Chapter 1

The Role of
Managerial
Finance
 The Field of Finance 1

• Finance fits between economics and

accounting.
• Economics provides picture of business
environment.
– Consider consumers and producers.
• Accounting provides financial data.
– Income statements, balance sheets,
cashflow statements.

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2
 The Field of Finance 2

• Financial manager needs to know how to

understand and interpret financial
statements.
• Finance is closely tied to accounting.
– CFO often in charge of financial planning,
accounting, and tax systems.
• Finance is forward thinking vs accounting
which measures business activity results.

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3
 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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 Activities of Financial
Management 1

• Financial managers perform numerous

activities.
– Daily activities include monitor cash
balances, manage credit decisions, monitor
inventory levels, collect and distribute cash.
– Less routine activities include negotiations
with banks for loans, sale of stocks and
bonds, establishment of capital budgeting
and dividend plans.

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5
Figure 1-1 Functions of the
Financial Manager

• Access the text alternate for slide

images.
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6
Focus on Practice

• Professional Certifications in Finance:

– Chartered Financial Analyst (CFA) – Offered by the CFA
Institute, the CFA program is a graduate-level course of
study focused primarily on the investments side of finance.
– Certified Treasury Professional (CTP) – The CTP program
requires students to pass a single exam that is focused on
the knowledge and skills needed for those working in a
corporate treasury department.
– Certified Financial Planner (CFP) – To obtain CFP status,
students must pass a ten-hour exam covering a wide range
of topics related to personal financial planning.

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Focus on Practice (cont.)

• Professional Certifications in Finance:

– American Academy of Financial Management (AAFM) – The
AAFM administers certifications including the Charter
Portfolio Manager, Chartered Asset Manager, Certified Risk
Analyst, Certified Cost Accountant, and Certified Credit
Analyst.
– Professional Certifications in Accounting –Professional
certifications in accounting include the Certified Public
Accountant (CPA), Certified Management Accountant
(CMA), and Certified Internal Auditor (CIA).

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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.
• Managers have to assess what return (cash inflow net of cash
outflow) the action will bring and how risky the return might
be.
Figure 1.2 Share Price Maximization Financial decisions and
share price

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Managerial Finance Function

• Can be broadly described by considering

(1) Its role within the organization
(2) Its relationship to economics and accounting
(3) The primary activities of the financial manager
Role within the organization
• The size and importance of the managerial finance
function depends on the size of the firm.
• In small firms, the finance function is generally
performed by the accounting department.
• As a firm grows, the finance function typically evolves
into a separate department linked directly to the
company president or CEO through the chief financial
officer (CFO) (see Figure 1.1).
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Figure 1.1 Corporate Organization

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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 accounting information.
• Difference between finance and accounting:
(1) on is related to emphasis on cash flow
(2) other is related to decision making
• 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

• Accrual method: in preparations of financial

statements, recognizes revenue at time of sale (
whether payment has been received or not) and
recognizes expenses when they are incurred.
• Cash Basis: recognizes revenues and expenses
only with respect to actual inflows and outflows of
cash.

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Managerial Finance Function:
Relationship to Accounting (cont.)
• Whether a firm earns a profit or experiences a loss,
it must have a sufficient flow of cash to meet its
obligations as they come due.
• The significance of this difference can be illustrated
using the following simple example.

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Managerial Finance Function:
Relationship to Accounting (cont.)
The Nassau Corporation experienced the following
activity last year:

Sales: $100,000 (1 yacht sold, 100% still uncollected)

Costs: $80,000 (all paid in full under supplier terms)

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Managerial Finance Function:
Relationship to Accounting (cont.)
Now contrast the differences in performance under
the accounting method (accrual basis) versus the
financial view (cash basis):

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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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Figure 1.3
Financial Activities

Investment decisions: determines what types of assets

the firms holds.
Financing decisions: determine how the firm raises
money to pay for the assets in which they invest.
**** They make decisions based on their effect on the
value of the firm, not on accounting principles used to
construct the balance sheet.
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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. The
interest of principal and agent differ
e.g. personal wealth job security, and fringe benefits. Managers may
not take more than moderate risk if they think taking too much
risk might reduce their personal wealth or losing his job
• Agency costs arise from agency problems that are
borne by shareholders and represent a loss of
shareholder wealth. e.g. failing to make best investment
decision or when managers need to be monitored to ensure the best
investment decision is made
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The Agency Issue:
Management Compensation Plans

• In addition to the roles played by corporate boards,

institutional investors, and government regulations,
corporate governance can be strengthened by
ensuring that managers’ interests are aligned with
those of shareholders.
• A common approach is to structure management
compensation to correspond with firm performance.

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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. Stock options: if the stock price rises overtime
managers will be rewarded by being able to purchase stock at
market price in effect at the time of grant and to resell the shares at
the prevailing higher price.
• 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.
Performance shares: shares of stock given to mgt for meeting
stated performance goals.
Cash bonuses: cash paid to mgt for achieving certain performance
goals.
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The Agency Issue: The Threat of Takeover

• When a firm’s internal corporate governance

structure is unable to keep agency problems in
check, it is likely that rival managers will try to gain
control of the firm.
• The threat of takeover by another firm, which
believes it can enhance the troubled firm’s value by
restructuring its management, operations, and
financing, can provide a strong source of external
corporate governance.

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