Chapter One

Overview of Managerial Finance

Principles of Managerial Finance
First Canadian Edition
Lawrence J. Gitman and Sean Hennessey

2004 Pearson Education Canada Inc. 1-1

 Learning Goals
LG1 Define finance and describe its three
major areas and career opportunities.
LG2 Review basic forms of business
organization, their strengths and
weaknesses.
LG3 Describe managerial finance function and
differentiate from economics and
accounting.

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 Learning Goals (continued)
LG4 Identify key activities of financial
manager within the firm.
LG5 Explain why wealth maximization is
firms goal.
LG6 Explain how EVA, stakeholder focus,
and ethical behaviour relate to firms
goal.
LG7 Discuss agency issue as it relates to
owner wealth maximization.
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 What is Finance?
At the macro level, finance is the study of financial
institutions and financial markets and how they operate
within the financial system in both the Canadian and
global economies.
At the micro level, finance is the study of financial
planning, asset management, and fund raising for
businesses and financial institutions.
Financial management can be described in brief using
the following balance sheet.

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 What is Finance?
Macro Finance

Assets: Liabilities & Equity:

Current Assets Current Liabilities
Cash & M.S. Accounts payable
Accounts receivable Notes Payable
Inventory Total Current Liabilities
Working Total Current Assets Long-Term Liabilities
Fixed Assets: Total Liabilities
Working
Capital Capital
Gross fixed assets Equity:
Less: Accumulated dep. Common Stock
Goodw ill Paid-in-capital
Other long-term assets Retained Earnings
Investment Total Fixed Assets Total Equity
Financing
Decisions Total Assets Total Liabilities & Equity
Decisions

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 What is Finance?
A well-developed financial system is a hallmark and
essential characteristic of any modern developed
nation.
Financial markets, financial intermediaries, and
financial management are the important components.
Financial markets and financial intermediaries
facilitate the flow of funds from borrowers to savers.
Financial management involves the efficient use of
financial resources in the production of goods.

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Areas of Specialization in Finance

Financial Markets
Markets of users and savers of funds.
Financial Services
Design and delivery of financial advice and
products to individuals, businesses, government.
Managerial Finance
Financial management of business firms.

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Areas of Employment in Finance
Financial Analyst
Capital budgeting analyst/manager
Project finance manager
Cash manager
Credit analyst/manager
Pension fund manager

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 Basic Forms of Business
Organization
Sole Proprietorship
Owned by one person, operated for personal profit.
Partnerships
Owned by two or more people, operated for joint
profit.
Corporations
Legal entity, owned by individuals, operated for
joint profit.

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 Sole Proprietorship
STRENGTHS: WEAKNESSES:
Low organizational cost Unlimited liability
Income taxed once as Limited funding
personal income Proprietor must be all
Independence Difficult to develop staff
Secrecy career opportunities
Ease of dissolution Lack of continuity on
death of proprietor

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 Partnerships
STRENGTHS: WEAKNESSES:
Improved funding Unlimited liability to
sources all partners
Increased managerial Partnership dissolved
talent
upon death of partner
Income split by
partnership contract, Difficult to liquidate
taxed as personal or transfer ownership
income

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 Corporations
STRENGTHS: WEAKNESSES:
Owners liability limited Higher tax rates
Large capitalization Expensive organization
possible, greater funding Greater government
Ownership readily regulation
transferable When publicly traded,
Indefinite life lacks secrecy
Professional management

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 Corporate Organization Chart

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Organization of Finance Functions

CFO Chief Financial Officer

Treasurer responsibilities:
Financial planning, fund raising, capital
expenditure decisions, cash and credit
management.
Controller responsibilities:
Corporate accounting, cost accounting, and tax
management.

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 Relationship to Economics
Fundamental Economic Principle:
Marginal Analysis
Financial decisions should be made and actions
taken only when the added benefits exceed the
added costs.

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 Relationship to Accounting
Cash Flows
Accrual Basis: recognizes sales revenue and
expenses incurred to make sale at time of sale.
Cash Basis: recognizes revenues and expenses
as they occur.

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Accounting vs. Financial Views
Accounting View Financial View
(Accrual Basis) (Cash Basis)
Income Statement Cash Flow Statement
Peakes Quay, Inc. Peakes Quay, Inc.
For year ended 12/31 For year ended 12/31

Sales revenue $100,000 Cash inflow $ 0

Less: Costs 80,000 Less: Cash outflow 80,000
Net Profit $ 20,000 Net cash flow ($80,000)

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Financial ManagerKey Activities

Financial Analysis & Planning

Balance Sheet
Current Current
Making Assets Liabilities Making
Investment _______________ _______________ Financing
Decisions Fixed Long-Term Funds Decisions
Assets (Debt & Equity)

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Should Firms Maximize Profit?
Corporations commonly define profit as
Earnings per Share (EPS).
A measure of total earnings divided by total
number of ownership shares.
EPS ignores critical factors of
the timing of the returns.
cash flows available to common shareholders.
risk factors facing the firm.

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 Or Should Firms Maximize
Shareholder Wealth?
Evaluating Shareholder Wealth addresses
factors of timing, cash flows and risk
ignored by the EPS.
Therefore, Maximizing Shareholder Wealth
is a more comprehensive goal for the firm,
its managers and employees.
This can be explored through economic
valued added and a focus on stakeholders.

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Economic Value Added EVA
EVA measures whether an investment
contributes to shareholder wealth.
EVA is calculated by subtracting cost of
funds used from after-tax operating profits.
While popular, EVA is essentially derived
from the concept of net present value.

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 What about Stakeholders?
Stakeholders include groups that have direct
economic links to the firm.
Stakeholders include not only owners, but
also employees, customers, suppliers, and
creditors.
Maintaining positive stakeholder
relationships helps maximize long-term
benefits to shareholders.

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 Importance of Ethics
The standards of conduct or moral judgment:
Honesty, trustworthiness, fair dealing are
foundations of sustainable business relations:
With customers,
With suppliers,
With creditors,
With employees,
With owners.
Ethical behaviour is necessary to achieve the goal
of maximizing shareholder wealth.

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 Internal Ethical Review
Are rights of stakeholders being violated?
Does firm have extra duties to stakeholders?
Will a decision unfairly discriminate benefits
among stakeholders?
If stakeholders are harmed, should this be
remedied? How?
What is the relationship between shareholders
and stakeholders?

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Financial Goals of a Company
Maximize sales. Maximize return on
Maximize cash flow. sales, investment,
Maximize market equity.
share. Ensure earnings
Maximize profit. stability.
Minimize costs. Achieve target goals
for sales, profits,
market share or return.

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 Agency Issues:
The Principal-Agent Problem
Whenever ownership is independent of
management there exists potential problem of
conflicts.
The owners goals for the firm are best described
as maximizing shareholder wealth.
Managers are also concerned with personal
wealth, job security, lifestyle, and benefits. These
concerns may conflict with shareholder interests.

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 Resolving the Agency Problem
Good corporate governance by the Board of
Directors is the heart of any resolution.
Agency Costs the costs of this governance:
Monitoring costs,
Bonding costs,
Structuring compensation costs.
Market forces, such as the potential for hostile
takeover provide some deterrence.
Legal forces, fraud, and fiduciary misconduct laws
aim to act as deterrents as well.

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Current View on Incentive Plans
Executive compensation packages generally
include incentive plans that grant stock
options, performance based shares, or cash
bonuses upon meeting or exceeding
corporate goals.
Such packages may also include long-term
benefits that can protect the manager
against poor corporate performance.

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 Overview of Text
Part 1: Introduction to Managerial Finance
Part 2: Financial Analysis and Planning
Part 3: Important Financial Concepts
Part 4: Long-Term Financing Decisions
Part 5: Long-Term Investment Decisions
Part 6: Working Capital Management
Part 7: Special Topics in Managerial Finance

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