Finance

Finance is the art and science of managing money. Virtually all individuals and organizations earn or
raise money and spend or invest money. Finance is concerned with the process, institutions, markets, and
instruments involved in the transfer of money among individuals, businesses, and governments.

Major Areas and Opportunities in Finance

1. Financial Services - area of finance concerned with the design and delivery of advice and
financial products to individuals, business, and government. It involves a variety of interesting
career opportunities within the areas of banking and related institutions, personal financial
planning, investments, real estate, and insurance.
2. Managerial Finance - concerned with the duties of the financial manager in the business firm.

Financial Managers
Financial managers actively manage the financial affairs of any type of businesses—financial and
nonfinancial, private and public, large and small, profit-seeking and not-for-profit. They perform such
varied financial tasks as planning, extending credit to customers, evaluating proposed large expenditures,
and raising money to fund the firm’s operations.

Business
Businesses are organizations engaged in commercial, industrial, or professional activities. They can be
for-profit or non-profit.
Most Common Legal Forms of Business
1. Sole Proprietorship
2. Partnership
3. Corporation

Why Study Managerial Finance?

An understanding of the concepts, techniques, and practices presented throughout this text will fully
acquaint you with the financial manager’s activities and decisions. Because most business decisions are
measured in financial terms, the financial manager plays a key role in the operation of the firm. People in
all areas of responsibility—accounting, information systems, management, marketing, operations, and so
forth—need a basic understanding of the managerial finance function.

The Managerial Finance Function

All personnel in all areas of responsibility must interact with finance personnel, and vice versa, so that the
forecasts and decisions of the finance personnel become useful.

The managerial finance function can be broadly described by:

1. Role within the organization
2. Relationship to accounting
3. Primary activities of the financial manager

Role Within the Organization

The size, importance, and role of finance depends on the size of the firm. For smaller firms, the
accounting department has the finance function. For larger firms, the finance function is typically a
separate department.
 • CEO (Chief Executive Officer) – highest-ranking; responsibilities include making major
corporate decisions, managing overall operations and resources, main point of communication
between BOD and corporate operations
• CFO (Chief Financial Officer) – has the primary responsibility for planning, implementation,
managing, and running of all the finance activities of a company, including business planning,
budgeting, forecasting, and negotiations.
• Treasurer (Chief Financial Manager) responsibilities include:
- financial planning
- manage cash
- manage credit activities
- manage pension fund
- manage foreign exchange
• Controller (Chief Accountant) handles accounting activities, such as:
- corporate accounting
- tax
- financial accounting
- cost accounting

Relationship to Accounting
The firm’s finance (treasurer) and accounting (controller) activities are closely related and generally
overlap. there are two basic differences between finance and accounting; one is related to the emphasis on
cash flows and the other to decision making.

The accountant’s primary function is to develop and report data for measuring the performance of the
firm, assess its financial position, comply with and file reports required by securities regulators, and file
and pay taxes. Using certain standardized and generally accepted principles, the accountant prepares
financial statements that recognize revenue at the time of sale (whether payment has been received or not)
and recognize expenses when they are incurred. This approach is referred to as the accrual basis. The
financial manager, on the other hand, places primary emphasis on cash flows, the intake and outgo of
cash. He or she maintains the firm’s solvency by planning the cash flows necessary to satisfy its
obligations and to acquire assets needed to achieve the firm’s goals. The financial manager uses this cash
basis to recognize the revenues and expenses only with respect to actual inflows and outflows of cash.
Regardless of its profit or loss, a firm must have a sufficient flow of cash to meet its obligations as they
come due.

The second major difference between finance and accounting has to do with decision making.
Accountants devote most of their attention to the collection and presentation of financial data. Financial
managers evaluate the accounting statements, develop additional data, and make decisions based on their
assessment of the associated returns and risks. Of course, this does not mean that accountants never make
decisions or that financial managers never gather data. Rather, the primary focuses of accounting and
finance are distinctly different.

Primary Activities of the Financial Manager

In addition to ongoing involvement in financial analysis and planning, the financial manager’s primary
activities are making investment decisions and making financing decisions. Investment decisions
determine both the mix and the type of assets held by the firm. Financing decisions determine both the
mix and the type of financing used by the firm.

Goal of the Firm

• Owners of the corporation are normally distinct from its managers
• Actions of the financial managers should take into consideration the objectives of the firm’s
owners (i.e. shareholders) – Maximize Profit and Maximize Shareholder Wealth

Profit Maximization
• General rule is that financial managers would only take those actions that are expected to make
major contributions to the firm’s overall profits.
• Commonly measured using Earnings Per Share (EPS).
• Arguments against profit maximization as a goal:
Timing – the receipt of funds sooner than later is preferred
Cash flows – profits do not necessarily result in cash flows available for the firm
Risk – profit maximization normally disregards risk (Axiom: Risk-Return Trade-Off)

Maximization of Shareholder Wealth

• Maximize the wealth of the owners for whom the firm is being operated.
• Measured in terms of the share price.
• Financial managers should accept only those actions that are expected to increase the share price.
• Includes preservation of stakeholder well-being as part of social responsibility.
Stakeholders include those parties such as employees, customers, suppliers, creditors, etc.
This does not alter the maximization of shareholder wealth

Financial Institutions and Markets

Most successful firms have ongoing needs for funds. They can obtain funds from external sources in three
ways. The first source is through a financial institution that accepts savings and transfers them to those
that need funds. A second source is through financial markets, organized forums in which the suppliers
and demanders of various types of funds can make transactions. A third source is through private
placement. Because of the unstructured nature of private placements, here we focus primarily on the role
of financial institutions and financial markets in facilitating business financing.

Financial Institutions
Financial institutions serve as intermediaries by channeling the savings of individuals, businesses, and
governments into loans or investments. Many financial institutions directly or indirectly pay savers
interest on deposited funds; others provide services for a fee (for example, checking accounts for which
customers pay service charges). Some financial institutions accept customers’ savings deposits and lend
this money to other customers or to firms; others invest customers’ savings in earning assets such as real
estate or stocks and bonds; and some do both. Financial institutions are required by the government to
operate within established regulatory guidelines.

• Key suppliers and customers:

Individuals
Businesses
Government

Individuals
• The savings that individual consumers place provide financial institutions with a large portion of
their funds.
• Although individuals also demand funds through loans, individuals as a group are net suppliers.

Businesses
• They also deposit some of their funds in financial institutions, primarily through checking
accounts in commercial banks.
• Businesses are net demanders of funds.

Government
• Governments maintain deposits of temporarily idle funds.
• They do not borrow directly from financial institutions; they issue debt securities such as
government bonds.
• Typically, governments are net demanders of funds.

Financial Markets
Financial markets are forums in which suppliers of funds and demanders of funds can transact business
directly. Whereas the loans and investments of institutions are made without the direct knowledge of the
suppliers of funds (savers), suppliers in the financial markets know where their funds are being lent or
invested. The two key financial markets are the money market and the capital market. Transactions in
short-term debt instruments, or marketable securities, take place in the money market. Long-term
securities—bonds and stocks—are traded in the capital market.

To raise money, firms can use either private placements or public offerings. Private placement involves
the sale of a new security issue, typically bonds or preferred stock, directly to an investor or group of
investors, such as an insurance company or pension fund. Most firms, however, raise money through a
public offering of securities, which is the nonexclusive sale of either bonds or stocks to the general public.

All securities are initially issued in the primary market. This is the only market in which the corporate or
government issuer is directly involved in the transaction and receives direct benefit from the issue. That
is, the company receives the proceeds from the sale of securities. Once the securities begin to trade
between savers and investors, they become part of the secondary market. The primary market is the one in
which “new” securities are sold. The secondary market can be viewed as a “preowned” securities market.

Relationship Between Financial Institutions and Financial Markets

Ten Axioms of Managerial Financial Management

1. The Risk-Return Trade-Off
• We won’t take additional risk unless we expect to be compensated with additional return.
• The greater the risk, the greater the expected return.
2. The Time Value of Money
• A dollar received today is worth more than a dollar received in the future. A dollar received today
is worth more than a dollar received by tomorrow because a dollar received today can earn a
day’s interest by tomorrow.
• Because of inflation, a dollar you receive today will buy more than a dollar you receive in the
future.
• The sooner you get the money, the better; the sooner you invest your money, the better
3. Cash, not profit, is king
• Accounting profit or loss frequently does not coincide with the actual transfer of money.
• First rule of business: do not run out of cash.
• You cannot spend “profits”; these are only paper figures
4. Incremental Cash Flows
• It’s only the increase or decrease in cash that really counts
• It’s the difference between cash flows if the project is done versus if the project is not done
5. Curse of Competitive Markets
• It’s hard to find and maintain exceptionally profitable projects.
• Success attracts competition, and competition lowers profit.
6. Efficient Capital Markets
• The markets are quick, and the prices are right.
• Security prices adjust very quickly and appropriately to publicly available information
7. The Agency Problem
• Managers will not work for owners unless it’s in their best interest.
• Managers may make decisions that are in their best interests and not in line with the long-term
best interests of the owners
8. Taxes Bias Business Decisions
• Decisions using cash flows must always use after-tax cash flows.
9. All Risk is not Equal
• Some risks can be diversified, and some cannot.
 • “Don’t put your eggs in one basket”
10. Ethical Behavior is Doing the Right Thing, and Ethical Dilemmas are Everywhere in Finance
• Businesses that are not trusted by other businesses or by customers will not maximize the wealth
of stockholders.

Risk and Return Discussion

Reference: Gitman, Lawrence J. Principles of managerial finance. Thirteenth edition. Copyright © 2012, 2009, 2006, 2003

In most important business decisions there are two key financial considerations: risk and return. Each
financial decision presents certain risk and return characteristics, and the combination of these
characteristics can increase or decrease a firm’s share price. Analysts use different methods to quantify
risk, depending on whether they are looking at a single asset or a portfolio—a collection, or group, of
assets. We will look at both, beginning with the risk of a single asset. First, though, it is important to
introduce some fundamental ideas about risk, return, and risk preferences.

Risk, Defined
In the most basic sense, risk is a measure of the uncertainty surrounding the return that an investment will
earn. Investments whose returns are more uncertain are generally viewed as being riskier. More formally,
the term risk is used interchangeably with uncertainty to refer to the variability of returns associated with
a given asset. A $1,000 government bond that guarantees its holder $5 interest after 30 days has no risk,
because there is no variability associated with the return. A $1,000 investment in a firm’s common stock,
the value of which over the same 30 days may move up or down a great deal, is very risky because of the
high variability of its return.

Return, Defined
Obviously, if we are going to assess risk on the basis of variability of return, we need to be certain we
know what return is and how to measure it. The total rate of return is the total gain or loss experienced on
an investment over a given period. Mathematically, an investment’s total return is the sum of any cash
distributions (for example, dividends or interest payments) plus the change in the investment’s value,
divided by the beginning of-period value. The expression for calculating the total rate of return earned on
any asset over period t, rt, is commonly defined as

rt = (Ct + Pt – Pt-1) / Pt-1

where:
rt = actual, expected, or required rate of return during period t
Ct = cash (flow) received from the asset investment in the time period t-1 to t
Pt = price (value) of asset at time t
Pt-1 = price (value) of asset at time t-1

Illustration:
Robin wishes to determine the return on two stocks that she owned during 2009, Apple Inc. and Wal-
Mart. At the beginning of the year, Apple stock traded for $90.75 per share, and Wal-Mart was valued at
$55.33. During the year, Apple paid no dividends, but Wal Mart shareholders received dividends of $1.09
per share. At the end of the year, Apple stock was worth $210.73 and Wal-Mart sold for $52.84.
Substituting into the equation, we can calculate the annual rate of return, r, for each stock.

APPLE:
rt = (Ct + Pt – Pt-1) / Pt-1
rt = ($0 + $210.73 - $90.75) / $90.75
rt = 132.2%
WAL-MART:
rt = (Ct + Pt – Pt-1) / Pt-1
rt = ($1.09 + $52.84 - $55.33) / $55.33
rt = -2.5%

Risk Preferences
Different people react to risk in different ways. Economists use three categories to describe how investors
respond to risk. The first category, and the one that describes the behavior of most people most of the
time, is called risk aversion. A person who is a risk averse investor prefers less risky over more risky
investments, holding the rate of return fixed. A risk-averse investor who believes that two different
investments have the same expected return will choose the investment whose returns are more certain.
Stated another way, when choosing between two investments, a risk-averse investor will not make the
riskier investment unless it offers a higher expected return to compensate the investor for bearing the
additional risk.

A second attitude toward risk is called risk neutrality. An investor who is risk neutral chooses investments
based solely on their expected returns, disregarding the risks. When choosing between two investments, a
risk neutral investor will always choose the investment with the higher expected return regardless of its
risk.

Finally, a risk-seeking investor is one who prefers investments with higher risk and may even sacrifice
some expected return when choosing a riskier investment. By design, the average person who buys a
lottery ticket or gambles in a casino loses money. After all, state governments and casinos make money
off of these endeavors, so individuals lose on average. This implies that the expected return on these
activities is negative. Yet people do buy lottery tickets and visit casinos, and in doing so they exhibit risk-
seeking behavior.