Photo Credits: Google Images

UNIT 1: Introduction to Managerial Finance

Introduction

Have you ever imagined yourself having your own business? It may only be a small one but just like
what Toyo, a man from Japan who owns an izakaya, have said: “It’s better to be the chicken’s head
than a bull’s tail.” However, being the manager of a small business, you have to be a jack-of-all-trades.
You have to be good at sales and marketing. You have to be knowledgeable about hiring, training, and
motivating employees. You have to understand production systems if you are in the manufacturing
business. You have to be smart at purchasing. You should be aware of business law and government
regulations. You have to figure out where you have an edge on your competitors. Equally important,
you need good skills for managing the financial affairs of your business.

Managing the finances of a small business is not just doing one or two things. Financial management
is broader than you might think — it involves a palette of functions:

• Raising sufficient capital for the assets needed by your business

• Earning adequate profit consistently and predictably
• Managing cash flow from profit
• Minimizing threats of fraud and other losses
• Minimizing the income tax burden on your business and its owners
• Forecasting the cash needs of your business
• Keeping your financial condition in good shape and out of trouble
• Putting a value on your business when the time comes

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When you grow your business to 50 or 100 million pesos annual sales or even more — who knows
— you can hire a chief financial officer (CFO) to manage the financial functions of your business. In
the meantime these responsibilities fall in your lap, so you better know how to manage the financial
affairs of your business. But what if you’re not the owner of the business? Yes, it’s a bit sad but cheer
up! You could be the CFO!

The failure rate of new businesses is high. Many entrepreneurs would like to think that if they have a
good business model, boundless enthusiasm, and work tirelessly they are sure to succeed. The
evidence speaks otherwise. Many embryonic businesses hit financial roadblocks because the owner/
manager does not understand how to manage the financial affairs of his or her business.

So, the question is: do you have now the basic skills and knowledge for managing the financial affairs
of your or one’s business?

Unit Learning Objective

By the end of this unit, you should be able to explain the essential features of financial management.

Timing

This unit is good for less than a week—2 days at max. You can devote three hours per day on the
subject. Don’t worry, the content is abridged, which means it only includes the most salient points you
need to know relative to our module learning outcomes (MLO).
For easier monitoring of your progress, you may use the study planner attached to this module. Be
sure to make use of your planner to have a more organized and orderly studying. Plus, the planner is
a PROCRASTINATION-beater!

Warm Up

Riddle me this!

I have a tail and a head yet I have no legs and body. What am I?

Sometimes I am harder than a rock, other times I am almost weightless. Everyone wants me, but
then gives me away. Some people have a lot, others have very little. I come in many different colors
all over the world. What am I?

Why do little people have a money problem?

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 Getting Started!

1.1 WHAT IS FINANCE?

It’s hard to define finance—the term has many facets, which makes it difficult to provide a clear
and concise definition. Nevertheless, finance as we know it today grew out of economics and
accounting.

Finance can be defined as the science and art of managing money. At the personal level, finance
is concerned with individuals’ decisions about how much of their earnings they spend, how
much they save, and how they invest their savings. In a business context, finance involves the
same types of decisions: how firms raise money from investors, how firms invest money in an
attempt to earn a profit, and how they decide whether to reinvest profits in the business or
distribute them back to investors.

1.2 CAREER OPPORTUNITIES IN FINANCE

Careers in finance typically fall into one of two broad categories: (1) financial services and (2)
managerial finance. Workers in both areas rely on a common analytical “tool kit,” but the types
of problems to which that tool kit is applied vary a great deal from one career path to the other.

Photo Credits: Google Images

• Financial Services
Financial services is the area of finance concerned with the design and delivery of
advice and financial products to individuals, businesses, and governments. It involves
a variety of interesting career opportunities within the areas of banking, personal
financial planning, investments, real estate, and insurance.

• Managerial Finance
Managerial finance is concerned with the duties of the financial manager working in a
business. Financial managers administer the financial affairs of all types of
businesses—private and public, large and small, profit seeking and not for profit. They
perform such varied tasks as developing a financial plan or budget, extending credit to
customers, evaluating proposed large expenditures, and raising money to fund the
firm’s operations.
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 The following are the career opportunities in managerial finance. You may already be
familiar with some of them and some may not ring a bell but it’s worth your while to
check them out.

✓ Financial analyst
Prepares the firm’s financial plans and budgets. Other duties include financial
forecasting, performing financial comparisons, and working closely with
accounting.

✓ Capital expenditures manager

Evaluates and recommends proposed long-term investments. May be involved
in the financial aspects of implementing approved investments.

✓ Project finance manager

Arranges financing for approved long-term investments. Coordinates
consultants, investment bankers, and legal counsel.

✓ Cash manager
Maintains and controls the firm’s daily cash balances. Frequently manages the
firm’s cash collection and disbursement activities and short-term investments
and coordinates short-term borrowing and banking relationships.

✓ Credit analyst/manager
Administers the firm’s credit policy by evaluating credit applications, extending
credit, and monitoring and collecting accounts receivable.

✓ Pension fund manager

Oversees or manages the assets and liabilities of the employees’ pension fund.

✓ Foreign exchange manager

Manages specific foreign operations and the firm’s exposure to fluctuations in
exchange rates.

1.3 FORMS OF BUSINESS ORGANIZATION

The basics of financial management are the same for all businesses, large or small, regardless
of how they are organized. Still, a firm’s legal structure affects its operations and thus should
be recognized. The following are the main forms of business organizations:

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1.3.1 Strengths and Weaknesses of the Common Legal Forms of Business Organization

Advantages Disadvantages

Sole Proprietorship 1. No formal charter 1. Limited ability to

required raise large sums
(A business owned by 2. Less regulation and of money
an individual.) red tape 2. Unlimited liability
3. Independence and for the owner
secrecy wherein wealth
4. Minimal can be taken to
organizational costs satisfy debts
5. Profits and control 3. Limited to the life
not shared with of the owner
others

Partnership 1. Can raise more funds 1. Unlimited

than sole liability for the
(A business is owned by proprietorships individual
partners and
more than one owner) 2. Minimal
may have to
organizational effort cover debts of
and costs and less other partners
governmental 2. Limited ability
regulations as to raise large
compared to sums of money
corporations compared to
corporations
3. Dissolved upon
the death or
withdrawal of
any of the
partners

Corporation 1. Long life of the firm 1. Difficult and

2. Limited liability for costly to
establish, as a
(A legal entity that its owners which formal charter is
exists apart from its guarantees that required
owners, better known they cannot lose 2. Subject to
as “stockholders”. more than they double taxation
Ownership is evidenced invested on its earnings
by possession of shares 3. Ease of transfer of and dividends
paid to
of stock.) ownership through
stockholders
transfer of stock
3. Subject to
4. Ability to raise
greater
large sums of government
capital regulation
4. Lacks secrecy
because
regulations
require firms to
disclose financial
results

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 In terms of numbers, most businesses are sole proprietorships. However, based on the dollar
value of sales, about 80% of all business is done by corporations. Because corporations
conduct the most business and because most successful businesses eventually convert to
corporations, we concentrate on them in this book. Still, it is important to understand the legal
differences between firms.

1.4 FINANCE WITHIN AN ORGANIZATION

Photo Credits: Google Images

The owners of a corporation are its stockholders, whose ownership, or equity, takes the form
of either common stock or preferred stock. Unlike the owners of sole proprietorships or
partnerships, stockholders of a corporation enjoy limited liability, meaning that they are not
personally liable for the firm’s debts. Their losses are limited to the amount they invested in
the firm when they purchased shares of stock. There are a lot of things that you will learn more
about common and preferred stock, but for now it is enough to say that common stock is the
purest and most basic form of corporate ownership. Stockholders expect to earn a return by
receiving dividends—periodic distributions of cash—or by realizing gains through increases
in share price. Because the money to pay dividends generally comes from the profits that a
firm earns, stockholders are sometimes referred to as residual claimants, meaning that
stockholders are paid last—after employees, suppliers, tax authorities, and lenders receive
what they are owed. If the firm does not generate enough cash to pay everyone else, there is
nothing available for stockholders.

The control of the corporation functions a little like a democracy. The stockholders (owners)
vote periodically to elect members of the board of directors and to decide other issues such as
amending the corporate charter.

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Photo Credits: Google Images
The board of directors is the top governing body,
and the chairperson of the board is generally the
highest-ranking individual. The chief executive
officer (CEO) comes next but note that the
chairperson of the board often serves as the CEO as
well. The president or chief executive officer (CEO)
is responsible for managing day-to-day operations
and carrying out the policies established by the board
of directors. The CEO reports periodically to the
firm’s directors. Below the CEO comes the chief
operating officer (COO) who is directs the firm’s
operations, which include marketing, manufacturing,
sales, and other operating departments. The chief
financial officer (CFO) is in charge of accounting,
financing, credit policy, decisions regarding asset
acquisitions, and investor relations, which involves
communications with stockholders and the press.

1.5 CORPORATE FINANCE, CAPITAL MARKETS, AND INVESTMENTS

Finance generally divided into three areas: (1) financial management, (2) capital markets, and
(3) investments.
• Financial management, also called corporate finance, focuses on decisions relating to
how much and what types of assets to acquire, how to raise the capital needed to buy
assets, and how to run the firm so as to maximize its value.

• Capital markets relate to the markets where interest rates, along with stock and bond
prices, are determined. Also studied here are the financial institutions that supply
capital to businesses. Banks, investment banks, stockbrokers, mutual funds, insurance
companies, and the like bring together “savers” who have money to invest and
businesses, individuals, and other entities that need capital for various purposes.

• Investments relate to decisions concerning stocks and bonds and include a number of
activities: (1) security analysis deals with finding the proper values of individual
securities (i.e., stocks and bonds); (2) portfolio theory deals with the best way to
structure portfolios, or “baskets,” of stocks and bonds. Rational investors want to hold
diversified portfolios in order to limit risks, so choosing a properly balanced portfolio
is an important issue for any investor; and (3) market analysis deals with the issue of
whether stock and bond markets at any given time are “too high,” “too low,” or “about
right.”

1.6 GOAL OF THE FIRM

What goal should managers pursue? There is no shortage of possible answers to this question.
Some might argue that managers should focus entirely on satisfying customers. Progress
toward this goal could be measured by the market share attained by each of the firm’s
products. Others suggest that managers must first inspire and motivate employees; in that
case, employee turnover might be the key success metric to watch. Clearly the goal that

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 managers select will affect many of the decisions that they make, so choosing an objective is a
critical determinant of how businesses operate.

1.6.1 Stock Prices and Shareholder Value

Finance teaches that managers’ primary goal should be to maximize the wealth of the firm’s
owners—the stockholders. The simplest and best measure of stockholder wealth is the firm’s
share price. However, there is a common misconception that when firms strive to make their
shareholders happy, they do so at the expense of other constituencies such as customers,
employees, or suppliers. This line of thinking ignores the fact that in most cases, to enrich
shareholders, managers must first satisfy the demands of these other interest groups.
Therefore, the goal of the firm, and also of managers, should be to maximize the wealth of
the owners for whom it is being operated, or equivalently, to maximize the stock price. This
goal translates into a straightforward decision rule for managers—only take actions that are
expected to increase the share price.

Goal of
“Value creation occurs
the Firm when we maximize the
share price for current
shareholders.”
Maximize
Shareholder
Wealth!

Photo Credits: Google Images

Note:

If a manager is to maximize shareholder wealth, he or she must know how that wealth is
determined. Essentially, shareholder wealth is the number of shares outstanding times the
market price per share. For example, if you own 100 shares of GE’s stock and the price is $40
per share, your wealth in GE is $4,000. The wealth of all of GE’s stockholders can be summed;
and that is the value of the firm’s stock, the item that management should maximize. The
number of shares outstanding is a given, so what really determines shareholder wealth is the
price of the stock.
We see then that if GE’s management makes good decisions, its stock price will increase;
however, if its managers make bad decisions, the stock price will decrease. Management’s goal
should be to make decisions designed to maximize the stock’s price. Note, though, that factors
beyond management’s control also affect stock prices. Thus, after the 9/11 terrorist attacks on
the World Trade Center, the price of most stocks fell no matter how effective their management
may have been.

1.6.2 Profit Maximization vs. Stockholder Wealth Maximization

It might seem intuitive that maximizing a firm’s share price is equivalent to maximizing its
profits, but that is not always correct. But does profit maximization lead to the highest possible
share price? The answer is often no. Profit maximization is basically a single-period or, at the
most, a short-term goal. It is usually interpreted to mean the maximization of profits within a
given period of time. A firm may maximize its short-term profits at the expense of its long-term
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 profitability and still realize this goal. In contrast, stockholder wealth maximization is a long-
term goal, since stockholders are interested in future as well as present profits. Wealth
maximization is generally preferred because it considers these three things:

• Timing
Timing is important. An investment that provides a lower profit in the short run may be
preferable to one that earns a higher profit in the long run.

• Cash Flows
Profits and cash flows are not identical. The profit that a firm reports is simply an
estimate of how it is doing, an estimate that is influenced by many different accounting
choices that firms make when assembling their financial reports. Cash flow is a more
straightforward measure of the money flowing into and out of the company. Companies
have to pay their bills with cash, not earnings, so cash flow is what matters most to the
financial managers.
• Risk
Risk matters a great deal. A firm that earns a low but reliable profit might be more
valuable than another firm with profits that fluctuate a great deal (and therefore can be
very high or very low at different times).

1.7 GOVERNANCE AND AGENCY

You may have come to know by now that the majority of owners of a corporation are normally
distinct from its managers. Nevertheless, managers are entrusted to only take actions or make
decisions that are in the best interests of the firm’s owners, its shareholders. In most cases, if
managers fail to act on the behalf of the shareholders, they will also fail to achieve the goal of
maximizing shareholder wealth. To help ensure that managers act in ways that are consistent
with the interests of shareholders and mindful of obligations to other stakeholders, firms aim
to establish sound corporate governance practices—the rules, processes, and laws by which
companies are operated, controlled, and regulated.

Photo Credits: Google Images

1.7.1 The Agency Problem

An agency relationship exists when one or more persons (called principals) employ one or
more other persons (called agents) to perform some tasks. Primary agency relationships exist
(1) between stockholders and managers and (2) between creditors/bondholders and
stockholders. They are the major source of agency problems.

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• Managers vs. Stockholders

The agency problem arises when a manager owns less than 100 percent of the company’s
ownership. As a result of the separation between the managers and owners, managers
may make decisions that are not in line with the goal of maximizing stockholder wealth.
For example, they may work less eagerly and benefit themselves in terms of salary and
perks. The costs associated with the agency problem, such as a reduced stock price and
various ‘‘perks,’’ is called agency costs. Several mechanisms are used to ensure that
managers act in the best interests of the shareholders:
(1) golden parachutes or severance contracts;
(2) performance-based stock option plans;
(3) the threat of firing; and
(4) the threat of takeover

Note:

If a firm’s stock is undervalued, corporate raiders will see it as a bargain and will attempt to
capture the firm in a hostile takeover. If the raid is successful, the target’s executives will
almost certainly be fired. This situation gives managers a strong incentive to take actions to
maximize their stock’s price.

• Stockholders vs. Creditors

Conflicts can also arise between stockholders and bondholders. Bondholders generally
receive fixed payment regardless of how well the company does, while stockholders do
better when the company does better. This situation leads to conflicts between these two
groups. Conflicts develop if:
(1) Managers, acting in the interest of shareholders, take on projects with
greater risk than creditors anticipated.
Note:

Suppose a company has the chance to make an investment that will result in a profit of $10
billion if it is successful but the company will be worthless and go bankrupt if the investment
is unsuccessful. Suppose further that the probability of success is 50% and the probability of
failure is 50%. If the project will succeed, the price of the stock will jump up per share, but the
value of the bonds will remain as is. The project looks wonderful from the stockholders’
standpoint but lousy for the bondholders. They just break even if the project is successful, but
they lose their entire investment if it is a failure.

(2) Raise the debt level higher than was expected.

Note:

Raising the debt level higher than was expected tend to reduce the value of the debt
outstanding. As we will see later in this module, the more debt a firm uses to finance a given
amount of assets, the riskier the firm is in a sense that the creditors or bondholders will suffer
a loss even if the value of the assets declines only slightly.

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1.8 FINANCIAL DECISIONS AND RISK-RETURN TRADE-OFF

Integral to the theory of finance is the concept of

a risk-return trade-off. All financial decisions
involve some sort of risk-return trade-off. The
greater the risk associated with any financial
decision, the greater the return expected from it.
Proper assessment and balance of the various
risk-return trade-offs available is part of
creating a sound stockholder wealth
maximization plan.

Photo Credits: Google Images

Self-Check:

□ What are the common forms of business organizations? And which one does most
businesses are categorized as?
□ What does wealth maximization mean?
□ Why does agency issues arise in a company?

Unit Summary
• Finance can be defined as the science and art of managing money.
• Careers in finance typically fall into one of two broad categories: (1) financial services;
and (2) managerial finance.
• Career opportunities in managerial finance include: financial analyst, capital
expenditures manager, project finance manager, cash manager, credit
analyst/manager, pension fund manager, and foreign exchange manager.
• The basics of financial management are the same for all businesses—sole
proprietorships, partnerships and corporations. Still, a firm’s legal structure affects its
operations and thus should be recognized.
• The owners of a corporation are its stockholders, whose ownership, or equity, takes the
form of either common stock or preferred stock. The stockholders (owners) vote
periodically to elect members of the board of directors—the governing body of the
corporation—and to decide other issues such as amending the corporate charter.
• The goal of the firm, and also of managers, should be to maximize the wealth of the
owners for whom it is being operated, or equivalently, to maximize the stock price.
• The agency problem arises when a manager owns less than 100 percent of the
company’s ownership. As a result of the separation between the managers and owners,
managers may make decisions that are not in line with the goal of maximizing
stockholder wealth.
• All financial decisions involve some sort of risk-return trade-off. The greater the risk
associated with any financial decision, the greater the return expected from it.

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