Overview of Managerial Finance

Lakehead University

September 2003

Overview of Managerial Finance

Outline of the Lecture

1.1 Finance as an Area of Study

1.2 Basic Forms of Business Organization

1.3 The Managerial Finance Function

1.4 Goal of the Financial Manager

1.5 The Agency Issue

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 1.1 Finance as an Area of Study

What is Finance?
Businesses (and individuals) regularly need answers to the
following questions:

• What long term investments to undertake?

• How to finance these projects? Debt or Equity?

• How to manage everyday financial activities?

A course in corporate finance provides the tools necessary to

answer these questions.

1.1 Finance as an Area of Study

Major Areas in Finance

• Financial Markets

• Financial Services

• Managerial Finance

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 1.1 Finance as an Area of Study

Career Opportunities in Managerial Finance

• Financial Analyst

• Capital Budgeting Analyst/Manager

• Project Finance Manager

• Cash Manager

• Credit Analyst/Manager

• Pension Fund Manager

1.2 Basic Forms of Business Organization

There are three different legal forms of business organization:

• Sole proprietorship

• Partnership

• Corporation

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Sole Proprietorship
Advantages:

Simple to form
Owner keeps all the profits

Disadvantages:

Owner has unlimited liability with respect to debt

Business income is taxed at the owner’s personal income
Life of business limited
Owner cannot raise more than her own wealth as equity
Ownership difficult to transfer

Partnership
Advantages and disadvantages are basically the same as sole
proprietorship, except for partners’ liability.
General partners have unlimited liability,
limited partners have limited liability.
In a general partnership, all partners have unlimited liability.
In a limited partnership, one or more general partners run the
business for one or more limited partners.

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Corporation
In terms of size, this is the most important form of organization
in Canada.
A corporation is a legal entity distinct from its owners.
A corporation has rights and responsibilities similar to that of a
person: It can borrow money, it can sue and can be sued, etc..
A corporation can be involved in partnerships, and can be the
owner of another corporation.

Corporation
Advantages:

Owners have limited liability for the firm’s debt

Ownership is easy to transfer
Life of the firm is basically inifinite
Easy to raise cash

Disadvantages:

Complex to form
Agency problems: shareholders-bondholders,
shareholders-managers
Double taxation of dividends

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 1.3 The Managerial Finance Function

Organization of the Finance Function

The size and importance of the managerial finance function
depends on the size of the company.
In small firms, the financial decisions are usually made by the
accounting department.
As a firm grows, a separate department is created for the finance
function.

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Board of Directors (elected by shareholders)

Chairman of the Board and CEO

President and COO

V-P Marketing V-P Finance (CFO) V-P Production

Treasurer Controller

Cash Credit Taxes Accounting

Capital Expenditures

Financial Planning

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 1.3 The Managerial Finance Function

Financial Decisions

• Capital Budgeting
What type of investment opportunities to consider?

• Capital Structure
How much to borrow? What should the mixture of debt and
equity be?

• Working Capital Management

How to manage short-term assets and liabilities?

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1.3 The Managerial Finance Function

Relationship to Economics
Financial managers must be aware of economic principles when
making decisions.
One of these principles is marginal analysis: Actions should be
taken only when added benefits exceed added costs.

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 1.3 The Managerial Finance Function

Example of Marginal Analysis

A firm is considering replacing its old computers with new ones.
The present value of all benefits from the old computers is
evaluated at $35,000.
The present value of all benefits from the new computers is
evaluated at $100,000.
Old computers can be sold for $20,000.
New computers cost $75,000.

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1.3 The Managerial Finance Function

Example of Marginal Analysis (continued)

Added benefits from replacing the old computers:

$100, 000 − $35, 000 = $65, 000.

Added costs from replacing the old computers:

$75, 000 − $20, 000 = $55, 000.

Net benefit is then

$65, 000 − $55, 000 = $10, 000.

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 1.3 The Managerial Finance Function

Emphasis on Cash Flows

Under the generally accepted accounting principles (GAAP),
sales and expenses are recognized on an accrual basis, which
means that revenues and cost of goods sold are recognized at the
time of the sale, not when cash is paid.
The financial manager is concerned about cash flows, i.e. cash
that is actually received and paid by the firm.

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1.3 The Managerial Finance Function

Cash Flow Example

XYZ, Inc., has sold $1M worth of goods in 2000, its first year of
operation.
$100,000 of the 2000 sales have yet to be paid by customers.
In January 2000, XYZ has purchased $5M worth of equipment
expected to depreciate to zero in a straight line over 10 years (the
equipement loses $500,000 of its value each year).
Costs of goods sold were $300,000 during the year, from which
$50,000 have yet to be paid by XYZ.

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 1.3 The Managerial Finance Function

Cash Flow Example (continued)

Accounting income in 2000:

$1, 000, 000 − $300, 000 − $500, 000 = $200, 000.

| {z } | {z } | {z }
Sales in 2000 COGS in 2000 Depreciation in 2000

Cash flow in 2000:

$900, 000 − $250, 000 − $5, 000, 000 = − $3, 850, 000.
| {z } | {z } | {z }
Cash from Sales Cash for COGS Investments in 2000

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1.3 The Managerial Finance Function

Key Activities of the Financial Manager

• Capital Budgeting
What type of investment opportunities to consider?

• Capital Structure
How much to borrow? What should the mixture of debt and
equity be?

• Working Capital Management

How to manage short-term assets and liabilities?

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 1.4 Goal of the Financial Manager

• Survive in business? Avoid financial distress?

• Maximize sales?

• Maximize profits?

• Maintain growth in earnings?

• Maximize the stock price?

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1.4 Goal of the Financial Manager

The right goal needs to take cash flows, the timing of these cash
flows and risk into account.
Maximizing shareholder wealth takes all these into account.
What about other stakeholders (employees, customers, creditors,
etc.)?

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 1.4 Goal of the Financial Manager

The Role of Ethics

• Environment-friendly operations

• Charity donations

• Timely disclosure of material information

• Transparent accounting practices

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1.4 Goal of the Financial Manager

Benefits from an Ethics Program

• Reduce potential litigation and judgement costs

• Maintain a positive corporate image

• Build shareholder confidence

• Gain the loyalty, commitment and respect of the firm’s

stakeholders

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 1.5 The Agency Issue

Agency relationship: A principal (owners) hires an agent

(managers) to generate revenues. If the principal cannot perfectly
monitor the agent’s actions and the latter has goals that differ
from those of the owner, then the owner’s objectives may not be
attained.
Managers’ potential goals: Keep their jobs (take insufficient
risks), perquisites, etc.

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1.5 The Agency Issue

Managers’ goals can be aligned with those of shareholders using

the right incentives.

• Managerial compensation linked to firm’s success.

• Control of the firm in shareholders’ hands: Takeover threats,

independence of directors.

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 1.5 Another Agency Problem

Bondholders and shareholders may have conflicting interests.

Due to shareholders’ limited liability, the latter may want to take
risks that reduce the market value of debt.
On the other hand, shareholders may prefer a dividend to the
undertaking of a profitable project, as some of the project’s
return will be distributed to bondholders, whereas dividends all
go to shareholders.

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Financial Markets and the Corporation

Financial markets bring buyers and sellers of capital together.

Firms obtain cash from individuals by issuing debt or equity.
Individuals obtain cash from firms through dividends, capital
gains and interest.

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 ¾ Firms issue securities

Firms invest Financial

in assets markets
¾ Cash reinvested
Current assets Short-term debt
Fixed assets Long-term debt
Dividends, interest payments - Equity shares

Taxes and other

?
Government
Other stakeholders

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