Chapter 1

The Role of
Managerial
Finance
What is Finance?

• 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
• How they invest their savings
• In a business context, finance involves:
• How firms raise money from investors
• How firms invest money in an attempt to earn a
profit
• How firms decide whether to reinvest profits in the
business or distribute them back to investors.

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Career Opportunities in Finance:
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. Tasks include:
• Developing a financial plan or budget: Which projects
revenues, expenditures, and financing needs over a given
period.
• Evaluating proposed large expenditures
• Raising money to fund the firm’s operations: Seeking the
best balance between debt and equity

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Legal Forms of Business Organization

• A sole proprietorship is a business owned by one

person and operated for his or her own profit.
• A partnership is a business owned by two or
more people and operated for profit.
• A corporation is an entity created by law.
Corporations have the legal powers of an individual
in that it can sue and be sued, make and be party
to contracts, and acquire property in its own name.

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Table 1.1 Strengths and Weaknesses of the
Common Legal Forms of Business Organization

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Figure 1.1 Corporate Organization

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Goal of the Firm:
Maximize Shareholder Wealth
• Decision rule for managers: only take actions that
are expected to increase the share price.
Figure 1.2 Share Price Maximization Financial decisions and
share price

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Goal of the Firm:
Maximize Profit
Which Investment is Preferred?

• Profit maximization may not lead to the highest possible share

price for at least three reasons:
1. Timing is important—the receipt of funds sooner rather than later
is preferred.
2. Profits do not necessarily result in cash flows available to
stockholders
3. Profit maximization ignores risk. Profit maximization doesn’t
consider the risk of the business concern. Risks may be external
or internal
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Goal of the Firm:
Maximize Shareholder Wealth
• The primary goal of a financial manager is maximizing
wealth.
Because maximizing shareholder wealth properly considers cash flows,
the timing of these cash flows, and the risk of these cash flows.

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.

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Goal of the Firm:
What About Stakeholders?
• Stakeholders are groups such as employees,
customers, suppliers, creditors, owners, and others
who have a direct economic link to the firm.
• A firm with a stakeholder focus consciously avoids
actions that would prove detrimental (harmful) to
stakeholders. The goal is not to maximize
stakeholder well-being but to preserve it.
• Such a view is considered to be "socially
responsible."

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Managerial Finance Function:
Relationship to Economics
• Marginal cost–benefit analysis is the economic
principle that states that financial decisions should
be made and actions taken only when the added
benefits exceed the added costs
• Marginal cost-benefit analysis can be illustrated
using the following simple example.

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Managerial Finance Function:
Relationship to Economics (cont.)

Nord Department Stores is applying marginal-cost

benefit analysis to decide whether to replace a
computer:

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Managerial Finance Function:
Relationship to Accounting
• The firm’s finance and accounting activities are
closely-related and generally overlap.
• In small firms accountants often carry out the
finance function, and in large firms financial
analysts often help compile (put together)
accounting information.
• 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.

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Managerial Finance Function:
Relationship to Accounting (cont.)
Finance and accounting also differ with respect to
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 on the basis
of their assessment of the associated returns and risks.

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Governance and Agency:
Corporate Governance
• Corporate governance refers to the rules,
processes, and laws by which companies are
operated, controlled, and regulated.

• It defines the rights and responsibilities of the

corporate participants such as the shareholders,
board of directors, officers and managers, and
other stakeholders, as well as the rules and
procedures for making corporate decisions.

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Governance and Agency:
The Agency Issue
• A principal-agent relationship is an arrangement
in which an agent acts on the behalf of a principal.
For example, shareholders of a company
(principals) elect management (agents) to act on
their behalf.
• Agency problems arise when managers place
personal goals ahead of the goals of shareholders.
• Agency costs arise from agency problems that are
borne by shareholders and represent a loss of
shareholder wealth.

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Governance and Agency:
Individual versus Institutional Investors

• Individual investors are investors who own

relatively small quantities of shares so as to meet
personal investment goals.
• Institutional investors are investment
professionals, such as banks, insurance companies,
mutual funds, and pension funds, that are paid to
manage and hold large quantities of securities on
behalf of others.
• Unlike individual investors, institutional investors
often monitor and directly influence a firm’s
corporate governance by exerting pressure on
management to perform or communicating their
concerns to the firm’s board.
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The Agency Issue:
Management Compensation Plans
• Incentive plans are management compensation
plans that tie management compensation to share
price; one example involves the granting of stock
options. Incentive plans are a type of employee
compensation structure that uses certain
rewards to motivate team members to work
harder and achieve specific goals.

• Performance plans tie management

compensation to measures such as EPS or growth
in EPS. Performance shares and/or cash
bonuses are used as compensation under
these plans.
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Multiple Choice Questions:
1) 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 most of its attention to the collection and presentation of
financial data
Answer: A

2) Which of the following is a strength of a corporation?

A) Low taxes
B) Limited liability
C) Low organization costs
D) Less government regulation
Answer: B

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Multiple Choice Questions:
3) Wealth maximization as the goal of a firm implies enhancing the
wealth of ________.
A) The auditors
B) The creditors
C) The federal reserve
D) The firm's stockholders
Answer: D

4) Which of the following is true of stakeholders?

A) They are the owners of a firm.
B) They are groups to whom a firm has financial obligations.
C) They are groups having a direct economic link to a firm.
D) They include only the bondholders, common stockholders, and
preferred stockholders.
Answer: C

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Multiple Choice Questions:

5) Corporate owners receive return ________.

A) By realizing gains through increases in share price and interest
earnings
B) By realizing gains through increases in share price and cash
dividends
C) Through capital appreciation and retained earnings
D) Through interest earnings and earnings per share
Answer: B
6) Which of the following is a duty of a financial manager in a business
firm?
A) Developing marketing plans
B) Controlling the stock price
C) Raising financial resources
D) Auditing financial records
Answer: C

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Multiple Choice Questions:

7) Which of the following is an example of agency cost?

A) Costs incurred for setting up an agency
B) Failure of making the best investment decision
C) Payment of income tax
D) Payment of interest
Answer: B

8) Incentive plans usually tie management compensation to ________.

A) Share price
B) Dividends
C) Coupon payments
D) Inventory turnover
Answer: A

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Multiple Choice Questions:

9) A financial manager must choose between three alternative

investments. Each asset is expected to provide earnings over a three-
year period as described below. Based on the wealth maximization goal,
the financial manager would ________.

A) Choose Asset 1
B) Choose Asset 2
C) Choose Asset 3
D) Be indifferent between Asset 1 and Asset 2
Answer: A

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Multiple Choice Questions:

10) Which of the following legal forms of organization

is most expensive to organize?
A) Sole proprietorships
B) Partnerships
C) Corporations
D) Limited partnership
Answer: C

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Multiple Choice Questions:

11) Which of the following is true of sole proprietorships

and corporations?
A) It is difficult to transfer ownership of corporations
compared to that of sole proprietorships.
B) Income from both forms of organizations are taxed only
at the corporate level.
C) Both sole proprietorships and corporations are equally
scrutinized and regulated by government bodies.
D) In sole proprietorships, owners have unlimited liability;
whereas, in corporations, owners have limited liability.
Answer: D

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Multiple Choice Questions:

12) Which of the following is true of cash flows and

risk?
A) Low cash flow and low risk result in an increase in
share price.
B) High cash flow and low risk result in an increase in
share price.
C) High cash flow and high risk result in an increase
in share price.
D) Low cash flow and high risk result in an increase in
share price.
Answer: B

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Multiple Choice Questions:

13) The primary goal of a financial manager is

________.

A) minimizing risk
B) maximizing profit
C) maximizing wealth
D) minimizing return

Answer: C

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Multiple Choice Questions:

14) The key variables in the owner wealth

maximization process are ________.

A) market risk premium and risk

B) cash flows and risk
C) risk-free rate and share price
D) total assets and risk

Answer: B

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Multiple Choice Questions:

15) The amount earned during the accounting period

on each outstanding share of common stock is called
________.

A) dividend per share

B) earnings per share
C) net profits after taxes
D) book value per share
Answer: B

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Multiple Choice Questions:

16) As the risk of a stock investment increases,

investors' ________.

A) return will increase

B) return will decrease
C) required rate of return will decrease
D) required rate of return will increase

Answer: D

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Multiple Choice Questions:

17) An accountant's primary function is ________.

A) the evaluation of the financial statements

B) making decisions based on financial data
C) the collection and presentation of financial data
D) the planning of cash flows

Answer: C

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Multiple Choice Questions:

18) Which of the following is true of cash basis

accounting?

A) All credit sales will be recorded as revenue.

B) Revenue is recognized when a customer pays cash.
C) Expenses are recognized when they are incurred.
D) Accounts receivable and accounts payable can
never be zero.

Answer: B

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Multiple Choice Questions:

19) The primary economic principle used in

managerial finance is ________.

A) purchase power parity

B) asset pricing theory
C) Porter's theory of five forces
D) marginal cost-benefit analysis

Answer: D

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Multiple Choice Questions:

20) ________ is one of the solution to the agency

problem in publicly-held corporations.

A) Stock options
B) Stock split
C) Demotion of employee designation
D) Distribution of dividends

Answer: A

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Multiple Choice Questions:

21) If managers are not owners of their company,

then they are ________.

A) dealers
B) agents
C) bondholders
D) brokers

Answer: B

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Multiple Choice Questions:

22) Johnson, Inc. has just ended the calendar year making
a sale in the amount of $10,000 of merchandise purchased
during the year at a total cost of $7,000. Although the firm
paid in full for the merchandise during the year, it is yet to
collect at year end from the customer. The net profit and
cash flow from this sale for the year are ________.

A) $3,000 and $10,000, respectively

B) $3,000 and -$7,000, respectively
C) $7,000 and -$3,000, respectively
D) $3,000 and $7,000, respectively

Answer: B

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