Chapter 1

Introduction to
Managerial Finance
What is Finance ?
 Finance can be defined as the art and science of managing money. It is
concerned with the process, institutions, markets and instruments
involved with the transfer of money among individuals, business and
government.

 Major Areas and Opportunities in Finance:

1. Financial Services- concerned with design and delivery of advice
and financial products to individuals, businesses and government.
Example: investment, real estate, personal financial, planning and
insurance.

2. Managerial Finance- concerned with duties of the financial

manager in the business firm. They manage the financial affairs of
any type of business.
Legal Forms of Business
 Sole Proprietorship-one person ownership with
personal profit motive. Unlimited liability.
 Partnership- two or more owners. Established by
written contract called Articles of Partnership.
Unlimited liability in general and legal
partnership.
 Corporations- known as legal entity is an
artificial being created by law. Limited liability
(they lose only the amount they invested)
..continuation
 Stockholders are the owners of the organization. This
ownership is called equity held in the form of Common
Stock or Preferred Stock.
 Common Stock: True owners of the corporation are
common stock holders who are also referred to as residual
owners. They receive what is left after all other claims of the
firm’s income and asset has been satisfied called dividends.
 Dividends: Periodic distribution of earning (profit) to the
stockholders of the firm.
Some features of Common Stock
 Ownership: can be privately owned by a single individual, closely
owned by small group of investors (family members) or publicly
owned by broad group of unrelated individuals.

 Par Value: Common stock are sold with par value or face value.

 Voting Rights: Each share of common stock usually entitles its

holder to one vote in election.
Features of Common Stock
 Authorized, Outstanding and Issued Shares: Authorized
shares are the number of shares of common stock that a
firm’s corporate charter allows it to issue.
 Outstanding Shares: Authorized shares become outstanding
when they are held by the public.
 Issued shares: these are shares of common stock that have
been put into circulation (outstanding shares).
…continuation
 Preferred Stock: gives its owners certain
advantage over common stock holders. 1.Preferred
stock holders are promised a fixed periodic
dividend stated in dollar amount of percentage on
its par value or face value.
2. Usually not given voting rights.
Why Study Managerial Finance?
 No matter what profession you enter
understanding the managerial finance function is
important.

 Career Opportunities in Finance: Refer to table 1.3

in textbook, page-9 (Gitman)
Relationship to Economics
1.Evaluation of cost and benefit. Marginal added
benefits must exceed the added marginal costs.

 Ex: Whether to buy a fleet of new computer and

replace old ones for better transaction and
efficiency? Refer to example (page -11).
Decision to buy or not: MB and MC
You are a financial manager and you want to replace your
company’s old computers with new ones for increasing
productivity and efficiency. Cost of new computer is $80,000.
The total benefit from the new computer measured in todays
dollar is $100,000. The old computer will be sold to net
$28,000. The benefits over a similar time period from the old
computer is $35,000. Should you replace or not?

Calculate MB and MC: If MB > MC accept.

Relationship to Accounting
 Finance and Accounting functions are related and
overlap. However there are two major differences.
1. Cash flow Emphasis: Accountant’s primary
emphasis is on accrual methods (recognizes revenue
at the time of sale and expenses when they are
incurred) and financial manager’s emphasis is on
cash basis that is actual inflow and outflow of cash to
reduce the probability of insolvency and reach the
firm’s goal. Example : page-11
Continuation…
2.Difference in decision making: Accountants
emphasize on collection and presentation of data.
But Financial Managers evaluate the accounting
statements, develop additional data and make
decisions on the basis of their assessment of
associated risk and return
Goal : Maximize Shareholder’s Wealth

 The goal of the firm of all managers and

employees is to maximize share holders wealth
or the owners for whom it is operated. Share
price is the indicator which depends on the timing
of cash flows, its magnitude and risk.
 Stakeholders: everyone who has direct economic
link to the firm. (Ex: suppliers, customers,
creditors, owners)
Types of investors
 Individual Investors- investors who buy
relatively small quantities of share to meet
personal investment goals.

 Institutional Investors- investment professionals

such as banks, insurance companies, pension
funds, mutual funds, that are paid to manage other
people’s money and that hold and trade large
quantities of securities.
Agency Issue and how to minimize the problem.

 The agency problem

 The goal of financial managers (agents of the

owners) is to maximize share holders wealth.
 Agency problem arises when the managers place
personal goals over the goals of the corporation.
Financial Institutions and Markets
 Financial institutions are intermediaries that channel funds
from savers to investors. They are key suppliers of funds and
the government individuals and businesses are the key
demanders.
 Financial Markets are forums where the direct transaction
between suppliers of funds and demanders of fund take
place.
1. Money Market -short term less than 1 year maturity
marketable securities and debt instruments are traded
2. Capital Market - long term securities such as stocks and
bonds are traded
How firms raise money or capital

 Private Placement by sale of new security issue such as

preferred stock or bonds exclusively to investors such as to
insurance companies or pension funds.
 Public Offering- the sale of bond or stock to the general public
 Primary Market: Financial Market where securities are
initially issued and the issuer is directly involved in the
transaction and receives direct benefit. New securities are sold
in primary market.
 Secondary Market: Financial market where pre owned
securities are traded.
Financial market Explanation

 Less than 1 year

Money  Debt securities only
 T-bill, CDs, C-paper
market

Corporation Financial
Market
 More than 1 year
Capital  Debt plus equity
market securities
 Shares, Bonds
The Capital Market
 The key capital market securities are bonds and
common stock and preferred stock.
 Bonds are long term debt instruments used by
businesses and government to raise large sums of
money from a diverse group of lenders. For
example : they have a coupon rate , a maturity date
(10 to 30 years) and a par or face value.
 Common Stock: are units of ownership or equity
in a corporation.
Broker Market & Dealer Market
 Broker Market : the securities exchanges on
which both the buyer and seller are brought
together to trade securities which takes place at
that point. With the help of a broker the securities
exchange effectively hands at the floor of
exchange
 Dealer Market: The buyers and sellers are not
brought together directly but the dealer execute the
buy or sell orders.
Marginal and Average Tax
 Ordinary income: For a corporation it is the
income earned by selling goods or services. Refer
to corporate tax schedule (table 1.4)
 Average tax rate is calculated by dividing a
company’s taxes by its taxable income.
 Marginal tax rate represents the rate at which
additional income is taxed.
Interest and Dividend income
Any interest earned by a corporation from bonds for example
will be included in the ordinary income. Dividends are treated
differently to moderate the effect of double taxation where the
already once taxed earnings are distributed as dividends to
stockholders who must pay tax on them.
Capital gains

 Refer to page 31 of Gitman

 Corporate Governance
 The system of rules, practices and processes by
which a company is directed and controlled.
 Corporate governance essentially involves balancing the
interests of the many stakeholders in a company - these include
its shareholders, management, customers, suppliers, financiers,
government and the community.

 Agency problem: Conflict of interest between a company's

management and the company's stockholders.