The Role & Environment of Managerial Finance

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 Treasurer Credit Manager Inventory Manager Capital Budgeting Director VP: Operations

Controller 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

1.
2. 3.

4.
5.

Stockholder wealth maximization. Profit maximization. Managerial reward maximization. Behavioral goals. Social responsibility.

Modern managerial finance theory operates on the assumption that the primary goal of the firm is to maximize

the wealth of its stockholders,

which

maximizing the price of the firms common stock.

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translates

into

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. 2. 3. 4. Wealth for the long term, Risk or uncertainty, The timing of returns, & The stockholders return.

Advantages
Easy

Disadvantages
Emphasizes

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

the short

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

Disadvantages
Offers

no clear term. relationship between financial decisions & Recognizes risk. stock price. Recognizes the timing Can lead to of returns. management anxiety & Consider stockholders frustration. return.
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the long

Modern Corporation
Shareholders Management

There exists a SEPARATION between owners and managers.

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Jensen

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

must provide incentives so that management acts in the principals best interests and then monitor results.

Principals

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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.

Major Shareholders. Threat of Takeover.

2.

Market Forces

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.

2.
3.

Financial Instruments. Financial Institutions. 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 Primary underlying Instruments Derivative Instruments
Value derived from the behavior of Underlying instruments.

Classes of Financial 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. 2. 3.

Primarily to transfer risk

1. 2. 3.

4.
5.

Bank Loans Bonds Home Mortgages Stocks Asset-backed securities

Insurance Futures Contracts 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 longterm 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

Characteristics of a well-run financial market

Low transaction costs. Information communicated must be accurate. Investors must be protected.

Primary vs. Secondary Markets Money Market VS Capital Market Centralized Exchanges vs. Over-thecounter Markets. Debt and Equity vs. Derivative Markets

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