CHAPTER 1 The Role and Environment of Managerial Finance

Learning Goals 1. Define finance, the major areas of finance, and Identify the primary activities of the financial manager within the firm. 2. Describe the managerial finance function and its relationship to accounting. 3. Understand the legal forms of business organization. 4. Explain why wealth maximization, rather than profit maximization, is the firm’s goal and how the agency issue is related to it.

What is Finance? Finance – The art and science of managing money Finance is the study of money that refers raising fund, managing them and determining their best use. Major Areas of Finance The study of finance consists of three areas: Financial Markets and Institutions Investments Managerial Finance : Primary activities of the financial manager Forecasting and planning Making investment decisions Making financing decisions Coordination and control Dealing with the financial markets

What is Finance? Finance is closely related to Economics Accounting Based on accounting data Cash flow emphasis rather than accrual basis Emphasis on decision making in finance Three basic factors of difference between finance and accounting: i) Time Value of Money ii) Profit iii) Asset

Basic Forms of Business Organization

Corporate Organization

Some Terminologies Stockholders: The owners of a corporation, whose ownership or equity, is evidences by either common stock or preferred stock. Stakeholder: Groups such as employees, customers, supplies, creditors, owners, govt. and others who have a direct economic link to the firm. Dividends: Periodic distributions of earnings to the stockholders of a firm. Common Stock: The purest and most basic forms of corporate ownership. Preferred Stock: A special form of ownership having a fixed periodic dividend that must be paid prior to payment of any common stock dividend. EPS (Earning per Share):The amount earned during the period on behalf of each outstanding share of common stock. EPS = Total earnings from the common SH / Number of common SH

Goal of the Firm What should be the prime goal of a corporation----- Profit Maximization?? Stockholders’ wealth Maximization or Stock price Maximization?? Answer: The primary goal of a financial manager should maximize the stockholders wealth by maximizing the price of the firms common stocks. Firms do, of course, have other objectives but stock price maximization is the most important goal for most corporation. Further more, the action that maximize the stock price also increase social welfare. (Page 16 from Brigham’s text) Goal of the firm can be stated in three ways Maximize Shareholder Wealth Maximize the Value of the Firm Maximize the Share Price

Firms’ Stock price determination Price of a stock depends on the following factors (Page 17 from Brigham’s text): Projected earning per share Timing of the earning steam Riskness of the projected earning Use of debt Dividend policy

Agency Relationships Agency Relationships: An agency relationship exist when one or more people (the principals) hire another person (the agent) to perform a service and then delegate decision-making authority to that agent. Important agency relationships exist between- Stockholders and managers and Stockholders and creditors Agency Problem: A potential conflict of between (1) the principals (outside shareholders) and the agent (manager) or (2) stockholders and creditors.

The Agency Issue In theory, managers would agree with shareholder wealth maximization. However, managers are also concerned with their personal wealth, job security, and lifestyle. This would cause managers to act in ways that do not always benefit the firm shareholders

Resolving the Agency Issue If conflict exist several mechanisms are used to motivate manager to act in the shareholders’ best interests. These includes: 1. The Threat of firing 2. The Threat of takeover: The acquisition of a company over the opposition of its management.Managers may use the following techniques to prevent the hostile takeover--- Poison Pill: an action taken by management to make a firm unattractive to potential buyers and thus to avoid a hostile takeover.(like selling the share at higher price) Greenmail: A situation in which a firm, trying to avoid a takeover, buys back stock at a price above the existing market price from the person trying to gain control of the firm. 3. Structuring managerial incentives

Agency Costs Monitoring expenditures Bonding expenditures Structuring expenditures Opportunity costs

Assignment Review Questions (RQ) from the Text (Gitman,chapter-1): 1-1 1-2 1-9 1-10 1-11 1-14 1-15 1-17