Chapter 1

The Role and Environment of Managerial Finance

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Learning Goals
1. Define finance, its major areas and opportunities available in this field, and the legal forms of business organization. 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.

Copyright 2009 Pearson Prentice Hall. All rights reserved.

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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 not-for-profit. They are also more involved in developing corporate strategy and improving the firms competitive position.

Copyright 2009 Pearson Prentice Hall. All rights reserved.

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Major Areas & Opportunities in Finance: Managerial Finance (cont.)

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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Table 1.1 Strengths and Weaknesses of the Common Legal Forms of Business Organization

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Figure 1.1 Corporate Organization

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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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The Managerial Finance Function: Relationship to Accounting The firms finance (treasurer) and accounting (controller) functions are closely-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. 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.)

INCOME STATEMENT SUMMARY ACCRUAL Sales Less: Costs Net Profit/(Loss) $100,000 (80,000) $ 20,000 $ 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. While accounting is primarily concerned with the presentation of financial data, the financial manager is primarily concerned with analyzing and interpreting this information for decision-making 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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Figure 1.2 Financial Activities

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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:
Figure 1.3 Share Price Maximization

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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. The structure of corporate governance was previously described in Figure 1.1.
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The Sarbanes-Oxley Act of 2002

The Sarbanes-Oxley Act of 2002 (commonly called SOX) eliminated many disclosure and conflict of interest problems that surfaced during the early 2000s. SOX:
established an oversight board to monitor the accounting industry; tightened audit regulations and controls; toughened penalties against executives who commit corporate fraud; strengthened accounting disclosure requirements; established corporate board structure guidelines.

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The Role of Ethics: Ethics Defined

Ethics is the standards of conduct or moral judgmenthave become an 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 Agency Issue: The Agency Problem

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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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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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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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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