Essentials of Managerial Finance by S. Besley & E.

Brigham
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Chapter 1

An Overview
of Managerial
Finance
Essentials of Managerial Finance by S. Besley & E. Brigham
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Learning Objectives
1. Understand the general framework for financial decision making.
2. Describe the role of financial decision making in maximizing the value of
the firm.
3. Identify how to determine whether an investment should be made and how
to finance acceptable investments.
4. Explain what is meant by the risk/return trade-off and how risk and return
can affect management decisions.
5. Understand the role of financial institutions and markets and its effect on
financial decisions made by the firm.
Essentials of Managerial Finance by S. Besley & E. Brigham
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What is Finance
Finance is concerned with decisions
about money or cash flows.
Finance decisions deal with how money
is raised and used by businesses,
governments, and indiiduals.
Essentials of Managerial Finance by S. Besley & E. Brigham
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Importance of Managerial Finance
Assets: Liabilities & Equity:
Current Assets Current Liabilities
Cash & M.S. Accounts payable
Accounts receivable Notes Payable
Inventory Total Current Liabilities
Total Current Assets Long-Term Liabilities
Fixed Assets: Total Liabilities
Gross f ixed assets Equity:
Less: Accumulated dep. Common Stock
Goodwill Paid-in-capital
Other long-term assets Retained Earnings
Total Fixed Assets Total Equity
Total Assets Total Liabilities & Equity
Company
Balance Sheet
As of December 31, 2004
Maximize
wealth
not
profit!
Debts
are paid
by cashflow
not income!
Investment
Decisions
utilize
funds
Financing
Decisions
require
funds
Essentials of Managerial Finance by S. Besley & E. Brigham
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The operation of a firm
Essentials of Managerial Finance by S. Besley & E. Brigham
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Forms of Business Organization
Advantages
Easy formation with low organizational costs
Affected by few government regulations
Income included and taxed only on proprietors
personal tax return (i.e. only one)

Proprietorship
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Forms of Business Organization
Drawbacks
Owner has unlimited liability (i.e. total wealth can be
taken to satisfy debts)
Lacks continuity when proprietor dies
Transferring of ownership is difficult
Limited fund-raising power tends to inhibit growth

Proprietorship
Essentials of Managerial Finance by S. Besley & E. Brigham
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Forms of Business Organization
Advantages
Fairly easy and inexpensive formation
Affected by few government regulations
Income included and taxed only on partners tax
return
Partnership
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Forms of Business Organization
Drawbacks
Owners have unlimited liability and may have to
cover debts of other partners
Partnership is dissolved when a partner dies
Difficulty to liquidate or transfer partnership
Difficulty of raising large amounts of capital


Partnership
Essentials of Managerial Finance by S. Besley & E. Brigham
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Forms of Business Organization
Advantages
Long life of firm even if owners do not have a
relationship with the business
Ownership (stock) is readily transferable
Owners have limited liability which guarantees that
they cannot lose more than they invested
Better access to financing



Corporation
Essentials of Managerial Finance by S. Besley & E. Brigham
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Forms of Business Organization
Drawbacks
More expensive to organize than other business
forms and subject to greater government regulation
Taxes are higher because of double taxation:
corporate income is taxed and also dividends paid
to owners are taxed




Corporation
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Value maximized for corporations
Limited Liability reduces the risk borne by investors
A firms current value is related to its future growth
opportunities
Corporate ownership can be transferred easier than the
ownership of either a proprietorship or a partnership
Why?
Essentials of Managerial Finance by S. Besley & E. Brigham
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Role of Finance in a Business
Organization
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The Goals of the Corporation
Stockholder wealth maximization
This should be the primary goal of a financial manager
Incentives against are to keep stockholder returns at
reasonable level and work for other goals such as:
pursue goals of public service activities
target employee benefits
pursue higher executive salaries
But
Competitive forces require financial managers to opt for
stockholder wealth maximization, to avoid losing their jobs
Essentials of Managerial Finance by S. Besley & E. Brigham
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The Goals of the Corporation
Social Responsibility
Firms should provide a safe environment, avoid air
pollution and produce safe products. Incentives against
for firms to act in a socially responsible manner are:
Disadvantage in attracting funds due to extra costs incurred
Inability to compete due to higher prices of products
Constraints by capital market factors
Therefore
Social Responsibility actions should be enforced on a
mandatory rather than a voluntary basis
Essentials of Managerial Finance by S. Besley & E. Brigham
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The Goals of the Corporation
Stock Price Maximization and Social Welfare
Shareholder Wealth Maximization is beneficial for the
society:
Stock price maximization requires efficient, low cost plants
that produce high-quality goods and services at a low cost
Stock price maximization requires the development of
products that customers want and need, leading to new
technology, new products and new jobs
Stock price maximization necessitates efficient service,
adequate stocks and well located business establishments
Essentials of Managerial Finance by S. Besley & E. Brigham
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The Goals of the Corporation
Therefore primary goal is to
Maximize Shareholder Wealth
Essentials of Managerial Finance by S. Besley & E. Brigham
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Decisions affecting the firms value
n
n
2
2
1
1
) k 1 (
CF
) k 1 (
CF
) k 1 (
CF
value
Asset
+

+
+

+
+

=
L
+
Value = Current (present) value of expected
cash flows (CFs) based on the return
demanded by investors (k)
How to finance (capital structure decision)
What assets to purchase (capital budgeting decision)
Pay dividends or re-invest earnings? (dividend policy
decision)
Essentials of Managerial Finance by S. Besley & E. Brigham
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Present Value explained
The value of any financial contract (i.e., stock)
answers the following questions:
1. How much do I expect receipts to be (expected cash flow
to the investor (i.e., dividends))?
2. When do I receive the payments (timing/opportunity cost)?
3. What is the chance I do not receive what I expected
(risk)?
The Present Value (discounted) of cash flows
received by an investor is used as the estimate of the
value of a contract (i.e., shareholder wealth)
The Present Value (discounted) of a single share is
the shares market price
Shareholders Wealth=Market Value of
Equity=Number of shares * share price
Essentials of Managerial Finance by S. Besley & E. Brigham
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Should Earnings Per Share Be
Maximized?
Beware: Wealth is NOT profit!
Investment Year 1 Year 2 Year 3 Total
A 2,90 0,00 0,00 2,90
B 0,00 0,00 3,00 3,00
EPS ()
Which Investment is Preferred?
Profit maximization fails to account for
differences in the level of cash flows (as
opposed to profits), the timing of these cash
flows, and the risk of these cash flows.
Essentials of Managerial Finance by S. Besley & E. Brigham
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Make decisions about the cash flow
Beware: Accounting is NOT an economic profit!
Sales Revenue (in ) 100.000 Cash Inflows (in ) 100.000
Less: Costs (in ) 80.000 Less: Cash Outflows(in ) 80.000
Net Profit (in ) 20.000 Net Cash Flow (in ) 20.000
Finance View
Cash Flow Statement
for the year ended 2004
Accounting View
Income Statement
for the year ended 2004
Cash flow is the actual cash generated by the
firm. CF = Net Income + Depreciation
or (CF = NI + DEP )
Essentials of Managerial Finance by S. Besley & E. Brigham
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Agency Relationships
Whenever a manager owns less than 100% of the
firms equity, a potential agency problem exists.
In theory, managers would agree with shareholder
wealth maximization.
However, managers are also concerned with their
personal wealth, job security, fringe benefits, and
lifestyle.
This would cause managers to act in ways that do not
always benefit the firms shareholders.
Stockholders versus Managers The problem
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Agency Relationships
Managerial compensation (in the form of performance
shares, executive stock options or restricted stock
grants)
But. Recent studies have failed to find a strong
relationship between CEO compensation and share price.
The threat of firing
Shareholder intervention
The threat of takeover
Stockholders versus Managers - Solutions
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Agency Relationships
Creditors consider the riskiness of the firm
Stockholders should not act against creditors because
Creditors protect themselves through restrictions in credit
agreements
Creditors may request an interest rate much higher than
normal to compensate for the stockholders actions
Result: Stockholders may find it difficult to borrow funds
in the future
Stockholders versus Creditors