Chapter 1

Introduction to managerial finance

What is Finance?
• Finance is about making decisions that focus
on creating value within the firm.
• Finance builds upon the disciplines of
economics and accounting.
• -- economics provides theories about economic
system and decision making,
• -- accounting supplies financial data and data
analysis tools.
 What is Finance?
• Finance tries to help financial managers to answer (i.e.
make decisions about) the following questions:
1. What long-term investments or projects the firm
should undertake? (capital budgeting decision)
2. How the firm should pay for these assets? By issuing

equity or debt? (capital structure decision)

3. How much cash or inventory the firm should carry?
How much trade credit the firm should provide or
use? (working capital management decision)
• These decisions are made within a risk-return
framework.
Legal Forms of Business
..continuation
Some features of Common Stock
Features of Common Stock
• Authorized, Outstanding and Issued Shares: Authorized shares are the
number of shares of common stock that a corporation is legally allowed
to issue.
• Outstanding Shares: Authorized shares become outstanding when they
are held by the public. Any repurchase of outstanding shares are
recorded as treasury stock and no longer becomes outstanding.
Outstanding shares have already been issued.
• Issued shares: these are shares are shares of common stock that have
been put into circulation (outstanding shares and treasury stock)
…continuation
• Preferred Stock: gives its owners certain advantage
over common stockholders. 1.Preferred
stockholders are promised a fixed periodic dividend
stated in dollar amount of percentage on its par
value or face value. It is also known as hybrid stock.
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: Corporate
financial officer, banker, stockbroker, financial
analyst, portfolio manager, investment banker,
financial consultant or personal financial planner.
 Relationship to Economics
• Finance and Economics are related, but not
identical disciplines. Economics studies local
or global markets, human behavior, goods and
services, etc. Finance focuses on financial
system and everything related: banks, loans,
investments, savings, etc. Both disciplines open
the doors to well-paid and in-demand jobs.
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?
2. Foreign exchange manager deals with exchange
rates fluctuation which is closely related to
economics.
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.
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.
Objective :Maximization of profit or Wealth

• The modern approach focuses on wealth maximization

rather than profit maximization. This gives a longer term
horizon for assessment, making way for sustainable
performance by businesses.
• For a business, it is not necessary that profit should be the
only objective; it may concentrate on various other aspects
like increasing sales, capturing more market share etc, which
will take care of profitability.
• So, we can say that profit maximization is a subset of wealth
and being a subset, it will facilitate wealth creation.
• Maximization of wealth approach believes that money has
time value.
Maximization of profit: Is it a
reasonable goal?
Drawbacks to Profit Maximization as the goal of the firm:

• Higher profit/return may lead to higher risk. Increased risk may not be
desirable
• It doesn’t consider time value of money.
• It’s almost impossible to accurately measure profit. (inflation, currency
transaction)
 Risk-Return Tradeoff
 Profitability   Risk
 Profitability   Risk

• e.g., investing in stocks vs. savings accounts

• Stocks may be more profitable but are riskier
• Savings accounts are less profitable and less risky (or
safer)
Financial manager must choose appropriate
combination
of potential profit (return) and level of risk (safety).
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 goal of maximizing shareholder wealth may
conflict with
- interests of management (their compensation)
- social/ethical goals
• Agency theory is about the potential conflict
between shareholders and managers.
•  A strategic investor or the owner of the firm would
be majorly concerned about the longer term
performance of the business that can lead to
maximization of shareholder’s wealth. Whereas, a
manager might focus on taking such decisions that
can bring quick result, so that he/she can get credit
for good performance.
 Factors that prevent agency
problem
• Market forces-
1. Large institutional shareholders exert pressure to perform well.
2. Threat of takeover
• Agency Cost- costs borne by stockholders to minimize agency problem by
maintaining a corporate governance structure and maximize shareholder’s
wealth.
1. Structure management compensation plans to correspond with share price
maximization such as incentive plan (stock options) and performance plan
(cash bonuses, performance share, tie performance compensation to EPS,
growth etc)
 Role of Financial Markets
• Financial markets are a vast global network of
corporations, financial institutions, governments
and individuals that either need money or have
money to lend or invest.
• Public financial markets assist governments and
business to access funds for investment and
operations.
• The effect of managerial decisions on the value of
the firm is realized in financial markets.
Overview of Financial Markets
 Overview of Financial Markets
• Money market: A segment of the financial market in
which financial instruments with high liquidity and
very short maturities are traded. The money market
is used by participants as a means for borrowing and
lending in the short term, from several days to just
under a year.

• deal in short-term securities (<1 year)

e.g.: Treasury Bills, commercial paper, repos…….
Overview of Financial Markets
• Capital market: Capital market is a market for securities
(debt or equity), where business enterprises (companies)
and governments can raise long-term funds. It is defined as
a market in which money is provided for periods longer than
a year. The capital market includes the stock market (equity
securities) and the bond market (debt). Financial regulators,
such as the Bangladesh Financial Services Authority or the
Bangladesh Securities and Exchange Commission (SEC),
oversee the capital markets in their designated jurisdictions
to ensure that investors are protected against fraud, among
other duties.deal in long-term securities
 e.g.: common stock, preferred stock, corporate and
government 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. Preferred stock has both the
features of Bond and Common stock. That’s why it
is also known as hybrid security.
 Types of Capital Market
• Primary market: It is that market in which shares, debentures and other
securities are sold for the first time for collecting long-term capital. Money
collected from this market is generally used by the companies to modernize the
plant, machinery and buildings, for extending business, and for setting up new
business unit. In this market, the flow of funds is from savers to borrowers
(industries), hence, it helps directly in the capital formation of the country. The
primary market is also called NEW ISSUE MARKET.
• new issues of bonds or shares
• Secondary market: The chief purpose of the secondary market is to create
liquidity in securities (bonds or shares). The transactions of the secondary
market are generally done through the medium of stock exchange. The
secondary market is that market in which the buying and selling of the
previously issued securities is done.
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 market makers or
the dealer execute the buy or sell orders.
The Eurocurrency Market
• International equivalent to domestic money
market.
• This is a market for short term bank deposits
denominated in USD or any other easily convertible
currency. Ex- if a multinational corporation is to
deposit USD in a London Bank it would create a
Eurodollar deposit. (deposit at a bank in Europe)
• They are usually time deposit to be repaid later
with interest but less than a year.
International Capital Market
• Eurobond market: Corporations and Government issue
bonds denominated in dollars and sell them to
investors outside the US.
• Foreign Bond Market: A foreign bond is a bond that is
issued by a foreign corporation or government and
denominated in the investor’s home currency and sold
in the investor’s home market. Eg. A bond issued by a
US company in Swiss Francs and sold in Switzerland.
• International Equity Market: Allows corporations to
sell blocks of share to investors in a number of
different countries simultaneously.
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) pg 29
• 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.
• Hence the dividends the corporations receive from other firms (inter
corporate dividends) are taxed 30%.
Tax deductibility benefit and
Capital gains
• Corporations are allowed to deduct operating expenses, as
well as interest expenses, in calculating their taxes.
• The tax deductibility of this expenses reduces the after tax
cost. Example : page 31
• Capital Gain: If a firm sells a capital asset for more than its
initial purchase price, the difference between the sale price
and purchase price is called a capital gain. For corporations,
Capital gain are added to ordinary income and taxed at
regular corporate tax rate, with a maximum marginal tax rare
of 39%.
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. Corporate Governance
reduces the probability of agency problem.