The Role &

Environment of
Managerial Finance

 Finance

is the art & science of

managing money. Finance is
concerned with the process,
institutions,
markets
&
instruments involved in the
transfer of money among
individuals,
businesses
&
governments.
)

Board of Directors
President
VP: Sales

VP: Finance
Treasurer

VP: Operations

Controller

Credit Manager

Cost Accounting

Inventory Manager

Financial Accounting

Capital Budgeting Director

Tax Department

 Maximize

stock value by:

Forecasting and planning

Investment and financing decisions
Coordination and control
Transactions in the financial markets
Managing risk

1.
2.
3.
4.
5.

Stockholder wealth maximization.

Profit maximization.
Managerial reward maximization.
Behavioral goals.
Social responsibility.

 Modern

managerial finance
theory
operates
on
the
assumption that the primary
goal of the firm is to maximize
the
wealth
of
its
stockholders,
which
translates into maximizing
the price of the firms
common stock.
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 Profit

maximization is basically a
single-period or short-term goal
which is usually interpreted to
mean the maximization of profits
within given a given period of time.
A firm may maximize its profits at
the expense of its long-term
profitability & still realize this goal.
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Stockholder wealth maximization

is along-term goal, since stockholders
are interested in future as well as
present profits. This concept is
preferred because it considers:
1.
2.
3.
4.

Wealth for the long term,

Risk or uncertainty,
The timing of returns, &
The stockholders return.

Advantages
Easy

to calculate.
Easy to determine the
link between financial
decisions & profits.

Disadvantages
Emphasizes

the short

term.
Ignores risk or
uncertainty.
Ignores the timing of
returns.
Require immediate
resources.
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Advantages
Emphasizes

the long

Disadvantages
Offers

no clear
term.
relationship between
financial decisions &
Recognizes risk.
stock price.
Recognizes the timing
Can lead to
of returns.
management anxiety &
Consider stockholders
frustration.
return.

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Modern Corporation
Shareholders

Management

There exists a SEPARATION between owners

and managers.
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 Jensen

and Meckling developed a

theory of the firm based on agency
theory.
theory

Principals

must provide incentives so

that
management
acts
in
the
principals best interests and then
monitor results.

12

 An

agency relationship exists

whenever a principal hires an
agent to act on their behalf.

Within

a corporation, agency
relationships exist between:
Shareholders and managers
Shareholders and creditors
13

Managers are naturally inclined to act in

their own best interests.
But the following factors affect managerial
behavior:

Managerial compensation plans

Direct intervention by shareholders
The threat of firing
The threat of takeover

14

Shareholders (through managers) could

take actions to maximize stock price that
are detrimental to creditors.

In the long run, such actions will raise the

cost of debt and ultimately lower stock
price.

15

1.

Market Forces

Major Shareholders.
Threat of Takeover.
2.

Agency Costs: These are the costs of

monitoring
management
behavior,
ensuring against dishonest acts of
management & giving managers the
financial incentives to maximize share
price.

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1.
2.
3.

Financial Instruments.
Financial Institutions.
Financial Markets.

17

financial instrument is the

written legal obligation of one
party to transfer something of
value usually money to
another party at some future
date, under certain conditions,
such as stocks, loans, or
insurance.

18

Characteristics

Standardization
Communicate Information

Classes of Financial Instruments

Primary underlying Instruments

Derivative Instruments
Value derived from the behavior of
Underlying instruments.

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1.
Size the promised payment.
(Face
Value)
2.
When the payment will be
received. (Maturity)
3.
The likelihood the payment will
be made
(risk).
4.
The conditions under which the
payment will be made. (Prerogatives)

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Primarily Stores of
Value
1.
2.
3.
4.
5.

Bank Loans
Bonds
Home Mortgages
Stocks
Asset-backed
securities

Primarily to
transfer risk
1.
2.
3.

Insurance
Futures Contracts
Options

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Financial institutions serve as intermediaries

by channeling the savings of individuals,
businesses & governments into loans or
investments, i.e., they facilitate the flow of
funds between surplus units & deficit units.
Role of Financial Institutions
Reduce transactions cost by specializing in the
issuance of standardized securities
Reduce information costs of screening and
monitoring borrowers.
Issue short term liabilities and purchase longterm loans.
)

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23

Financial Markets are the places where

financial instruments are bought and
sold.
Role of Financial Markets.

Offer liquidity to borrowers and savers.

Pool and communicate Information.

Allow risk sharing

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Structure of Financial Markets

Primary vs. Secondary Markets

Money Market VS Capital Market
Centralized Exchanges vs. Over-thecounter
Markets.

Debt and Equity vs. Derivative Markets

Characteristics of a well-run
financial market

Low transaction costs.

Information communicated must be
accurate.

Investors must be protected.

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