CHAPTER 1: Introduction to Managerial Finance

AIM
The aim of this subject is to ensure that students understand the nature and scope of
financial management. They should be able to assess an entity’s funding requirements,
calculate the cost of the available sources of finance, and advise on the optimum financing
structure for an entity. Students should be able to evaluate the role of, and apply, corporate
planning and budgetary control techniques. They are also expected to demonstrate excellent
written communication skills and the ability to integrate learning from the syllabi of this and
other subjects.

By the end of this Chapter, you should be able to:

 Explain the Essential Features of Financial Management

1.1 WHAT IS FINANCE?

It’s hard to define finance—the term has many facets, which makes it difficult to provide a clear
and concise definition. Nevertheless, finance as we know it today grew out of economics and
accounting.
Finance can be defined as the science and art of managing money. At the personal level,
finance is concerned with individuals’ decisions about how much of their earnings they spend,
how much they save, and how they invest their savings. In a business context, finance involves

1
the same types of decisions: how firms raise money from investors, how firms invest money in
an attempt to earn a profit, and how they decide whether to reinvest profits in the business or
distribute them back to investors.

(Additional info)
FINANCIAL MANAGEMENT
 Also referred to as managerial finance, corporate finance or business finance.
 Described as the process for and the analysis of making financial decisions in a manner
that achieves the Firm’s desired goals.

1.2 CAREER OPPORTUNITIES IN FINANCE

Careers in finance typically fall into one of two broad categories: (1) financial services
and (2) managerial finance. Workers in both areas rely on a common analytical “tool kit,” but
the types of problems to which that tool kit is applied vary a great deal from one career path to
the other.

Photo Credits: Google Images

• Financial Services
Financial services is the area of finance concerned with the design and delivery of
advice and financial products to individuals, businesses, and governments. It involves
a variety of interesting career opportunities within the areas of banking, personal
financial planning, investments, real estate, and insurance.
• Managerial Finance
Managerial finance is concerned with the duties of the financial manager working in a
business. Financial managers administer the financial affairs of all types of
businesses—private and public, large and small, profit seeking and not for profit. They
perform such varied tasks as developing a financial plan or budget, extending credit to
customers, evaluating proposed large expenditures, and raising money to fund the
firm’s operations.

The following are the career opportunities in managerial finance. You may already be
familiar with some of them and some may not ring a bell but it’s worth your while to
check them out.

✓ Financial analyst
Prepares the firm’s financial plans and budgets. Other duties include financial
forecasting, performing financial comparisons, and working closely with
accounting.
✓ Capital expenditures manager
Evaluates and recommends proposed long-term investments. May be involved

2
in the financial aspects of implementing approved investments.
✓ Project finance manager
Arranges financing for approved long-term investments. Coordinates
consultants, investment bankers, and legal counsel.
✓ Cash manager
Maintains and controls the firm’s daily cash balances. Frequently manages the
firm’s cash collection and disbursement activities and short-term investments
and coordinates short-term borrowing and banking relationships.

✓ Credit analyst/manager
Administers the firm’s credit policy by evaluating credit applications, extending
credit, and monitoring and collecting accounts receivable.
✓ Pension fund manager
Oversees or manages the assets and liabilities of the employees’ pension fund.
✓ Foreign exchange manager
Manages specific foreign operations and the firm’s exposure to fluctuations in
exchange rates.

1.3 FORMS OF BUSINESS ORGANIZATION

The basics of financial management are the same for all businesses, large or small, regardless
of how they are organized. Still, a firm’s legal structure affects its operations and thus should
be recognized. The following are the main forms of business organizations:

1.3.1 Strengths and Weaknesses of the Common Legal Forms of Business

Organization
Advantages Disadvantages

Sole Proprietorship 1. No formal charter 1. Limited ability to

required raise large sums
(A business owned by 2. Less regulation and of money
an individual.) red tape 2. Unlimited liability
3. Independence and for the owner
secrecy wherein wealth
4. Minimal can be taken to
organizational costs satisfy debts
5. Profits and control 3. Limited to the life
not shared with of the owner
others

3
 Partnership 1. Can raise more funds 1. Unlimited
than sole liability for the
(A business is owned by proprietorships individual
more than one owner) 2. Minimal partners and
organizational effort may have to
and costs and less cover debts of
governmental other partners
regulations as 2. Limited ability
compared to to raise large
corporations sums of money
compared to
corporations
3. Dissolved upon
the death or
withdrawal of
any of the
partners

Corporation 1. Long life of the firm 1. Difficult and

2. Limited liability for costly to
(A legal entity that its owners which establish, as a
exists apart from its guarantees that formal charter is
owners, better known they cannot lose required
as “stockholders”. more than they 2. Subject to
Ownership is evidenced invested double taxation
by possession of shares 3. Ease of transfer of on its earnings
of stock.) ownership through and dividends
transfer of stock paid to
4. Ability to raise stockholders
large sums of 3. Subject to
capital greater
government
regulation
4. Lacks secrecy
because
regulations
require firms to
disclose financial
results

In terms of numbers, most businesses are sole proprietorships. However, based on the dollar
value of sales, about 80% of all business is done by corporations. Because corporations
conduct the most business and because most successful businesses eventually convert to
corporations, we concentrate on them in this handout. Still, it is important to understand the
legal differences between firms.

4
1.4 FINANCE WITHIN AN ORGANIZATION

1.5 CORPORATE FINANCE, CAPITAL MARKETS, AND INVESTMENTS

Finance generally divided into three areas: (1) financial management, (2) capital markets,
and (3) investments.
• Financial management, also called corporate finance, focuses on decisions relating to
how much and what types of assets to acquire, how to raise the capital needed to buy
assets, and how to run the firm so as to maximize its value.
• Capital markets relate to the markets where interest rates, along with stock and bond
prices, are determined. Also studied here are the financial institutions that supply
capital to businesses. Banks, investment banks, stockbrokers, mutual funds, insurance

5
companies, and the like bring together “savers” who have money to invest and
businesses, individuals, and other entities that need capital for various purposes.
• Investments relate to decisions concerning stocks and bonds and include a number of
activities: (1) security analysis deals with finding the proper values of individual
securities (i.e., stocks and bonds); (2) portfolio theory deals with the best way to
structure portfolios, or “baskets,” of stocks and bonds. Rational investors want to hold
diversified portfolios in order to limit risks, so choosing a properly balanced portfolio
is an important issue for any investor; and (3) market analysis deals with the issue of
whether stock and bond markets at any given time are “too high,” “too low,” or “about
right.”

1.6 GOAL OF THE FIRM

 In a for-profit businesses, the goal of financial management is to make money and add
value for the owners.
 To be more precise, the goal is to make decisions that will increase the value of the
firm or the value of the stocks for the owners or shareholders. (maximize shareholders
wealth/maximize the stock price)

1.6.2 Profit Maximization vs. Stockholder Wealth Maximization

It might seem intuitive that maximizing a firm’s share price is equivalent to maximizing its
profits, but that is not always correct. But does profit maximization lead to the highest possible
share price? The answer is often no. Profit maximization is basically a single-period or, at the
most, a short-term goal. It is usually interpreted to mean the maximization of profits within a
given period of time. A firm may maximize its short-term profits at the expense of its long-term
profitability and still realize this goal. In contrast, stockholder wealth maximization is a long
term goal, since stockholders are interested in future as well as present profits. Wealth
maximization is generally preferred because it considers these three things:

• Timing
Timing is important. An investment that provides a lower profit in the short run may be
preferable to one that earns a higher profit in the long run.
• Cash Flows
Profits and cash flows are not identical. The profit that a firm reports is simply an
estimate of how it is doing, an estimate that is influenced by many different accounting
choices that firms make when assembling their financial reports. Cash flow is a more
straightforward measure of the money flowing into and out of the company. Companies
have to pay their bills with cash, not earnings, so cash flow is what matters most to the

6
financial managers.
• Risk
Risk matters a great deal. A firm that earns a low but reliable profit might be more
valuable than another firm with profits that fluctuate a great deal (and therefore can be
very high or very low at different times).

(Additional info)
PROFIT MAXIMIZATION
Profit maximization refers to achieving the highest possible profits during the year (a short-term
goal). This could be achieved by either increasing sales revenue or by reducing expenses.

Note that:
Profit = Revenue – Expense

The sales revenue can be increased by either increasing the sales volume or the selling price. It
should be noted however, that maximizing sales revenue may at the same time result to
increasing the firm’s expenses. The pricing mechanism will however, help the firm to determine
which goods and services to provide so as to maximize profits of the firm.
The profit maximization goal has been criticized because of the following:
1. It ignores time value of money
2. It ignores risk and uncertainties
3. It is vague
4. It ignores other participants in the firm rather than shareholders

1.7 GOVERNANCE AND AGENCY

You may have come to know by now that the majority of owners of a corporation are
normally distinct from its managers. Nevertheless, managers are entrusted to only take actions
or make decisions that are in the best interests of the firm’s owners, its shareholders. In most
cases, if managers fail to act on the behalf of the shareholders, they will also fail to achieve the
goal of maximizing shareholder wealth. To help ensure that managers act in ways that are
consistent with the interests of shareholders and mindful of obligations to other stakeholders,
firms aim to establish sound corporate governance practices—the rules, processes, and laws by
which companies are operated, controlled, and regulated.

Corporate governance refers to a system of organizational control that is used to define and
establish lines of responsibility and accountability among major participants in the corporation.
These participants include the shareholders, board of directors, officers and managers of the
corporations and other stakeholders.

7
1.7.1 The Agency Problem
An agency relationship exists when one or more persons (called principals) employ one or
more other persons (called agents) to perform some tasks. Primary agency relationships exist
(1) between stockholders and managers and (2) between creditors/bondholders and
stockholders. They are the major source of agency problems.

• Managers vs. Stockholders

The agency problem arises when a manager owns less than 100 percent of the company’s
ownership. As a result of the separation between the managers and owners, managers
may make decisions that are not in line with the goal of maximizing stockholder wealth.
For example, they may work less eagerly and benefit themselves in terms of salary and
perks. The costs associated with the agency problem, such as a reduced stock price and
various ‘‘perks,’’ is called agency costs. Several mechanisms are used to ensure that
managers act in the best interests of the shareholders:
(1) golden parachutes or severance contracts;
(2) performance-based stock option plans;
(3) the threat of firing; and
(4) the threat of takeover

• Stockholders vs. Creditors

Conflicts can also arise between stockholders and bondholders. Bondholders generally
receive fixed payment regardless of how well the company does, while stockholders do
better when the company does better. This situation leads to conflicts between these two
groups. Conflicts develop if:
(1) Managers, acting in the interest of shareholders, take on projects with
greater risk than creditors anticipated.

(2) Raise the debt level higher than was expected.

8
1.8 FINANCIAL DECISIONS AND RISK-RETURN TRADE-OFF

• Finance can be defined as the science and art of managing money.

• Careers in finance typically fall into one of two broad categories: (1) financial services;
and (2) managerial finance.
• Career opportunities in managerial finance include: financial analyst, capital
expenditures manager, project finance manager, cash manager, credit
analyst/manager, pension fund manager, and foreign exchange manager.
• The basics of financial management are the same for all businesses—sole
proprietorships, partnerships and corporations. Still, a firm’s legal structure affects its
operations and thus should be recognized.
• The owners of a corporation are its stockholders, whose ownership, or equity, takes
the
form of either common stock or preferred stock. The stockholders (owners) vote
periodically to elect members of the board of directors—the governing body of the
corporation—and to decide other issues such as amending the corporate charter.
• The goal of the firm, and also of managers, should be to maximize the wealth of the
owners for whom it is being operated, or equivalently, to maximize the stock price.
• The agency problem arises when a manager owns less than 100 percent of the
company’s ownership. As a result of the separation between the managers and owners,
managers may make decisions that are not in line with the goal of maximizing
stockholder wealth.
• All financial decisions involve some sort of risk-return trade-off. The greater the risk
associated with any financial decision, the greater the return expected from it.
-END-

“Education is the passport to the future, for tomorrow belongs

to those who prepare for it today.” —Malcolm X

9
INTRODUCTION TO FINANCIAL MANAGEMENT
Chapter Exercises
TRUE or FALSE
Instructions: Identify whether the statement written below is TRUE or FALSE.
1. Financial Management is that specialized activity which is responsible for obtaining and
affectively utilizing the funds for the efficient functioning of the business and, therefore, it
includes financial planning, financial administration, and financial control.
2. The goal of the firm should be to maximize earning per share.
3. Maximizing the price of a share of the firm’s common stock is the equivalent of maximizing
the wealth of the firm’s present owners.
4. Financial Accounting is the process of planning, directing, organizing, controlling, and
monitoring the monetary resources of the company in order to achieve its objectives or goals.
5. Profit maximization does not consider the discount rate which reflects the risks of
capitalization and the time value of money unlike market value maximization.
6. The role of financial managers are to decide on its investing, financing and operating
activities.
7. The Chief Financial Officer is also known as the Vice President of Finance Department who
supervises the treasurer not the controller.
8. The board of directors is considered owners who are responsible for the overall governance
of the corporations.
9. If these agents do not prioritize the interest of the principal owners rather their own interest,
agency conflicts may exist.
10. Ethics and the goal of maximizing shareholder wealth generally lean towards of opposite
ends since managers of an organization would not profit from ethical behavior.

Multiple Choice Questions

1. Basic objective of Financial Management is ________________.
A. Maximization of shareholder's wealth
B. Maximization of profit
C. Ensuring Financial discipline in the firm.
D. All of these.
2. Financial structure refers to ________________.
A. Short-term resources.
B. All the financial resources.
C. Long-term resources.
D. All of these.
3. The market value of the firm is the result of__________.
A. Dividend decisions.
B. Working capital decisions.
C. Capital budgeting decisions.
D. Trade-off between risk and return.

10
4. Which of the following statements is correct regarding profit maximization as the primary
goal of the firm?
A. Profit maximization considers the firm's risk level.
B. Profit maximization will not lead to increasing short-term profits at the expense of lowering
expected future profits.
C. Profit maximization does consider the impact on individual shareholder's EPS.
D. Profit maximization is concerned more with maximizing net income than the stock

5. Which of the following is not normally a responsibility of the treasurer of the modern
corporation but rather the controller?
A. Budgets and forecasts.
B. Asset management.
C. Investment management.
D. Financial management

6. The long-run objective of financial management is to _____________.

A. Maximize earnings per share.
B. Maximize the value of the firm's common stock.
C. Maximize return on investment.
D. Maximize market share.

7. One of the major disadvantages of a sole proprietorship is

A. that there is unlimited liability to the owner
B. the simplicity of decision making
C. low organizational cost
D. low operating costs

8. The partnership form of organization

A. avoids the double taxation of earnings and dividends found in the corporate form of
organization
B. usually provides limited liability to the partners.
C. has unlimited life
D. simplifies decision making

9. A corporation is
A. owned by stockholders who enjoy the privilege of limited liability
B. easily divisible between owners
C. a separate legal entity with perpetual life
D. all of the above

10. Proper-risk return management means that

A. the firm should take as few risks as possible
B. consistent with the objectives of the firm, an appropriate trade-off between risk and return
should be determined.
C. the firm should earn highest return possible.
D. the firm should value future profits more highly than current profits.

11. Corporate governance success includes three key groups. _____________ represents these
three groups.
A. Suppliers, managers, and customers.
B. Board of directors, executive officers, and common shareholders.
C. Suppliers, employees, and customers.
D .Common shareholders, managers, and employees.

11
12. I. Stockholders of a corporations are not personally liable for the firm’s debts.
II. Stockholders are sometimes referred to as residual claimants, meaning that they are paid
last after employees, suppliers, tax authorities, and lenders receive what they are owed.

A. both statement are false

B. both statement are true
C. statement I only is true
D. statement II only true

13. Plans that tie management as a result of meeting the stated performance goals.
A. performance plans
B. incentive plans
C. investment plan
D. financial plan

14. When a firm’s 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. This is called.
A. the threat of makeover
B. the threat of takeover
C. the threat of pullover
D. the threat of pushover

15. Is a type of internal company expense, which comes from the actions of an agent acting on
behalf of a principal. It typically arise in the wake of core inefficiencies, dissatisfactions, and
disruptions, such as conflicts of interest between shareholders and management.
A. Agency problem
B. Principal problem
C. Agency costs
D. Principal costs

12