"Chapter One :An overview of Managerial Finance"

What is Finance

Finance is the application of economic principlesFinance is the art and science of managing
moneyFinance is concerned with the process of money transfer between the various
economic units ( individuals, households, businesses and governments).
Finance is the study of money that refers raising fund, managing them and determining their
best use. Finance can be defined as the art and science of managing money. Finance is
concerned with the process, institution, markets and instruments involved in the transfer of
money among individuals, businesses, and governments.

Business Finance Some important questions that are answered using finance –

What long-term investments should the firm have? –Where will we get the long-term
financing to pay for the investment? –How will we manage the everyday financial activities
of the firm?

What three questions does financial management seek to answer?

What causes a company to have a particular stock value? How can managers make choices
that add value to their companies? How can managers ensure that their companies don’t run
out of cash while executing their plans?

Finance in the organizational structure of the firm

The three main /major areas /Opportunities of finance

The Field of Finance : Financial Management, Capital Markets/Financial Institutions, &

Investments.
(1) Financial management: corporate finance, which deals with decisions related to how
much and what types of assets a firm needs to acquire, how a firm should raise capital to
purchase assets, and how a firm should do to maximize its shareholders wealth - the focus of
this class (2) Capital markets: study of financial markets and institutions, which deals with
interest rates, stocks, bonds, government securities, and other marketable securities. It also
covers Federal Reserve System and its policies.
(3) Investments: study of security analysis, portfolio theory, market analysis, and behavioral
finance

Responsibilities of Financial Management/Financial Staff or Executive

Main responsibility is to make decisions concerning the acquisition and use of funds for the
greatest benefit of the firm
i. Forecasting and planning
ii. Making investment decisions & financial decisions
iii. Coordination and control
iv. Dealing with the financial markets
v. Managing Risk
Financial Management Issues of the New Millennium

The effect of changing technology

The globalization of business

Alternative legal Forms of Business Organization

Sole proprietorship Partnership Corporation

Sole Proprietorship “A business owned and managed by one individual. An unincorporated
business owned by one individual”.Sole Proprietorship Advantages: Ease of formation
Subject to few regulations No corporate income taxes Disadvantages: Limited life Unlimited
liability Difficult to raise capital
Partnership “A business owned by two or more people. An unincorporated business owned
by two or more people”. 
Partnership A partnership has roughly the same advantages and disadvantages as a sole
proprietorsh

Corporation: A legal entity created by a state

Separate and distinct from it’s owners and managers.Management is separated from
ownersIncorporation : is the process by which a company receives a state charter allowing it
to operate as a corporation.Articles of incorporation: document filed with a state or
government by the founders of a corporation.

Advantages of Corporations

Limited liabilityLarge capital could be obtainedOwnership easily transferredUnlimited

life.Can easily raise money in the financial market.

Disadvantages of Corporations

Double taxationSubject to greater government regulationExpensive and complex to

form.Setting up a corporation could be time consuming.

S Corporation: allows small business to be taxed as proprietorship or partnership

Restrictions: no more than 100 shareholders; for small and privately owned firms
Limited Liability Company (LLC) and Limited Liability Partnership (LLP): LLCs
Hybrid between a partnership and a corporation - limited liability but taxed as partnership
LLPs are used in professional fields of accounting, law, and architecture while LLCs are used
by other businesses

Forms of businesses in other countries

In the US : corporations are “open" companies, are publicly traded and independent of each
other and of the government.In England & Canada: most large companies are “open" and
their stocks widely dispersed among different investors . However two thirds of the traded
stocks in England are owned by institutional investors.In much of Continental Europe stock
ownership is more concentrated. investor groups include families, Banks and other
corporations.In Japan & S.Korea firms belong to industrial groups These are organizations
comprise of companies in different industries with common ownership interest which include
firms necessary to manufacture and sell industrial products (a network of
manufacturers,suppliers,retailers etc) examples are Toyota,Toshiba.
Economic Profit Versus Accounting Profit

Economic profit Opportunity cost Normal profit Accounting profit Ignores opportunity costs
and normal profits Does not reflect the firm’s actual cash flows

The Goals of a Corporation /What should be the prime goal of a corporation-Profit

Maximization??  Stockholders’ wealth Maximization or Stock price Maximization??

The primary goal of a financial manager should maximize the stockholders wealth by
maximizing the price of the firms common stocks. Firms do, of course, have other objectives
but stock price maximization is the most important goal for most corporation. Further more,
the action that maximize the stock price also increase social welfare.

Goals of Corporation

The Main goal of corporations is maximizing shareholders wealth ( maximizing the value of
the firm) by maximizing the price of the firm’s stock.Managerial Incentives to Maximize
Shareholder Wealth: Besides wealth and dividend maximization objectives, managers may
pursue other objectives such as higher executive salaries and employee benefits. However,
competitive forces generally require managers to make attempts to maximize shareholders
wealth. If they don't, then managers risk loosing their jobs.Social responsibility; May include
welfare of the employees, customer satisfaction and the community at large.
Ethical Responsibility ;providing safe working environment, avoid polluting the air and to
produce safe products.Socially responsible actions have costs and firms which act in a a
socially responsible manner ,while others do not ,will be at a disadvantage in attracting
funds.Cost –increasing actions associated with social responsibility will have to be put on a
mandatory rather than a voluntary basis to ensure that the burden falls uniformly on all
businesses and to maintain fair competition.Stock price maximization and social welfare:
Most actions that help a firm increase the price of its stock also are beneficial to society at
large.Most executives believe that there is a positive correlation between ethics and long run
profitability of the firm !!!!
Some Terminologies Stockholders:
The owners of a corporation, whose ownership or equity, is evidences by either common
stock or preferred stock. Stakeholder: Groups such as employees, customers, supplies,
creditors, owners, govt. and others who have a direct economic link to the firm. Dividends:
Periodic distributions of earnings to the stockholders of a firm. Common Stock: The purest
and most basic forms of corporate ownership. Preferred Stock: A special form of ownership
having a fixed periodic dividend that must be paid prior to payment of any common stock
dividend. EPS (Earning per Share):The amount earned during the period on behalf of each
outstanding share of common stock. EPS = Total earnings from the common SH / Number of
common SH.
Intrinsic value and market price of a stock
Intrinsic value is an estimate of a stock’s “fair” value (how much a stock should be worth)
Market price is the actual price of a stock, which is determined by the demand and supply of
the stock in the market
Managerial Actions to Maximize Shareholder Wealth

Management’s decisions can significantly affect the firm’s value.Managers can increase the
value of a firm by making decision that :- Increase the level of expected future cash flows
(CFs)- Generate the expected (CFs) sooner (The timing of CFs)Increase the certainty of the
expected CFs. (riskiness of CFs)
Given external factors and constraints such as ; the legal constraints, level of economic
activity, tax laws and stock market conditions, management makes a set of long-run strategic
policy decisions that chart a future course for the firm.

Should Earnings Per Share (EPS) be maximized?

Financial managers who attempt to maximize earnings might not maximize value.!!Earnings
maximization is a short-sighted goal as it does not consider the timing of earnings nor the
firm’s future risk position.N.B (EPS= NI divided by the numbers of shares outstanding)The
firm’s stock price and thus its value is dependent on: its future expected cash flows, the
timing of the CFs and the risk associated with such CFs.
Factors That Affect the Firm’s Stock Price
Internal Factors Amount of cash flows expected by shareholders Timing of the cash flow
stream Risk of the cash flows Use of debt Dividend policy
External Factors Legal constraints General level of economic activity Tax laws Conditions in
the stock market Investor expectations

Agency Relationships
Agency relationship exist when one or more persons (The principals) hire another person
(The agent) to act on their behalf.In corporations ,important agency relationship exist
:Between stockholders and managers, andBetween stockholders and creditors

Agency Problems Shareholders versus managers :

Management is separate from ownershipAgency problem arises when a manager own less
than 100%of the co.’s ownershipManagers may make decisions that are not in line with the
goal of maximizing stockholders wealth ( may work less eagerly and tend to benefit
themselves in terms of salary and perks)Agency costs: Are costs associated with agency
problem such as reduced stock price and “perks”
Agency Problems Shareholders versus Creditors :
Stockholders Versus CreditorsCreditors lend the firm at a certain interest rate based on
expectations regarding the factors that determine the riskiness of the firm’s expected cash
flows, such as:The riskiness of the firm’s existing assetsThe riskiness of future asset
additionsPresent capital structure.Expected capital structure.
Conflict develops if;- Managers , acting in the interest of shareholders, take on projects with a
greater risk than creditors anticipated.-Raise the debt level higher than was expected.* The
above actions tend to reduce the value of debt outstanding.

The goal of maximizing shareholders wealth require fair play with the creditors and other
stakeholders !!Managers as agents of both the creditors and stockholders ,must act in a
manner that is fairly balanced between the interest of these two classes of security holders

Mechanisms Used To Ensure That Managers Act In The Shareholders Best Interest

Managerial compensation (Incentives) plans: include giving management performance

shares, stock options or restricted stock grants.The proper structuring of managerial
incentives( All incentive compensation plans are designed to provide inducements to
management to act in a manner that will contribute to stock price maximization as well as to
attract and retain top-level executives )The threat of firing.Shareholders intervention
( institutional shareholders with large stakes in the firm)The threat of takeover ( in a hostile
takeover, the managers of the acquired firm generally are fired)

Tactics That Managers Can Use To Ward Off a Hostile Takeovers :

Hostile takeover : takeover of a company against the wishes of current management and the
board of directors.Tactics used by management include:- Scorched earth policy: technique
used by a takeover- target company to make itself unattractive to the acquirer.e.g it may agree
to sell off the most attractive parts of its business (Crown Jewels) or it may schedule all debt
to become due immediately after a merger.- Poison Pill ; A move by a take over target
company to make its stocks less attractive to an acquirer.e.g issue a new series of preferred
stock that gives shareholders the right to redeem it at a premium price after a takeover.-
Greenmail (Bon Voyage Bonus); payment of a premium to a raider trying to take over a
company through a proxy contest or other means.
Stakeholders
Individual or entities that have interest in the well-being of a firm such
as:StockholdersCreditorsEmployeesCustomers andSuppliers

Business Ethics
Company’s attitude and conduct toward its stakeholders (employees, customers,
stockholders…) Ethical behavior requires fair and honest treatment toward all parties Avoids
fines and legal expenses Builds public trust Attracts business from customers who appreciate
and support the firm’s policies Attracts and keeps employees of the highest caliber Supports
the economic viability of the communities in which it operates

What is a multinational corporation?

A multinational corporation is one that operates in two or more countries. At one time, most
multinationals produced and sold in just a few countries. Today, many multinationals have
world- wide production and sales.
Multinational Corporations Firms that operate in two or more countries
1.To seek new markets—e.g., Coke
2.To seek raw material—e.g., Exxon Mobil
3.To seek new technology—e.g., Xerox
4.To seek production efficiency—e.g., GM
5.To avoid political and regulatory hurdles— e.g., Honda, Nissan, Toyota
Five reasons firms go “international”
Why do firms expand into other countries?
To seek new markets To seek new supplies of raw materials To gain new technologies To
gain production efficiencies To avoid political and regulatory obstacles To reduce risk by
diversification
What are the major factors that distinguish multinational from domestic financial
management? Exchange rate risk Currency differences Economic risk Political risk
Government roles Cultural, legal, and institutional differences Cultural differences Language
differences Legal differences
Why is corporate finance important to all managers?
Corporate finance provides the skills managers need to: Identify and select the corporate
strategies and individual projects that add value to their firm. Forecast the funding
requirements of their company, and devise strategies for acquiring those funds.