The Role of Managerial Finance

Define Finance and the managerial finance Function

Finance is defined as the management of money and includes activities such as investing,
borrowing, lending, budgeting, saving, and forecasting.
Finance is the science and art of how individuals and firms raise, allocate, and invest money.
The science of finance utilizes financial theories and concepts to establish general rules that can
guide managers in their decisions. The art of finance involves adapting theory to particular
business situations with their own unique circumstances.
Managerial finance is concerned with the duties of the financial manager in the business firm.
The financial manager actively manages the financial affairs of any type of business, whether
private or public, large or small, profit-seeking or not-for-profit. They are also more involved in
developing corporate strategy and improving the firm’s competitive position.
Managerial finance functions are functions that require managerial skills in their planning,
execution, and control It is focused on assessment rather than technique.
The managerial finance functions are as follows:

 Investment Decision : The investment decision, also known as capital budgeting

decision, is the managerial decision regarding investment in long-term investment
proposals. It includes the decisions concerned with the acquisition, modification, and
replacement of long-term assets like plant, machinery, equipment, land, and buildings.
Long-term assets require a huge amount of capital outlay at the beginning but the benefits
are derived over several periods in the future. Because the future benefits are not known
with certainty, long-term investment proposals involve risks. The financial manager
should at first estimate the expected risk and return of the long-term investment and then
should evaluate the investment proposals in terms of both expected return and risk. The
financial manager accepts the log-term investment proposal only if the investment
maximizes the shareholder's wealth. Shareholder wealth is maximized only if the present
value of benefits from the investment proposal exceeds the present value of cost.
 Financing Decision: Financing decision which is also known as capital structure
decision is concerned with determining the sources of funds and deciding upon the
proportionate mix of funds from different sources. It calls for raising of funds from
different sources maintaining appropriate mix of capital.

The sources of long-term funds include equity capital and debt capital. The financial
manager should decide an optimal structure of debt and equity capital.

 Dividend Decision: Dividend decision is the decision about the allocation of earnings to
common shareholders. It is concerned with deciding the portion of earnings to be
 allocated to common shareholders. The net income after paying preferred dividends
belongs to common shareholders. The financial manager has three alternatives regarding
dividend decision:

 Pay all earnings as a dividend

 Retain all earnings for reinvestment
 Pay certain percentage of earning and retain the rest for reinvestment.

The financial manager must choose among the above alternatives. The choice should be
optimum in the sense that it should maximize the shareholder’s wealth. While taking dividend
decisions, the financial manager should consider the preference of shareholders as well as the
investment opportunities available to the firm.

 Working Capital:

Working capital decisions refer to the management of a firm’s short-term resources.

Decision Working Capital Decision refers to the current asset's investment and financing
decision. Investment in current assets affects a firm's profitability and liquidity. More
investment in current assets enhances liquidity. Liquidity refers to the capacity to meet
the short-term obligation of the firm. At the same time, more investment in current assets
negatively affects profitability because idle current assets earn nothing. Even if they earn,
they earn much less than their cost of capital. Similarly, less investment in current assets
negatively affects the firm's liquidity and the firm may lose its profitable opportunities.
So, a financial manager should achieve a proper trade-off between liquidity and
profitability. This requires maintaining optimal investment in current assets.

Once the level of current assets investment is decided, the financial manager should
consider the financing pattern of current assets. The financial manager could use both
long-and short-term funds to satisfy the financing need of current assets. However, it also
requires addressing liquidity versus profitability tradeoff. The cost of short-term funds to
some extent enhances the profitability of the firm because short-term fund costs less than
long-term funds. But excess use of short-term funds may lead the firm into technical
insolvency because it reduces the liquidity. Therefore, a proper trade-off between the use
of short-term and long-term funds is required.

Describe the goal of the firm, and explain why maximizing the value of the firm is an
appropriate goal for a business

Firm is a business organization that sells goods or services.

Wealth maximization: Wealth maximization is the concept of increasing the value of a

business in order to increase the value of the shares held by its stockholders.
profit maximization: is the approach or process which increases the profit or Earnings per
Share (EPS) of the business.

The financial management has come a long way by shifting its focus from traditional approach
to modern approach. The modern approach focuses on wealth maximization rather than profit
maximization. This gives a longer-term horizon for assessment, making way for sustainable
performance by businesses.

A myopic person or business is mostly concerned about short term benefits. A short-term
horizon can fulfill objective of earning profit but may not help in creating wealth. It is because
wealth creation needs a longer-term horizon Therefore, financial management emphasizes on
wealth maximization rather than profit maximization. For a business, it is not necessary that
profit should be the only objective; it may concentrate on various other aspects like increasing
sales, capturing more market share etc., which will take care of profitability. So, we can say that
profit maximization is a subset of wealth and being a subset, it will facilitate wealth creation.

Wealth maximization is better operative criteria then profit maximization on following ground:

 Profit maximization avoids time value of money but wealth maximization

recognizes it
 wealth maximization is based on cash flows and not on profits.
Profit maximization is a short-term objective where wealth maximization is long
term objective
 Profit maximization ignore risk and invest but wealth maximization take care of
it
 Profit maximization acts as a yardstick for completing the operational efficiency
of the entity ,on the other hand wealth maximization aims at gaining a large
market share
How to Maximize Shareholder’s Wealth?
Capital investment decisions of a firm have a direct relation with wealth maximization. All
capital investment projects with an internal rate of return (IRR) greater than the cost of capital
or having a positive NPV create value for the firm. These projects earn more than the firm’s
‘required rate of return.’ In other words, these projects maximize the shareholders’ wealth
because they are earning more than what they can earn by investing themselves .

What is the goal of the firm and, therefore, of all managers and employees? Discuss how
one measures achievement of this goal?

The primary goal is to maximize the wealth of the firm's owners-the stockholders. The simplest
and best measures of stockholder wealth is the firms share price.

For What three basic reasons is profit maximization inconsistent with wealth
maximization?
Timing-Because the firm can earn a return on funds it receives, the receipt of funds sooner
rather than later is preferred.

Cash Flows-Profits and cash flows are not identical. The profit that a firm report is simply an
estimate of how it is doing, an estimate that is influenced by many different accounting choices
that firm make. Cash flow is a more straightforward measures of the money flowing into and
out of the company. Companies have to pay their bills with cash, not earnings.

Risk-Risk matters. A firm that earns a low but reliable profit might be more valuable than
another firm with profits that fluctuate a great deal.

What is risk? Why must risk as well as return be considered by the financial manager
who is evaluating a decision alternative or action?

Risk is the chance that actual outcomes may differ from those expected. Risk and return must
be considered by financial managers because they are the key determinants of share price,
which represents the wealth of the owners in the firm.

Describe the role of corporate ethics policies and guidelines, and discuss the relationship
that is believed to exist between ethics and share price.

Business Ethics are standards of conduct or moral judgment that apply to persons engaged in
commerce. It will reduce potential litigation, and build corporate image and shareholder
confidence. Such actions maintain and enhancing cash flow and reducing perceived risk, can
affect the firm's share price.

Identify the primary activity of a financial manager

Financial manager key decision:

 Investment decisions

 Financing decisions

 Dividend decision

 Working capital decision

Principles that guide manager decisions:

The Time Value of Money As we discussed earlier, timing matters in finance. Having money
today is better than having it later because firms and individuals can invest the money on hand
and earn a return on that money.
The Tradeoff between Return and Risk “Nothing ventured, nothing gained” is a famous
quote attributed to Benjamin Franklin. The equivalent financial principle is that a tradeoff exists
between return and risk. Investors who want to earn higher returns must be willing to accept
greater risk. Or, from the perspective of a business, a firm that puts investors’ funds in riskier
projects must offer those investors higher returns. For financial managers tasked with advising
firms on investment decisions, this tradeoff means that any analysis of alternative investment
projects quantify both the returns that investments may provide and the risks that they entail.

Cash Is King In discussing the differences between maximizing shareholder value and profits,
we noted that cash flow and profit are not identical concepts. In finance, cash flow matters more
than profit because firms can pay investors only with cash, not with profits. Ultimately, the cash
flows that investors receive or expect to receive over time determine the value of the firm. If a
firm is not generating positive cash flow, it cannot pay investors, even if its financial statements
show that it is earning a profit. The same is true regarding a firm’s dealings with its suppliers,
employees, and anyone else to whom the firm owes money—those bills must be paid with cash

Competitive Financial Markets When we think of the term competition in a business context,
what usually comes to mind is the competition that occurs between firms in the markets for
goods and services. A competitive market is a term in economics that refers to a marketplace
where there are a large number of buyers and sellers and no single buyer or seller can affect the
market. Competitive markets have no barriers to entry, lots of a buyers and sellers and
homogeneous products.

what are the main types of decisions that financial manager takes?

There are four decisions that financial managers have to take:

 Investment Decision.
 Financing Decision and.
 Dividend Decision.

 Working capital decision

Why is it important that manager recognize that tradeoff exists between risk and return?
Why does that trade off exist?

Higher risk is associated with greater probability of higher return and lower risk with a greater
probability of smaller return. This trade off which an investor faces between risk and return
while considering investment decisions is called the risk return trade off.

The risk-return trade-off states that the level of return to be earned from an investment should
increase as the level of risk goes up.

What is the primary economic principles used in managerial finance?

The primary economic principle used in managerial finance is marginal cost-benefit analysis,
the principle that financial decisions should be made and actions taken only when the added
benefits exceed the added costs.

What are the major difference between accounting and finance with respect to emphasis
on cash flow and decision making?

• Finance and accounting also differ with respect to decision-making.

• While accounting is primarily concerned with the presentation of financial data, the
financial manager is primarily concerned with analyzing and interpreting this
information for decision-making purposes.

• The financial manager uses this data as a vital tool for making decisions about the
financial aspects of the firm.

If manager do not act in the best interest of shareholder, what role might incentive play in
explaining that behavior?

A CEO has to choose between 2 strategies:

1 produces a modest growth for the firm and a big jump in stock price
2 generates rapid growth but stock price will rise more modestly.
CEO wants to pick option 2. closely link compensation to firm stock price to keep CEO priority
to max stockholder's wealth
Legal forms of business organization

From book.

Describe the nature of principal and agent relationship between the owner and manager
of a corporation, explain how various corporate governance mechanism attempt to
manage agency problem

A principal-agent problem arises when there is a conflict of interest between the agent and the
principal, which typically occurs when the agent acts solely in his/her own interests. In a
principal-agent relationship, the principal is the party that legally appoints the agent to make
decisions and take actions on its behalf.

Principal agent problem is a problem that arise because the owner of a firm and its manager are
not same people and does not act in the interest of the principle.

The following cases are among the most common examples of the principal-agent problem:

 Shareholders (principal) vs. management (agent)

  Voters (principal) vs. politicians (agent)
 Financial institutions (principal) vs. rating agencies (agent)

Agency Costs are the costs borne by stockholders to maintain a corporate governance structure
that minimizes agency problems and contributes to the maximization of shareholder wealth.

Corporate governance is a system by which organization are directed and controlled.

Corporate governance is a set of relationship between company’s director, its shareholder and
other stakeholder. It also provides the structures through the objective of the company is set and
the means of achieving those objective and monitoring performance are determined.

Which legal form of business organization is most common? Which form do the largest
businesses typically take and why?

 Sole proprietorship is the most common form of business(73%).

 Corporations account for nearly 90% of total business revenues making them the
dominant in terms of revenue.

Describe the roles of, and the relationships among, the major parties in a corporation:
stockholders, board of directors, and managers. How are corporate owners rewarded for
the risks they take?

 Stockholders-the owners of a corporation, whose ownership, or equity, takes the form of

either common stock or preferred stock. They are rewarded through dividends or residual
claimants.
 Board of Directors-Voted individuals who are typically responsible for approving
strategic goals and plans, setting general policy, guiding corporate affairs, and approving
major expenditures.
 Managers-Managing day-to-day operations and carrying out the policies established by
the board of directors.

Explain why corporations face a double taxation problem? For corporations, how are the
marginal and average tax rates related?

Double taxation is a tax principle referring to income taxes paid twice on the same source of
income. It can occur when income is taxed at both the corporate level and personal level.
Double taxation also occurs in international trade or investment when the same income is taxed
in two different countries.

Double taxation often occurs because corporations are considered separate legal entities from
their shareholders. As such, corporations pay taxes on their annual earnings, just like
individuals. When corporations pay out dividends to shareholders, those dividend payments
incur income-tax liabilities for the shareholders who receive them, even though
the earnings that provided the cash to pay the dividends were already taxed at the corporate
level.
Define agency problems, and describe how they give rise to agency costs. Explain how a
firm’s corporate governance structure can help avoid agency problems.

Agency problems arise when managers deviate from the goal of maximization of shareholder
wealth by placing their personal goals ahead of the goals of shareholders. These problems give
rise to agency cost. Agency cost are costs borne by shareholders due to the presence or
avoidance of agency problems, and in either case represent a loss of shareholder wealth.

How can the firm structure management compensation to minimize agency problems?

The firm structure management can compensate through incentive plans(owned stock rises in
price) or performance plans(stock or cash).

How do market forces—both shareholder activism and the threat of takeover—prevent or

minimize the agency problem? What role do institutional investors play in shareholder
activism?

If firms stock is depressed, it will make it an attractive takeover target. As a result, this tends to
motivate management to act in the best interest of the firm's owners. Institutional investors
include owners.

The Financial Market Environment

What are financial institutions? Describe the role they play within the financial market
environment.

Who are the key customers of financial institutions? Who are net suppliers, and who are
net demanders of funds?

Describe the role of commercial banks, investment banks, and the shadow banking system
within the financial market environment.