Faculty of Commerce Financial Management Course

1. Faculty of CommerceFinancial Management Course Chapter 1 The Role and Environment of Managerial Finance

2. 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.

3. Learning Goals (cont.) • 5. Understand financial institutions and markets, and the role they play in managerial finance. • 6. Discuss business taxes and their importance in financial decisions.

4. 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.

5. Major Areas & Opportunities inFinance: 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.

6. Major Areas & Opportunities inFinance: 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 firm’s competitive position.

7. Major Areas & Opportunities inFinance: 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 (more investment, sales, purchases and fund raising • Changing economic and regulatory conditions also complicate the financial management function.

8. Legal Forms of Business Organization • Sole Proprietorship • Partnership • Corporation

9. Sole Proprietorship • Strength: • Owner receives all profits (and sustain all loses) • Low organizational costs • Income included and taxed on proprietor’s personal tax return • Independence – Secrecy • Ease of dissolution

10. Sole Proprietorship • Weaknesses: • Owner has unlimited liability (wealth can be taken) • Limited fund-raising • Difficult to give employees long-run career opportunities • Lacks of continuity when proprietor passes away

11. Partnership • Strength: • Can raise more funds than sole prop. • Borrowing power enhanced by more owners • Brain power and managerial skills • Income included and tax on partner’s personal tax return

12. Partnership • Weaknesses: • Owners have unlimited liability (may have to cover other partners’ debts) • Partnership is dissolved when a partner dies • Difficult to liquidate or transfer partnership

13. Corporation • Strength: • Owners have limited liability (invested lost) • can achieve large size thru’ sale of ownership (stock) which is transferable • Long life of firm • Can hire professional managers • Better access to financing • Offer attractive retirement plans

14. Corporation • Weaknesses: • Taxes higher (both corporate income dividends paid to owners are taxed) • More expensive • Subject to greater government regulation • Lacks secrecy, because stock-holders must receive financial reports

15. Corporate Organisation • Look at Page 7 in the text book (Figure 1.1)

16. Other limited liability organisations • Look at Page 8 in the text book (Table 1.2)

17. Why study Managerial Finance? • Understanding of concepts, techniques, and practices will fully acquaint you with the financial manager’s activities and decisions • People in all areas of responsibility need a basic understanding as well to get their duties done (justify labor requirements, negotiate operating budgets….)

18. Managerial Finance Function • People in all areas within the firm must interact with finance personnel and procedures • Example: to consider a new product, F.M. needs to obtain sales forecasts, pricing guidelines, advertising and promotion budget estimates from marketing personnel…

19. 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

20. The Managerial Finance Function:Relationship to Economics • The field of finance is actually an outgrowth of economics. • In fact, finance is sometimes referred to as financial economics. • F.Ms must understand the economic framework within which they operate in order to react or anticipate to changes in conditions

21. The Managerial Finance Function:Relationship to Economics (cont.) • The primary economic principal used by financial managers is marginal cost-benefit analysis which says that financial decisions should be implemented only when added benefits exceed added costs. - Give an example, buying new computer (speed processing & volume of transactions)

22. The Managerial Finance Function:Relationship to Economics (cont.) • Benefits with new PC $100,000 • Less: benefits with old PC $ 35,000 • (1) Marginal (added) benefits $65,000 • Cash of new PC $ 80,000 • Less: proceeds from sale of old PC $ 28,000 • (2) Marginal (added) costs $52,000 • Net Profit {(1) – (2)} $13,000

23. The Managerial Finance Function:Relationship to Accounting • The firm’s finance (treasurer) and accounting (controller) functions are closely-related and overlapping. • In smaller firms, the financial manager generally performs both functions.

24. 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 (intake & outgo of cash) • The significance of this difference can be illustrated using the following simple example.

25. The Managerial Finance Function:Relationship to Accounting (cont.) • The Nassau Corporation experienced the following activity last year: Sales $100,000 (1 yacht sold, 100% still uncollected) Costs $ 80,000 (all paid in full under supplier terms) • Now contrast the difference in performance under the accounting method versus the cash method

26. The Managerial Finance Function:Relationship to Accounting (cont.) INCOME STATEMENT SUMMARY AccrualCash Sales $100,000 $0 Less: costs ($80,000) ($80,000) Net Profit/(loss) $20,000 $(80,000)

27. The Managerial Finance Function:Relationship to Accounting (cont.) • In accounting terms, the Nassau corporation is profitable, but in the terms of actual cash flow, it is a financial failure. • Accrual accounting data do not fully describe the position of a firm. • F.M. must look beyond financial statements • F.M. should be able to avoid insolvency and achieve the firm’s financial goals. • Regardless of its profit or loss, a firm must have a sufficient flow of cash to meet its obligations as they come due

28. 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.

29. Primary Activities ofthe Financial Manager • Ongoing involvement in financial analysis and planning • Making investment decisions: This determines both the mix and the type of assets held by a firm (debit side of B.S.) • Making financing decisions: This determines both the mix and the type of financing used by the firm (credit side of B.S.) – Figure 1.2, P. 13

30. Goal of the Firm: Maximize Profit??? • Corporations measure profits in terms of Earnings Per Share (EPS) which is calculated by dividing the period’s total earnings available for the firm’s common stockholders by the No. of shares of common stock outstanding. • Q?: Is profit maximization is a reasonable goal??? Which investment is preferred (marine engine components) Earnings per share (EPS) • Investment Year 1 Year 2 Year 3 Total (years 1-3) • Rotor $1.40 $1 $0.40 $2.80 • Valve $0.60 $1 $1.40 $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.

31. Goal of the Firm: Maximize Profit??? • Valve is preferred !!! However, because of: • Timing: Rotor is preferred (1st year earns) • Cash flows available for stockholders: profits do not necessarily result in cash flows available to stockholders. Higher EPS does not mean higher stock price. Only when earnings increases are accompanied by increase future cash flows would a higher stock price be expected.

32. Goal of the Firm: Maximize Profit??? 3) Risk: Trade-off exists between return (cash flow) and risk. - Stockholders are risk-averse, i.e. want to avoid risk! • Return and Risk are the key determinants of share price, which represents the wealth of owners in a firm • When risk is involved, stockholders expect to earn higher rates of return on investments (visa-versa) **Conclusion: as profit max. does not achieve the objectives of firm’s owners, it should be the primary goal of the financial manager

33. Goal of the Firm:Maximize Shareholder Wealth!!! • Why? . F.Ms. should accept only actions that are expected to increase share price. • 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:

34. Goal of the Firm:Maximize Shareholder Wealth!!! • Share Price = Future Dividend/Required Return • Future dividend considers level & timing of cash flows • Required return considers risk of cash flows

35. Goal of the Firm:Maximize Shareholder Wealth!!! • The process of shareholder wealth • maximization can be described using the • following flow chart: • Figure 1.3 – P. 15

36. 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.“ No conflict with stakeholders & maintain positive relationship

37. 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.

38. 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 people’s 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.

39. 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.

40. The Role of Ethics: Ethics Defined • Ethics is the standards of conduct or moral judgment—have 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

41. 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?

42. The Role of Ethics:Considering Ethics (cont.) • Cooke suggests that the impact of a proposed decision should be evaluated from a number of perspectives: – Are the rights of any stakeholder being violated? – Does the firm have any overriding duties to any stakeholder? – Will the decision benefit any stakeholder to the detriment of another stakeholder? – If there is a detriment to any stakeholder, how should it be remedied, if at all? – What is the relationship between stockholders and stakeholders?

43. 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. ** Therefore, ethical behaviour is viewed as necessary for achieving the firm’s goal of owner wealth maximization

44. The Agency Issue:The Agency Problem • Whenever a manager (Agent) owns less than 100% of the firm’s equity, a potential agency problem exists (conflict between owners or corporate goals & personal goals) • In theory, managers would agree with shareholder wealth maximization. • However, managers are also concerned with their personal wealth, job security, fringe benefits, and lifestyle. They take moderate risk decisions (reluctant & unwilling to jeopardise) • This would cause managers to act in ways that do not always benefit the firm shareholders.

45. The Agency Issue:Resolving the Problem • 2 Factors serve to minimize agency problems: 1• Market Forces such as major shareholders such as a) institutional investors (insurance comp. pension funds) exert pressure on management to perform well, exercise voting rights to respond positively to their concerns) and b) the threat of a hostile takeover act to keep managers in check and motivated to act in the best interests of firms 2• 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.

46. The Agency Issue:Resolving the Problem (cont.) • Examples would include bonding or monitoring management behaviour, and structuring management compensation to make shareholders interests their own. ** 2 key types of compensation plans: 1• A stock option is an incentive plan allowing managers to purchase stock at the market price set at the time of the grant.

47. 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. * Also, much of evidence suggests that share price max. is the primary goal of most firms

48. Financial Institutions & Markets • Firms that require funds from external sources can obtain them in three ways: – through a bank or other financial institution – through financial markets – through private placements

49. Financial Institutions & Markets:Financial Institutions • Financial institutions are intermediaries that channel the savings of individuals, businesses, and governments into loans or investments. • The key suppliers and demanders of funds are individuals, businesses, and governments. • In general, individuals are net suppliers of funds (they save more money than they borrow), while businesses and governments are net demanders of funds (they borrow more money than they save).

50. Financial Institutions & Markets:Financial Markets • Financial markets provide a forum in which suppliers of funds and demanders of funds can transact business directly. • The two key financial markets are the money market and the capital market. • Transactions in short term marketable securities take place in the money market while transactions in long-term securities take place in the capital market.