclear whether they are effective in practice. The four categories of agency cost are
monitoring expenditures incurred by the owners for audit and control procedures, bonding expenditures to protect against the potential consequences of dishonest acts by managers, structuring expenditures that use managerial compensation plans to provide financial incentives for managerial actions consistent with share price maximization, and opportunity costs resulting from the difficulties typically encountered by large organizations in responding to new opportunities.
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Agency Relationship
The agency problem and the associated agency costs can be reduced by a properly constructed and followed corporate governance structure. The structure of the governance system should be designed to institute a system of checks and balances to reduce the ability and incentives of management to deviate from the goal of shareholder wealth maximization.

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The Agency Issue: Resolving the Problem (cont.)

Examples would include bonding or monitoring management behavior, and structuring management compensation to make shareholders interests their own. A stock option is an incentive allowing managers to purchase stock at the market price set at the time of the grant.
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Agency Relationship
Structuring expenditures are currently the most popular way to deal with the agency problemand problem also the most powerful and expensive. Compensation plans can be either incentive or performance plans. Incentive plans tie management plans. performance to share price. Managers may receive stock options giving them the right to purchase stock at a set price. This provides the incentive to take actions that maximize stock price so that the price will rise above the options price level. This form of compensation plan has fallen from favor recently because market behavior, which has a significant effect on share price, is not under managements control.
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Agency Relationship
As a result, performance plans are more popular today. With these, compensation is based on performance measures, such as earnings per share (EPS), EPS growth, or other return ratios. Managers may receive performance shares and/or cash bonuses when stated performance goals are reached. In practice, recent studies have been unable to document any significant correlation between CEO compensation and share price.
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The Agency Issue: Resolving the Problem (cont.)

Performance plans tie management compensation to measures such as EPS growth; performance shares and/or cash bonuses are used as compensation under these plans. Recent studies have failed to find a strong relationship between CEO compensation and share price.
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LG1

Define finance and the managerial finance function.

Finance is the science and art of managing money. Managerial finance is concerned with the duties of the financial manager working in a business.

LG2 LG3

Describe the legal forms of business organization.

The legal forms of business organization are the sole proprietorship, the partnership, and the corporation.

Describe the goal of the firm, and explain why maximizing the value of the firm is an appropriate goal for a business.
The goal of the firm is maximize its value, and therefore the wealth of its shareholders. Maximizing the value of the firm means running the business in the interest of those who own it it the shareholders.

LG4

Describe how the managerial finance function is related to economics and accounting.
The financial manager must understand the economic environment and rely heavily on the economic principle of marginal cost cost benefit analysis to make financial decisions. Financial managers Dr Catherine S F Ho 46 use accounting but concentrate on cash flows and decision making.

LG5

Identify the primary activities of the financial manager.

The primary activities of the financial manager, in addition to ongoing involvement in financial analysis and planning, are making investment decisions and making financing decisions.

LG6

Describe the nature of the principle-agent relationship principlebetween the owners and managers of a corporation, and explain how various corporate governance mechanisms attempt to manage agency problems.
This separation of owners and managers of the typical firm is representative of the classic principal-agent relationship, where the principalshareholders are the principles and mangers are the agents. A firms corporate governance structure is intended to help ensure firm that managers act in the best interests of the firms shareholders, firm and other stakeholders, and it is usually influenced by both internal and external factors.

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