Topic 1

Introduction to Financial
Management
Learning Goals

1. Define finance, its major areas, 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.

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Learning Goals (cont.)

4. Explain the goal of the firm, corporate

governance, the role of ethics, and
the agency issue.

5. Understand financial institutions and markets,

and the role they play in managerial finance.

6. Discuss business taxes and their importance

in financial decisions.

1-3
Multiple Choice

• Finance can be defined as

(a) the system of debits and credits.
(b) the science of the production, distribution, and
consumption of wealth.
(c) the art and science of managing money.
(d) the art of merchandising products and
services.

1-4
True or False

• Finance is concerned with the process,

institutions, markets, and instruments
involved in the transfer of money among
individuals, businesses, and governments.

• True

1-5
Multiple Choice

• The part of finance concerned with design and

delivery of advice and financial products to
individuals, business, and government is called
(a) Managerial Finance.
(b) Financial Manager.
(c) Financial Services.
(d) None of the above.

1-6
Major Areas & Opportunities in
Finance: 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.

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Career Opportunities

1-8
Multiple Choice

• Managerial finance
(a) involves tasks such as budgeting, financial
forecasting, cash management, and funds
procurement.
(b) involves the design and delivery of advice and
financial products.
(c) recognizes funds on an accrual basis.
(d) devotes the majority of its attention to the
collection and presentation of financial data.
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Multiple Choice

• Career opportunities in financial services include

all of the following EXCEPT
(a)investments.
(b)real estate and insurance.
(c) capital expenditures management.
(d)personal financial planning.

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Major Areas & Opportunities in
Finance: Managerial Finance (cont.)
• The following complicates the financial
management function:
– Increasing globalization
• cash flows in different currencies and
• protecting against the risks inherent in
international transactions.
– Changing economic and regulatory conditions

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Legal Forms of Business Organization

1-12
Multiple Choice

• Which of the following legal forms of organization

is most expensive to organize?
(a) Sole proprietorships.
(b) Partnerships.
(c) Corporations.
(d) Limited partnership.

1-13
Multiple Choice

• Under which of the following legal forms of

organization, is ownership readily transferable?
(a) Sole proprietorships.
(b) Partnerships.
(c) Limited partnership.
(d) Corporation.

1-14
Multiple Choice

• A major weakness of a partnership is

(a) limited liability.
(b) difficulty liquidating or transferring ownership.
(c) access to capital markets.
(d) low organizational costs.

1-15
Multiple Choice

• All of the following are key strengths of a

corporation EXCEPT
(a) access to capital markets.
(b) limited liability.
(c) low organization costs.
(d) readily transferable ownership.

1-16
Multiple Choice

• A “legal entity” which can sue and be sued, make

and be party to contracts, and acquire property in
its own name is
(a) a sole proprietorship.
(b) a partnership.
(c) a corporation.
(d) a professional partnership.

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Corporate Organization

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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.

1-19
Multiple Choice

• The true owner(s) of the corporation is (are) the

_________.
(a) board of directors
(b) chief executive officer
(c) stockholders
(d) creditors

1-20
Multiple Choice

• The _________ has/have the ultimate

responsibility in guiding corporate affairs and
carrying out policies.
(a) board of directors
(b) chief executive officer
(c) stockholders
(d) creditors

1-21
Multiple Choice

• In a corporation, the members of the board of

directors are elected by the
(a) chief executive officer.
(b) creditors.
(c) stockholders.
(d) employees.

1-22
Multiple Choice

• The responsibility for managing day-to-day

operations and carrying out corporate policies
belongs to the _________.
(a) board of directors
(b) chief executive officer
(c) stockholders
(d) creditors

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Multiple Choice

• The treasurer is commonly responsible for

(a) taxes.
(b) data processing.
(c) making capital expenditures.
(d) cost accounting.

1-24
Multiple Choice

• The controller is commonly responsible for

(a)managing cash.
(b)financial accounting.
(c) managing credit activities.
(d)financial planning.

1-25
Multiple Choice

• The accountant may be responsible for any of the

following EXCEPT
(a) processing purchase orders and invoices.
(b) ensuring accounts payable are paid on time.
(c) preparing the monthly income statement.
(d) analyzing the mix of current to fixed assets.

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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.

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The Managerial Finance Function:
Relationship to Accounting (cont.)
True or False
• 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.
• T

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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 differences in

performance under the accounting method
versus the cash method.
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The Managerial Finance Function:
Relationship to Accounting (cont.)

INCOME STATEMENT SUMMARY

ACCRUAL CASH
Sales $100,000 $ 0
Less: Costs (80,000) (80,000)
Net Profit/(Loss) $ 20,000 $(80,000)

1-30
Multiple Choice

• A firm has just ended its calendar year making a sale in

the amount of $150,000 of merchandise purchased during
the year at a total cost of $112,500. Although the firm paid
in full for the merchandise during the year, it has yet to
collect at year end from the customer. The net profit and
cash flow from this sale for the year are
(a) $0 and $150,000, respectively.
(b) $37,500 and –$150,000, respectively.
(c) $37,500 and –$112,500, respectively.
(d) $150,000 and $112,500, respectively.

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Multiple Choice

• The primary emphasis of the financial manager is the use

of
(a) accrued earnings.
(b) cash flow.
(c) organization charts.
(d) profit incentives.

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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.

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The Managerial Finance Function:
Relationship to Economics
• The field of finance is actually an
outgrowth of economics.
– Financial economics
• Financial managers must understand the
economic framework within which they
operate in order to react or anticipate to
changes in conditions.

1-34
Multiple Choice

• Economic theories that the financial manager

must be able to utilize for efficient business
operations, include
(a) supply-and-demand analysis.
(b) marginal analysis.
(c) profit-maximizing strategies.
(d) price theory.
(e) all of the above.

1-35
The Managerial Finance Function:
Relationship to Economics (cont.)
True or False
• 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.
• T

1-36
Multiple Choice

• Included in the primary activities of the financial manager

are
(a) financial analysis and planning.
(b) making investment decisions.
(c) making financing decisions.
(d) analyzing and planning cash flows.
(e) all of the above.

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Primary Activities of
the Financial Manager

1-38
Multiple Choice

• Making investment decisions includes all of the following

EXCEPT
(a) inventory.
(b) fixed assets.
(c) accounts receivable.
(d) notes payable.

1-39
Multiple Choice

• Making financing decisions includes all of the following

EXCEPT
(a) determining the appropriate mix of short-term and
long-term financing.
(b) deciding which individual short-term sources are best
at a given point in time.
(c) analyzing quarterly budget and performance reports.
(d) deciding which individual long-term sources are best
at a given point in time.

1-40
Goal of the Firm: Maximize Profit???

Which Investment is Preferred?

Earnings per share (EPS)

Investment Year 1 Year 2 Year 3 Total (years 1-3)
Rotor $ 1.40 $ 1.00 $ 0.40 $ 2.80
Valve $ 0.60 $ 1.00 $ 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.

1-41
Multiple Choice

• The primary goal of the financial manager is

(a) minimizing risk.
(b) maximizing profit.
(c) maximizing wealth.
(d) minimizing return.

1-42
Goal of the Firm:
Maximize Shareholder Wealth!!!
• Why?
• 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:
level & timing
of cash flows
Share Price = Future Dividends
risk of cash
Required Return
flows

1-43
Goal of the Firm:
Maximize Shareholder Wealth!!! (cont.)
• The process of shareholder wealth
maximization can be described using the
following flow chart:

1-44
Multiple Choice

• Wealth maximization as the goal of the firm implies

enhancing the wealth of
(a) the Board of Directors.
(b) the firm’s employees.
(c) the government.
(d) the firm’s stockholders.

1-45
Multiple Choice

• Corporate owner’s receive realizable return through

(a) earnings per share and cash dividends.
(b) increase in share price and cash dividends.
(c) increase in share price and earnings per share.
(d) profit and earnings per share.

1-46
Multiple Choice

• The goal of profit maximization would result in priority for

(a) cash flows available to stockholders.
(b) risk of the investment.
(c) earnings per share.
(d) timing of the returns.

1-47
Multiple Choice

• Profit maximization does NOT take into consideration

(a) risk and cash flow.
(b) cash flow and stock price.
(c) risk and EPS.
(d) EPS and stock price.

1-48
Multiple Choice

• Return and risk are the key determinants in share price.

Increased return results in _________, other things
remaining the same.
(a) a lower share price.
(b) a higher share price.
(c) an unchanged share price.
(d) an undetermined share price.

1-49
Multiple Choice

• Return and risk are the key determinants in share price.

Increased risk, other things remaining the same, results in
(a) a lower share price.
(b) a higher share price.
(c) an unchanged share price.
(d) an undetermined share price.

1-50
Multiple Choice

• Return and risk

(a) have no effect on share price.
(b) have an inverse effect on share price.
(c) adversely affect share price.
(d) have the same effect on share price.

1-51
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."

1-52
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.

1-53
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.

1-54
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

1-55
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?

1-56
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?

1-57
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

1-58
The Role of Ethics:
Ethics & Share Price
• WorldCom (2002) scandal
– $3.8 billion (Php 190.0 billion) worth of normal
operating expenses were capitalized

$60
(Php 3,000)

20 cents
(Php 10)
1-59
The Role of Ethics:
Ethics & Share Price
• Enron Scandal (2001)

1-60
The Role of Ethics:
Ethics & Share Price
• Enron Scandal (2001)
– Enron shareholders filed a $40 billion
(Php 2 trillion) lawsuit after the
company's stock price, which
achieved a high of US$90.75 (Php
4,537.50) per share in mid-2000,
plummeted to less than $1 (Php
50.00) by the end of November 2001

1-61
Multiple Choice

• The implementation of a pro-active ethics program is

expected to result in
• (a) a positive corporate image and increased respect, but
is not expected to affect cash flows.
• (b) an increased share price resulting from a decrease in
risk, but is not expected to affect cash flows.
• (c) a positive corporate image and increased respect, but
is not expected to affect share price.
• (d) a positive corporate image and increased respect, a
reduction in risk, and enhanced cash flow resulting in an
increase in share price.
1-62
The Agency Issue:
The Agency Problem
• Whenever a manager owns less than
100% of the firm’s equity, a potential
agency problem exists.
• In corporate finance, the agency
problem usually refers to a conflict of
interest between a company's
management and the company's
stockholders.
1-63
The Agency Issue:
The Agency Problem

Source: Kaplan Knowledge Bank

1-64
The Agency Issue:
The Agency Problem

Source: WordPress.com
1-65
The Agency Issue:
The Walmart Case (2015)

Source: http://shaungwright.blogspot.com
1-66
The Agency Issue:
Resolving the Problem
• 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.

1-67
Multiple Choice

• One way often used to insure that management decisions

are in the best interest of the stockholders is to
(a) threaten to fire managers who are seen as not
performing adequately.
(b) remove management’s perquisites.
(c) tie management compensation to the performance of
the company’s common stock price.
(d) tie management compensation to the level of earnings
per share.

1-68
The Agency Issue:
Resolving the Problem (cont.)
• Managerial compensation
• Direct intervention by stockholders
– Threat of firing
– Threat of takeovers
• Monitoring
– Stockholders
– Board of Directors
– Outside auditors
• Bonding 1-69
The Agency Issue:
Resolving the Problem (cont.)
• Recent studies have failed to find a strong
relationship between CEO compensation
and share price.

1-70
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

1-71
The Relationship between Financial
Institutions and Financial Markets

1-72
Financial Institutions & Markets:
Financial Institutions
True or False
• Financial institutions are intermediaries that channel the savings of
individuals, businesses, and governments into loans or investments.
• T
• The key suppliers and demanders of funds are individuals,
businesses, and governments.
• T
• In general, individuals are net suppliers of funds, while businesses
and governments are net demanders of funds.
• T

1-73
Financial Institutions & Markets:
Financial Markets
• Financial markets provide a forum in which
suppliers of funds and demanders of funds can
transact business directly.
• T
• The two key financial markets are the money
market and the capital market.
• T

1-74
Financial Institutions & Markets:
Financial Markets
• Transactions in short term marketable securities
take place in the money market while
transactions in long-term securities take place in
the capital market.
• T

1-75
Financial Institutions & Markets:
Financial Markets (cont.)
• Whether subsequently traded in the money or
capital market, securities are first issued through
the primary market.
• The primary market is the only one in which a
corporation or government is directly involved in
and receives the proceeds from the transaction.
• Once issued, securities generally then trade on
the secondary markets such as the Philippine
Stock Exchange.
1-76
The Money Market

• The money market exists as a result of the

interaction between the suppliers and
demanders of short-term funds (those having
a maturity of a year or less).
• Most money market transactions are made in
marketable securities which are short-term
debt instruments such as T-bills and
commercial paper.
• Money market transactions can be executed
directly or through an intermediary.
1-77
The Capital Market

• The capital market is a market that enables

suppliers and demanders of long-term funds to
make transactions.
• The key capital market securities are bonds
(long-term debt) and both common and
preferred stock (equity).

1-78
True or False

• The return in money markets are usually low while the

returns in capital markets are high.
• T
• The risk in money markets are comparatively higher
than capital markets.
• F

1-79
Business Taxes

• Both individuals and businesses must pay taxes

on income.
• The income of sole proprietorships and
partnerships is taxed as the income of the
individual owners, whereas corporate income is
subject to corporate taxes.
• Both individuals and businesses can earn two
types of income—ordinary income and
capital gains income.
1-80
Multiple Choice

• The dividend exclusion for domestic corporations receiving

dividends from another domestic corporation has resulted in
(a) a lower cost of equity for the corporation paying the
dividend.
(b) a higher relative cost of bond-financing for the
corporation paying the dividend.
(c) stock investments being relatively less attractive, relative
to bond investments made by one corporation in another
corporation.
(d) stock investments being relatively more attractive
relative to bond investments made by one corporation in
another corporation.
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Situational

• Consider two firms, Go Debt corporation and No Debt

corporation. Both firms are expected to have earnings
before interest and taxes of $100,000 during the coming
year. In addition, Go Debt is expected to incur $40,000 in
interest expenses as a result of its borrowings whereas No
Debt will incur no interest expense because it does not
use debt financing. However, No Debt will have to pay
stockholders $40,000 in dividend income. Both firms are in
the 40 percent tax bracket. Calculate the Earnings after
tax for both firms. Which firm has the higher after-tax
earnings? Which firm appears to have the higher cash
flow? How do you account for the difference?
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Situational - Answer
Go No
Debt Debt
Earnings before interest $100,000 $100,000
and taxes
Less: Interest expense 40,000 0
Earnings before taxes $ 60,000 $100,000
Less: Taxes (40%) 24,000 40,000
Earnings after taxes $ 36,000 $ 60,000
Less: Dividends paid 0 40,000

1-83
References

• Principles of Managerial Finance by Lawrence

J. Gitman (Brief Fourth Edition)

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