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THE ROLE AND ENVIRONMENT OF MANAGERIAL FINANCE OVERVIEW_S1_2018

Finance is the science and art of managing money. Finance functions involve
analysing the proper allocation of financial assets. The financial analysis applies
to business decision making of all types of businesses—private and public, large
and small, profit-seeking and not-for-profit.

The financial services area encompasses financial product design and the
delivery of financial advice. Loan officers, bank managers, and stock brokers are
some of the many financial services positions. The managerial finance area
encompasses the duties of the financial manager working in a business. Financial
analysts, cash managers, and credit analysts perform managerial finance roles.

Forms of business organisation

There are three major forms of business organisation: (1) sole proprietorships, (2)
partnerships and (3) company/corporations.

Sole proprietorship

A sole proprietorship is an unincorporated business that is owned and operated


by only one person, who has complete liability for all assets, and complete rights
to all profits.

The sole proprietorship has three important advantages:

1. It is easy and inexpensively formed


2. It is subject to few government regulations. Large firms that potentially
threaten competition are much more heavily regulated.
3. It is taxed like an individual, not a corporation; thus, earnings are taxed
once.
The sole proprietorship also has four important limitations:

1. The proprietor has unlimited personal liability for business


debts, because any debts of the business are considered
obligations of the sole owner.

With unlimited personal liability, the proprietor can potentially lose all of their
personal assets, even those assets not invested in the business

2. A proprietorship’s life is limited to the time the individual who


created it owns the business.

When a new owner takes over the business, legally the firm becomes a new
proprietorship

3. Transfer of ownership is somewhat difficult


4. It is difficult for a proprietorship to obtain large sum of capital
because the firm’s financial strength generally is based only
on the financial strength of the sole owner

Partnership

A partnership is the same as a proprietorship, except that it has two or more


owners. Partnerships can operate under different degrees of formality, ranging
from informal, oral understandings to formal agreements filed with the secretary
of the state in which the partnership does business.

Most legal experts recommend that partnership agreement be put in writing.

Shared ownership among two or more individuals, some of whom may, but do
not necessarily, have limited liability

The advantages and disadvantages are basically the same as sole proprietorship,
except that most partnerships have more source available for raising funds
because there are more owners, with more relatives, more friends and more
opportunities to raise funds through credit.

Even though they generally have greater capabilities than proprietorships to raise
funds to support growth, partnerships still have difficulty in attracting substantial
amounts of funds.

Under partnership law, each partner is liable for the debts of the business.
Therefore, if any partner is unable to meet their pro rata claim in the event the
partners must make good on unsatisfied claims, drawing on their personal assets
if necessary

Corporation

A corporation is a legal entity created by a state. It is separate and distinct from


its owners and managers.

This separateness gives the corporation four major advantages:

1. A corporation offers its owners limited liability

To illustrate the concept of limited liability, suppose you invested R10 000 to
become a partner in a business formed as a partnership that subsequently went
bankrupt, owing creditors R1 million. Because the owners liable for the debts of a
partnership, as a partner you would be assessed for a share of the company’s
debt; you could even be held liable for the entire R1 million if your partners could
not pay their shares. This is the danger of unlimited liability.

On the other hand, if you invested R10 000in the shares of a corporation that then
went bankrupt, your potential loss on the investment would be limited to your
R10 000 investment.

2. Ownership interests can be divided into shares, which can be transferred far
more easily than can proprietorship or partnership interest;
Shares can be bought and sold in minutes, whereas interests in proprietorships
and partnerships generally cannot.

3. A corporation can continue after its original owners and managers no longer
have a relationship with the business; thus it is said to have a limited life

The life of a corporation is based on the longevity of its shares, not the longevity
of those who own the shares (the owners).

4. The first three factors-


Limited liability, easy transferability of ownership interest and unlimited life-
Make it much easier for corporations than for proprietorships or partnerships to
raise money in the financial market.
Corporation can issue shares and bonds to raise funds, whereas proprietorships
and partnership cannot.

Company
A company is a separate entity from the owners of the business. This means that
a company can be sued and taxed separately from the owners, and the owners
have limited liability.
A company can only be started if the business complies with the South African
Companies Act

Alternative forms of business organisation

These alternative forms of business of business combine some characteristics of


proprietorships and partnerships with some characteristics of corporations.
Limited liability partnership

A partnership wherein at least one partner is designated as a general partner with


unlimited personal financial liability, and the other partners are limited partners
whose liability is limited to amounts they invest in the firm.

Limited liability company

A relatively new business form that offers the limited personal liability associated
with a corporation; however, the company’s income is taxed like that of a
partnership.

The goals of financial management

Financial managers need goals to guide and motive them when making
decisions on behalf of the organisation. Financial managers may formulate a
number of goals-to increase turnover, enhance market share, minimise costs,
avoid insolvency, maximise earnings per share or maximise profitability.

Other financial management goals may include maximising rates of return,


shareholders’’ wealth, market value added and economic value added. Three
of these goals deserve closer attention, given how prevalent they are in financial
–management practice.

 Profit maximisation
 Maximising the rate of return
 Maximising shareholders wealth

The goal of profit maximisation however has three main flaws. Firstly, accounting
profit can be manipulated through malpractice. Secondly, the goal of profit
maximisation ignores the issues of timing and risk associated with generating the
profit.
Shareholders’ wealth maximisation represents a forward-looking goal centred on
increasing the wealth of the owners, or shareholders, of the firm

The most important financial-management goal is to increase the wealth of the


shareholders by operating the company in such a way that it leads to a
sustainable increase in the current share price.

The value of a firm can be measured by the market value of its shares. Thus, the
firm maximises value/wealth by maximising the value of its shares.

Value is measured as the present value of the cash flows that an investment is
expected to generate during its life. The three factors that determine value are:
(1) the amount of the future cash flows, (2) the timing of the future cash flows, and
(3) investors’ required rate of return. If the amount of the cash flows increases, the
cash flows are received sooner, investors’ required rate of return decreases, or
any combination of these events occur, the value of an investment will increase.

The agency problem

In a sole proprietorship and some partnerships, the owners are generally also the
managers of the business. It is therefore assumed that they will run the business in
such a manner as to maximise their own wealth. However, in publicly listed
companies, shares are held by a large number of shareholders. As the
shareholders cannot all be involved in the day-day management of the business,
managers are appointed.

Managers therefore become agents and are obligated to maximise the interests
of those who appointed them (the shareholders, also called the principals).

Unfortunately, it is often the case that managers run business to protect their own
interests (such as their job security, benefits and personal wealth) rather than to
promote the interests of the shareholders. This phenomenon is known as agency
problem
Example: You want to sell your house, but you do not have time to look for a
buyer. So you appoint an agent, Jack, to sell the house for you. You will pay Jack
R10 000 for selling the house. Your house is worth R500 000. In this scenario you are
the principal and Jack is the agent, who should take care of your interest.
Whether Jack sells the house for R300 000 or for R600 000, he will still receive
R10 000 for his efforts. However, he was appointed to look after your best interests,
and if he sells the house for less than R500 000 he has failed to do so. Jack’s fee
can be constructed as an agency cost because the agent deliberately did not
maximise the wealth of the principal.

Mechanisms that are used by large corporation to motivate managers to act in


the shareholders best interest include:

1. Managerial compensation (incentives)

A common method used to motivate managers to operate in a manner


consistent with share price maximisation is to tie mangers’ compensation to the
company’s performance. Such compensation packages should be developed
so that managers are rewarded on the basis of the firm’s performance in any
particular year.

All incentive compensation plans should be designed to accomplish to things:

 Provide inducements to executives to act on those factors under


their control in a manner that will contribute to share price
maximisation; and
 Attract and retain top-level executives. Well-designed plans can
accomplish both goals

2. Shareholder intervention

Along with such institutional shareholders as pension funds and mutual funds,
individual shareholders often ‘flex their muscles’ to ensure firms pursue goals that
are in the best interest of shareholders rather than mangers (where conflict might
arise). In addition, many institutional investors routinely monitor top companies to
ensure that managers pursue the goal of wealth maximisation.

When it is determined that action is needed to realign management decisions


with the interest of investors, these institutional investors exercise their influence by
suggesting possible remedies to management or by sponsoring proposals that
must be voted on by shareholders at the annual meeting. Shareholders-
sponsored proposals are not binding, but the votes are notices by corporate
management.

In situations where large blocks of the shares are owned by relatively few
institutions that have enough clout to influence a fir’s operations, these
institutional owners often have enough voting power to overthrow management
teams that do not act in the best interests of shareholders.

Financial institutions and markets

Financial managers and investors don’t operate in a vacuum- they make


decisions within a large and complex financial environment. This environment
includes financial markets and institutions, tax and regulatory policies and state
of the economy. Starting and growing a business requires funding: financial
markets and institutions are necessary to ensure that funds flow between
borrowings and lenders. These markets act as intermediaries between buyers and
sellers of financial securities

Financial markets

A financial market can be defined as a meeting place where economic units


with excess funds can transact with economic units in need of funds. Financial
markets thus bring together the suppliers of funds and those seeking funds.
There are two types of financial markets: the money market and capital market.
Markets can also be divided into primary and secondary markets.

Money markets

A money market is a market where short-term debt securities are bought and sold.
Short-term debt securities are those securities with a maturity of one year or less.
Money markets do not have a physical location, but participants (which include
individuals, businesses, government and financial institutions such as banks) are
connected electronically.

The main purpose of a money market is to enable participants that temporarily


have extra funds to earn interest on those funds. Other participants may be in
need of short-term financing and, therefore money markets provide a platform to
bring these parties together.

Capital markets

A capital market is a market where long-term debt securities are bought and sold.
Long-term debt securities have a maturity of more than one year, and the main
securities bought and sold are shares and bonds.

Primary and secondary markets

A primary market is a market in which listed companies and governments sell


securities for the first time. Therefore, when companies (or the government) are in
need of funds, they could offer securities to participants in this market.

There are two types of primary-market transactions. The first is a private


placement, where the securities are only for sale to specific buyers. The second is
a public offering, which is available to the general public.

A secondary market is a market in which the original securities that were bought
in the primary market can be traded. For instance, If you were one of the investors
who bought shares in the original public offering for R10 and you decide to sell
your shares, you will do so in the secondary market.

Consequently, a secondary market needs a buyer and a seller, so that ownership


of securities can be transferred.

Financial institution

Financial institution, such as commercial banks, life insurers, pension funds and
collective investment schemes (which include unit trusts), bring savers and lenders
together in an effort to allocate funds efficiently. Think, for instance, about your
local bank. If you save money in your account, you will receive a certain amount
of interest. The bank pays you that interest in return for the opportunity to lend
your money to some party in need of funds.

So, if the owner of the bakery is in need of a specific amount of money, he can
go to the bank and apply for a loan, for which he would be charged a certain
interest rate. So, in effect, the bank acts as a financial intermediary:

It uses the money of savers (suppliers of funds) to allocate funds to borrowers


(demanders of funds). The interest rate that the financial institution charges for
lending money is always more than the interest that is paid to savers. The
difference between the two interest rates represents the financial institution’s
revenue. Financial institutions also generate income through service charges.

Financial institutions, therefore, are an important factor when examining the


business environment, as individuals, businesses and governments cannot act
efficiency without them.
STUDY GUIDELINES

ASSESSMENT FORMAT

The role of managerial finance and the financial market environment will be
assessed mainly by means of multiple-choice questions (MCQs) because of its
highly theoretical nature. In the examination, you will be required to continuously
apply these basic concepts to other areas of finance.

Prescribed book reference: Chapter 1 and Chapter 2: Principal of Managerial


Finance, 2nd edition

REVIEW QUESTIONS

Question 1

Which of the following would be best considered as a principal agent problem in


the behaviour of the following managers?

1. Ethan chooses to pursue a risky investment for the company’s fund because
his compensation will substantially rise if it succeeds.
2. Emma instructs her staff to skip safety inspections in one of the company’s
factories, knowing that it will likely fail the inspection and will have to incur
significant costs to fix it.
3. Olivia ignores an opportunity for her company to invest in a new drug to fight
Alzheimer’s disease judging the drug’s chances of succeeding as low.
4. Henry chooses to enhance his firm’s reputation at some costs to shareholders
by sponsoring a team of athletes for the Special Olympics.
Answer 1
Question 2

Which of the following is typically the major factor in limiting the growth of a sole
proprietorship?

1. The owner will make decisions in his own best interest.


2. The organisation tends to become extremely complicated over time.
3. Investors have a great deal of control over the running of the organisation,
which leads to confusion when conflicts in direction arise.
4. The amount of money that can be raised by the organisation is limited by the
fact that the owner is personally liable for all debt.

Answer: 4

Question 3

Which of the statements on a sole proprietorship is correct?

1. A sole proprietorship is the least common form of business ownership.


2. A sole proprietorship is often structured as a limited liability company.
3. The owner of a sole proprietorship may be forced to sell his/her personal
assets to pay company debts.
4. The owners of a sole proprietorship share profits as established by the
partnership agreement.

Answer: 3

Question 4

Which of the following best describes a capital market?

1. A financial relationship created by institutions and arrangements that allows


suppliers and demanders of short-term funds to make transactions.
2. An intangible market for the purchase and sale of securities not listed on
organised exchanges.
3. A market that allocates funds to their most productive uses as result of
competition among wealth-maximising investors.
4. A financial relationship created by institutions and arrangements that allows
suppliers and demanders of long-term funds to make transactions.

Answer:4

Question 5

Which of the following should be the primary goal pursued by the financial
manager of a company?

1. To maximise the company’s profit.


2. To maximise the market value of the company’s shares.
3. To maximise the company’s book value.
4. To maximise dividends paid to ordinary shareholders.

Answer: 2

Question 6

If all else were equal, in which of the following forms of business would the
possibility of an agency problem be the greatest?

1. A sole proprietorship.
2. A foreign corporation that is publicly traded.
3. A foreign corporation with concentrated ownership – that is, relatively few
owners.
4. A partnership in which all partners share management and decision-making
responsibilities equally.

Answer: 2
Question 7

Which of the following options best describes the money market?

1. It is where long-term securities are exchanged.


2. It is where short-term securities are exchanged.
3. It is where long-term debt securities are bought and sold.
4. It is where short-term debt securities are bought and sold.

Answer: 4

Question 8

Which of the following statements is correct regarding profit maximisation as the


primary goal of the firm?

1. Profit maximisation considers the firm's risk level.


2. Profit maximisation will not lead to an increase in short-term profits at the
expense of expected future profits.
3. Profit maximisation does consider the impact on individual shareholders'
earnings per share (EPS).
4. Profit maximisation is concerned more with maximising profits than the share
price.

Answer: 4

Question 9

Which of the following statements concerning a firm's quest to maximize wealth


are correct?

1. Actions that maximise a firm's stock price are inconsistent with maximising
social welfare.
2. If government did not mandate socially responsible corporate actions, such
as those relating to product safety and fair hiring practices, most firms in
competitive markets probably would not pursue such policies voluntarily.
3. In extremely competitive industries, we would expect firms would voluntarily
engage in many socially beneficial projects to try to maximise their stocks'
values.
4. The concepts of social and ethical responsibility on the part of corporations
are completely different and neither is relevant in the maximisation of stock
price.

Answer: 2

Question 10

Which of the following is the most suitable definition of an agency problem?

1. The difficulties that arise in professional baseball when players become free
agents.
2. The difficulties that arise when a principal hires an agency to represent their
company.
3. The difficulties that arise when a principal hires an agent and cannot fully
monitor the agent's actions.
4. When a principal hires an agent and must monitor every move they make
because they have found the agent to be unethical.

Answer: 3

Question 11

The agency problem shows up in many different situations within a firm. Which of
the following is not a good example of this problem?

1. Firm managers sometimes want to relax on the job.


2. Firm owners are more able to accept risks than firm managers are.
3. Firm managers receive bonuses based on the performance of the firm.
4. Firm managers take action to maximise their salaries.

Answer: 3

Question 12

A basic distinction between a primary and secondary market is that …

1. proceeds from sales in the primary market go to the current owner of a


security, while proceeds in a secondary market go to the original owner.
2. primary markets involve direct dealings with regional exchanges.
3. only new securities are sold in the primary market, while only outstanding
(issued) securities and sold in the secondary market.
4. primary markets deal exclusively in debentures, while secondary markets deal
primarily in ordinary shares.

Answer: 3

Question 13

Which one of the following statements about the company form of business
organisation is incorrect?

1. The shareholders of a company have limited liability.


2. The company is the easiest form of business organisation to establish.
3. Companies are typically larger than either partnership or sole proprietorship.
4. Companies generate a significantly greater percentage of total annual sales
than either partnerships or sole proprietorships.

Answer: 2
Question 14

Which of the following would not be considered a secondary market transaction?

1. Apple issues new ordinary shares using its investment bank.


2. An institutional investor sells some FGZ shares through his broker.
3. Shane Corporation is trading funds and issuing shares in the market.
4. An individual investor purchases some existing shares of KK Ltd through his
broker.

Answer: 1

Question 15
Until this year, Cheers Inc. was organised as a partnership. This year, the partners
have decided to organise the business as a corporation. As a result of this change
in organisational form, which of the following statements are most correct?
1. Cheers will now be subject to fewer regulations.
2. Cheers will now find it more difficult to raise additional capital.
3. Cheers’ investors will now find it more difficult to transfer ownership.
4. Cheers’ shareholders (the ex-partners) will now have limited liability.
Answer: 4