The Role & Environment of

Managerial Finance

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Finance is the art & science of managing money. Finance is concerned with the process, institutions, markets & instruments involved in the transfer of money among individuals, businesses & governments.

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Board of Directors

President

VP: Sales VP: Finance VP: Operations

Treasurer Controller

Credit Manager

Inventory Manager

Capital Budgeting Director

Cost Accounting

Financial Accounting

Tax Department

Maximize stock value by:◦Forecasting and planning◦Investment and financing decisions◦Coordination and control◦Transactions in the financial markets◦Managing risk

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1. Stockholder wealth maximization.2. Profit maximization.3. Managerial reward maximization.4. Behavioral goals.5. Social responsibility.

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Modern managerial finance theory operates on the assumption that the primary goal of the firm is to maximize the wealth of its stockholders, which translates into maximizing the price of the firm’s common stock.

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Profit maximization is basically a single-period or short-term goal which is usually interpreted to mean the maximization of profits within given a given period of time. A firm may maximize its profits at the expense of its long-term profitability & still realize this goal.

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Stockholder wealth maximization is along-term goal, since stockholders are interested in future as well as present profits. This concept is preferred because it considers:1. Wealth for the long term,2. Risk or uncertainty,3. The timing of returns, &4. The stockholders return.

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Advantages Disadvantages

Easy to calculate.Easy to determine the link between financial decisions & profits.

Emphasizes the short term.Ignores risk or uncertainty.Ignores the timing of returns.Require immediate resources.

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Advantages Disadvantages

Emphasizes the long term.Recognizes risk.Recognizes the timing of returns.Consider stockholders return.

Offers no clear relationship between financial decisions & stock price.Can lead to management anxiety & frustration.

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There exists a SEPARATION between owners and managers.

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Modern Corporation

Shareholders Management

Jensen and Meckling developed a theory of the firm based on agency agency theorytheory.

Principals must provide incentivesincentives so that management acts in the principals’ best interests and then monitormonitor results.

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An agency relationship exists whenever a principal hires an agent to act on their behalf.

Within a corporation, agency relationships exist between:

◦Shareholders and managers

◦Shareholders and creditors

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Managers are naturally inclined to act in their own best interests.

But the following factors affect managerial behavior:◦ Managerial compensation plans◦ Direct intervention by shareholders◦ The threat of firing◦ The threat of takeover

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Shareholders (through managers) could take actions to maximize stock price that are detrimental to creditors.

In the long run, such actions will raise the cost of debt and ultimately lower stock price.

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1. Market Forces• Major Shareholders.• Threat of Takeover.

2. Agency Costs: These are the costs of monitoring management behavior, ensuring against dishonest acts of management & giving managers the financial incentives to maximize share price.

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1. Financial Instruments.2. Financial Institutions.3. Financial Markets.

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A financial instrument is the written legal obligation of one party to transfer something of value – usually money – to another party at some future date, under certain conditions, such as stocks, loans, or insurance.

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Characteristics◦ Standardization◦ Communicate Information

Classes of Financial Instruments◦ Primary – underlying Instruments◦ Derivative Instruments

Value derived from the behavior of Underlying instruments.

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1. Size the promised payment. (Face

Value)2. When the payment will be

received. (Maturity)3. The likelihood the payment

will be made (risk).4. The conditions under which

the payment will be made. (Prerogatives)

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Primarily Stores of Value

1. Bank Loans

2. Bonds

3. Home Mortgages

4. Stocks

5. Asset-backed securities

Primarily to transfer risk

1. Insurance

2. Futures Contracts

3. Options

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Financial institutions serve as intermediaries by channeling the savings of individuals, businesses & governments into loans or investments, i.e., they facilitate the flow of funds between surplus units & deficit units.

Role of Financial Institutions

◦ Reduce transactions cost by specializing in the issuance of standardized securities

◦ Reduce information costs of screening and monitoring borrowers.

◦ Issue short term liabilities and purchase long-term loans.

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Financial Markets are the places where financial instruments are bought and sold.

Role of Financial Markets.◦ Offer liquidity to borrowers and

savers.

◦ Pool and communicate Information.

◦ Allow risk sharing

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Structure of Financial Markets◦ Primary vs. Secondary Markets◦ Money Market VS Capital Market ◦ Centralized Exchanges vs. Over-the-

counter Markets.◦ Debt and Equity vs. Derivative Markets

Characteristics of a well-run financial market◦ Low transaction costs.◦ Information communicated must be

accurate.◦ Investors must be protected.

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