overview of managarial finance

5/21/2018 Overview of Managarial Finance

1/24Essentials of Managerial Finance by S. Besley & E. Brigham Slide 1of 23

Chapter 1

An Overview

of Managerial

Finance



Learning Objectives1. Understand the general framework for financial decision making.

2. Describe the role of financial decision making in maximizing the value of

the firm.

3. Identify how to determine whether an investment should be made and how

to finance acceptable investments.

4. Explain what is meant by the risk/return trade-off and how risk and return

can affect management decisions.

5. Understand the role of financial institutions and markets and its effect on

financial decisions made by the firm.



What is Finance

Finance is concerned with decisions

about money or cash flows.

Finance decisions deal with how moneyis raised and used by businesses,

governments, and indiiduals.



Importance of Managerial Finance

Assets: Liabilities & Equity:

Current Assets Current Liabilities

Cash & M.S. Accounts payable

Accounts receivable Notes Payable

Inventory Total Current Liabilities

Total Current Assets Long-Term Liabilities

Fixed Assets: Total Liabilities

Gross f ixed assets Equity:

Less: Accumulated dep. Common Stock

Goodw ill Paid-in-capital

Other long-term assets Retained Earnings

Total Fixed Assets Total Equity

To ta l Assets To ta l L i a b i l i t i es & Equ i t y

CompanyBalance Sheet

As of December 31, 2004

Maximize

wealth

notprofit!

Debts

are paid

by cashflow

not income!

InvestmentDecisions

utilize

funds

Financing

Decisions

require

funds



The operation of a firm



Forms of Business Organization

Advantages

Easy formation with low organizational costs

Affected by few government regulations

Income included and taxed only on proprietors

personal tax return (i.e. only one)

Proprietorship




Drawbacks

Owner has unlimited liability (i.e. total wealth can be

taken to satisfy debts)

Lacks continuity when proprietor dies

Transferring of ownership is difficult

Limited fund-raising power tends to inhibit growth

Proprietorship




Advantages

Fairly easy and inexpensive formation

Affected by few government regulations

Income included and taxed only on partners tax

return

Partnership




Drawbacks

Owners have unlimited liability and may have to

cover debts of other partners

Partnership is dissolved when a partner dies

Difficulty to liquidate or transfer partnership

Difficulty of raising large amounts of capital

Partnership




Advantages

Long life of firm even if owners do not have a

relationship with the business

Ownership (stock) is readily transferable

Owners have limited liability which guarantees that

they cannot lose more than they invested

Better access to financing

Corporation




Drawbacks

More expensive to organize than other business

forms and subject to greater government regulation

Taxes are higher because of double taxation:

corporate income is taxed and also dividends paid

to owners are taxed

Corporation



Value maximized for corporations

Limited Liability reduces the risk borne by investors

A firms current value is related to its future growth

opportunities

Corporate ownership can be transferred easier than the

ownership of either a proprietorship or a partnership

Why?

R l f Fi i B i



Role of Finance in a Business

Organization



The Goals of the CorporationStockholder wealth maximization

This should be the primary goal of a financial managerIncentives against are to keep stockholder returns at

reasonable level and work for other goals such as:

pursue goals of public service activities

target employee benefits

pursue higher executive salaries

But

Competitive forces require financial managers to opt for

stockholder wealth maximization, to avoid losing their jobs



The Goals of the CorporationSocial Responsibility

Firms should provide a safe environment, avoid airpollution and produce safe products. Incentives against

for firms to act in a socially responsible manner are:

Disadvantage in attracting funds due to extra costs incurred

Inability to compete due to higher prices of products

Constraints by capital market factors

Therefore

Social Responsibility actions should be enforced on a

mandatory rather than a voluntary basis



The Goals of the CorporationStock Price Maximization and Social Welfare

Shareholder Wealth Maximization is beneficial for the

society:

Stock price maximization requires efficient, low cost plants

that produce high-quality goods and services at a low cost

Stock price maximization requires the development of

products that customers want and need, leading to new

technology, new products and new jobs

Stock price maximization necessitates efficient service,

adequate stocks and well located business establishments


17/24

Essentials of Managerial Finance by S. Besley & E. Brigham Slide 17of 23

The Goals of the Corporation

Therefore primary goal is to

Maximize Shareholder Wealth


18/24


Decisions affecting the firms value

n

n

2

2

1

1

)

k

1

(

CF

)

k

1

(

CF

)

k

1

(

CF

value

Asset

+

+

+

+

+

= L+

Value = Current (present) value of expectedcash flows (CFs) based on the return

demanded by investors (k)

How to finance (capital structure decision)

What assets to purchase (capital budgeting decision)

Pay dividends or re-invest earnings? (dividend policy

decision)


19/24


Present Value explained The value of any financial contract (i.e., stock)

answers the following questions: 1. How much do I expect receipts to be (expected cash flow

to the investor (i.e., dividends))?

2. When do I receive the payments (timing/opportunity cost)?

3. What is the chance I do not receive what I expected

(risk)?

The Present Value (discounted) of cash flowsreceived by an investor is used as the estimate of thevalue of a contract (i.e., shareholder wealth)

The Present Value (discounted) of a single share isthe shares market price

Shareholders Wealth=Market Value ofEquity=Number of shares * share price


20/24


ou arn ngs er are eMaximized?

Beware: Wealth is NOT profit!

Investment Year 1 Year 2 Year 3 Total

A 2,90 0,00 0,00 2,90

B 0,00 0,00 3,00 3,00

EPS ()

Which Investment is Preferred?

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.


21/24


Make decisions about the cash flow

Beware: Accounting is NOT an economic profit!

Sales Revenue (in 100.000 Cash Inflow s (in ) 100.000

Less: Costs (in ) 80.000 Less: Cash Outflow s(in ) 80.000

Net Profit (in ) 20.000 Net Cash Flow (in ) 20.000

Finance View

Cash Flow Statement

for the year ended 2004

Accounting View

Income Statem ent

for the year ended 2004

Cash flow is the actual cash generated by the

firm. CF = Net Income + Depreciation

or (CF = NI + DEP )


22/24


Agency Relationships

Whenever a manager owns less than 100% of thefirms 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 firms shareholders.

Stockholders versus ManagersThe problem


23/24



Managerial compensation (in the form of performanceshares, executive stock options or restricted stock

grants)

But. Recent studies have failed to find a strong

relationship between CEO compensation and share price.

The threat of firing

Shareholder intervention

The threat of takeover

Stockholders versus Managers - Solutions


24/24

Essentials of Managerial Finance by S Besley & E Brigham Slide 24 of 23


Creditors consider the riskiness of the firm

Stockholders should not act against creditors because

Creditors protect themselves through restrictions in credit

agreements

Creditors may request an interest rate much higher than

normal to compensate for the stockholders actions

Result: Stockholders may find it difficult to borrow funds

in the future

Stockholders versus Creditors

overview of managarial finance

Documents

finance finance

brigham slide

finance decisions deal

longterm assets

total wealth

liabilities equity

i t i es equ

government regulations