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CHAPTER 1

An Overview of Managerial
Finance

Concept of Finance and Managerial Finance


Types of Finance
Functions of Managerial Finance
Forms of Businesses
Goals of the Corporation
Principles of Finance
Agency Relationship
Business Ethics
Multinational vs Domestic Managerial
Finance

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Concept of Finance
The process of:
determining the required fund for an activity
or a purpose,
identifying the available sources for raising
the fund,
calculating the cost of each source,
collecting the fund from the minimum cost
source and
allocating the collected fund in such a way
that maximizes the target is called
finance.

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Types of Finance
1. Business finance: The process of determining the required fund for
an activity or a purpose by a business enterprise, identifying the
available sources for raising the fund, calculating the cost of each
source, collecting the fund from the minimum cost source and
utilizing the collected fund in such a way that maximizes the profit
is called finance.
2. Public/Government finance: The process of determining the
required fund for an activity or a purpose by the government of a
particular country, searching the available sources for collecting the
required fund, estimating the cost of each source, raising the fund
from the minimum cost source and disbursing the collected fund in
such a way that maximizes the welfare of the common people of
the country is called public finance.
3. Personal/Private finance: The process of determining the required
fund for an activity or a purpose by an individual, identifying the
available sources for raising the fund, calculating the cost of each
source separately, collecting the fund from the minimum cost
source and using the fund for maximizing personal and family

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Differences among Business,


Public and Private Finance
1.
2.
3.
4.
5.
6.
7.
8.

Definition
Objective
Sources of fund
Issuing new notes and coins
Foreign borrowings
Confidentiality
Bankruptcy
Income & expenditure decision

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Definition of Managerial
Finance
The process of determining the required fund
for a business purpose, identifying the
available sources for raising the fund,
calculating the cost of fund, collecting the
fund from the minimum cost source and
allocating the collected fund in such a way
that maximizes the profit and achieving

the target of the manager is called


managerial finance.
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Functions of Managerial
Finance

1. Procurement of funds: There are alternative


sources of fund like a company can take loan or it
can issue common stock, preferred stock,
debenture or bond to raise the fund required based
on cost minimization is the goal of financing.
Finance managers need to select the best possible
sources of funds among the different alternatives
called Capital structure Decision. Ordinary stock
holders are the owners of the firm (like they have
voting rights) but debtors are not the owners. So,
common stock is called Internal source; and bond,
debenture and loan are called external sources.
Purpose is also important in the choice of funds.
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Functions of Managerial
Finance
2. Utilization of funds: Capital Budgeting decision. Long
term investment decision is made on the basis of risk
and return. The goal is profit maximization. This is the
most important and challenging function of finance. To
predict future profit is difficult as Profit=TR-TC. TR=P.Q.
TC=FC+TVC.
3. Short term asset management: Working capital
management by considering liquidity and profitability.
4. Distribution of funds: Dividend policy decision.
Dividend policy, repurchase of shares and amortization
of debt.
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Alternative Forms of
Business Organization

Sole proprietorship
Partnership
Corporation

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Sole proprietorships &


Partnerships

Advantages

Ease of formation
Subject to few government regulations
No corporate income taxes

Disadvantages

Difficult to raise capital


Unlimited liability
Limited life
Lack of liquidity
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Corporation

Advantages

Unlimited life
Easy transfer of ownership
Limited liability
Raising huge capital
Formal monitoring by government agencies

Disadvantages

Double taxation
Cost of set-up and report filing
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Goals of the Corporation

The conventional goal of a firm is profitmaximization. However, since profit is


reported by the management so it can
be manipulated. Moreover, accounting
profit is not estimated on cash basis.
So, the modern goal of firm is
shareholders wealth maximization,
which refers to maximizing stock prices
at the market.
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Market Price of Shares

A graphical approach to
wealth maximization
S2
S1

W2=P2
W1=P1

D2
D1
Q1

Quantity of stock
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Goal of a firm:

Profit Maximization Vs. Wealth

Maximization

Vagueness in definition: There are many


definitions of Profit and so it is vaguely defined.
Wealth is the present value of all future dividends
which is readily observed in current share price at
the market.
Profit is an annual concept and so it is a short
term concept but wealth is a long term concept.
Profit can be manipulated by the management
(like window dressing) but wealth is beyond the
direct manipulation of management.
Risk consideration. The theory of risk says that
risk and return is proportional. Profit can not be
increased without increasing risk.
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Why is Wealth Maximization?


For overcoming the following drawbacks of
profit maximization, wealth maximization
is considered as ultimate goal:
Vagueness in definition
No standard/measurement/base
Profit is an annual concept
Profit can be manipulated by the
management (like window dressing)
No risk consideration
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Agency Relationship

Stockholders vs Managers:
managerial compensation, threat of firing,
shareholder intervention and threat of
takeover

Stockholders vs Creditors:

long
term investment is risky projects, payment
to employees, shareholders and financing
from others.

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MNCs and Multinational vs Domestic Managerial


Finance

Different currency denominations


Economic and legal ramifications
Language differences
Cultural differences
Role of governments
Political risk
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Principles of Managerial Finance

Return and risk


Time value of money
Cash flow
Profitability vs liquidity
Diversification
Hedging
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