Managerial Finance

Managing the finances of a corporation can be complex and involved and requires capable and experienced financial leadership and management. Corporations seek to provide a return on investment to stockholders and need money to finance daily operations and long term plans. Managerial finance is made up of the investment decisions financial managers make. These can be decisions about dividend policy, capital spending, funding of long and short term projects and managing long and short term debt. Financial managers also have to balance their decisions with the risk involved. Financial managers use specific tools and techniques to make investment decisions and evaluate and assess the appropriate techniques based on company strategy and current economic conditions.

Keywords Abandonment Option; Bankruptcy Risk; Debt; Debt Financing; Equity; Equity Financing; Finance; Financial Managers; Net Present Value; Pecking-order; Present Value; Working Capital

Finance > Managerial Finance

Overview

Finance looks at how businesses make, use and deploy financial resources. Managerial finance considers the challenges of the financial manager who must make decisions about the techniques used to manage company finances. The decisions that the financial manager makes affect the ability of the company to adequately use its cash and liquid assets, raise funds when needed and make investment moves that benefit stockholders.

Faulkender & Wang (2006, p 1957) note that investors and shareholders care about the amount of cash that a firm has because "corporate liquidity enables firms to make investments without having to access external capital markets." In this way, companies avoid transaction costs. Companies have an objective to produce a positive financial result to ensure the continuation of the company and to provide value to investors and stockholders. When a company is publicly owned, it is important that companies make decisions that are not simply in the interest of internal stakeholders but that consider the objectives of external stakeholders such as stockholders and financial analysts. These external stakeholders are interested in predicting the profitability of a company for investment reasons.

Financial Analysis

There are two techniques of financial analysis involved in security selection and valuation. These include fundamental analysis and technical analysis.

• Fundamental analysis involves researching industry information, financial statements and other factors to determine the true value of a firm.
• Technical analysis is tracking trends and patterns that might exist in stock price.

In order to make corporate investment decisions, financial managers must understand the time value of money, capital budgeting, capital structure and dividend policy. In addition, financial managers face the problem of dealing with and making decisions about risk and return. Risk is the chance that you will get a result other than the one you expected. Other topics financial managers consider include capital budgeting, raising capital, cash flow techniques, market efficiency and the capital asset pricing model (CAPM). One technique used by financial managers is that of discounted cash flow (DCF). French (2013) provides an overview of how the DCF model is used quarterly. This technique makes sure that companies examine the income produced by capital investments.

Efficiency

Market efficiency can refer to economic efficiency or information efficiency.

• Economic efficiency has to do with how funds are allocated or directed and what the transaction cost is for these positions.
• Information efficiency refers to the availability of critical information related to investments and transactions.

Besley & Brigham (2001) note three types of information efficiency: Weak, semi-strong, and strong. Each refers to the relative strength of information related to price, price movement and how useful that information is in relation to the return on investment. The capital asset price model (CAPM) relates risk to return when considering the value of a stock. Morgenson & Harvey (2002) noted that CAPM is a model for the pricing of risky securities.

Time Value of Money

The time value of money is a statement of how one feels about money. It is the notion that a dollar today is worth more than the promise of a dollar in the future. Financial managers must observe how money reacts over time in order to decide the best use of money and what investments make sense. If a company has money tied up in investments, there is a cost that the company incurs because that money is not available to do something else. There are certain benefits of capitalizing on time. "Equity market timing" is "issuing shares at high prices and repurchasing at low prices" (Baker & Wurgler, 2002).

Capital Budgeting

Capital budgeting is the process of analyzing various investment alternatives in machinery and equipment and is used for planning long term acquisitions of capital assets. Although capital equipment may be useful for a company, the cost has to be balanced against the reward. For example, a manufacturing company may be in a position where old equipment is costing the company money because of high repair and maintenance costs and lost production. In addition, the older equipment might present a safety cost to employees and maintenance workers and may interfere with worker productivity because employees spend a lot of time dealing with equipment breakdowns. Similarly, a company may decide to invest in new equipment but it may be costly, there may be long lead times on the equipment and it may take a long time to get a return on the capital investment. Ghahremani, Aghaie, and Abedzadeh (2012) studied the effectiveness of various capital budgeting techniques over four decades and argue for the importance of adopting the real option approach to capital budgeting decisions.

Capital Structure

Capital structure refers to the framework a company uses to generate financing for assets. Companies may choose to use debt or equity financing or some combination of the two. When raising capital, a financial manager has many options. Companies can use internal money for projects or can turn to venture capital firms or banks. Loans can be obtained either as short term, working capital loans or long term loans.

Dividends

A dividend is money that is paid out of a company's profit to holders of stock. Dividend policy describes how a company will decide whether or not to pay dividends. Dividends are typically paid quarterly and can be paid out in cash or more stock to the stockholders. One of the measures of dividend policy used by financial managers is dividend yield. Dividend yield is a function of the annual dividend per share divided by the price per share (Morgenson & Harvey, 2002).

Cash Flow Analysis

An analysis of cash flow examines the in and outflows of cash and whether or not enough cash is available to meet company needs. Companies can breakeven, have a positive cash flow or net loss of cash. Projecting cash flow can prevent uncomfortable shortfalls which may result in borrowing or otherwise changing the company's financial position. However, excessive cash can uncover other signs of mismanagement. Financial managers may make changes in product prices or analyze where costs are coming from to identify the business units that generate the most in cost. Some companies find cash relief by improving their ability to collect on bills. That is why some companies employ collections agencies as an adjunct to their own accounts receivable personnel to collect stubborn, delinquent accounts. Other companies may look for ways to increase sales to bring in more cash. Financial managers also find ways to create cash reserve to prevent restrictions on company activities due to lack of cash flow.

Financial Markets

The financial markets in which the marketplace invests, buys and sells fall into the categories of markets for goods and services, financial assets, money balances, and resources (Schenk, 1997). The financial manager may deal with external parties in the course of investing or seeking financing. These institutions include banks, insurance companies and investment brokerages.

The Role & Decisions of the Financial Manager

Financial managers are responsible for acquiring needed funds for the company and positioning these funds so that they will be invested in projects that will maximize the return on investment and the enhance the value of the company.

It may sound as if the job of a managerial finance professional is an easy one and that each professional only needs to know a few formulas. However, the job is quite complex; the professional has to consider the industry, economic conditions, internal size and structure as well as financial opportunities. Pagano and Stout (2004) looked at the weighted average of cost of capital for two large firms, Microsoft and General Electric. The authors found that using three different methods, they yielded three different results, meaning that financial managers must go beyond the equations and use a myriad of techniques, subjective and objective, to make corporate investment decisions. So while financial expertise is needed and required, other skills such as decision making and weighing alternatives are also important. The financial information possessed by the financial manager must be augmented with up to date market and industry information and with new tools for analyzing corporate investments.

Managerial finance has gone through a number of evolutions regarding its context (Besley & Brigham, 2001). During the 1940s and 50s, an emphasis was placed on liquidity while the 1950s and 60s saw a shift towards maximizing the value and analysis of alternatives. Risk management was the focus of the 1970s while the 1990s considered globalization, government regulations and increased use of technology. The focus of financial managers again evolved in the post 2007 recession economy (West, 2013). Financial managers are seen as the coordinators and directors of financial decisions and must receive coherent input from other parts of the business such as operations and marketing to adequately make decisions.

Some of the ways in which financial managers optimize a company's value is by efficient forecasting and planning, coordinating major investment and financing decisions, control of financial information gathering and reporting and participating in financial markets (Besley & Brigham, 2001).

Financial Instruments

Tangible and financial assets are the primary instruments that financial managers deal with and have to maximize. A tangible asset may have value to others and can be sold or borrowed against. Similarly, financial assets are financial instruments which promise the holder a cash flow distribution at some point in the future. The types of financial instruments that financial managers may work with include equity and debt instruments such as:

• Certificates of Deposit
• Treasury Bills
• Eurodollars
• Commercial Paper
• Common Stock
• Preferred Stock
• Corporate Bonds
• Term Loans
• Treasury notes and bonds.

One of the ways in which a corporation can use financial instruments it has issued is to buy tangible assets that are income-producing assets.

Debt

Financial managers must analyze corporate activities related to short and long-term debt. Debt is when a loan is made to someone or some entity and has the features of principal value, face value, maturity value and par value. Principal value is also called principal amount or simply principle. It is equivalent to the amount being borrowed. Par, maturity or face value is the amount that will be paid on a financial security such as a bond when mature. A feature of debt that financial managers must consider is the fact that interest payments will be due in addition to principal payments. Certain types of debt result in turning over controlling interests in the company.

Some examples of short term debt are treasury bills, repurchase agreements, commercial paper and certificates of deposit. Examples of long-term debt include term loans, bonds (government treasury or municipal bonds, corporate bonds, mortgage bonds). Equity financing can take on the form of preferred or common stock. Preferred stock is preferred over common stock when dividends are distributed. Some of the features of preferred stock that are different from common stock are the possible allowance for cumulative dividends or the conversion of preferred stock into common stock (Besley & Brigham, 2001).

Common stock allows stockholders to have a stake of ownership in a firm. These stockholders may also have a preemptive right to purchase additional shares sold by the company. Capital stock is a term that refers to all the stock issued by a company and includes common and preferred stock. A company's charter authorizes the number and value of shares of stock available (Morgenson & Harvey, 2002)

Financial managers may decide to participate in the financial markets through the use of derivatives. Derivatives are financial securities based on an underlying asset like a stock or bond. Derivatives are considered to be risky investments but have the potential for a high rate of return and can possibly balance out a portfolio.

Viewpoint

Comparing Options for Investment & Raising Capital

Financial managers have many choices for investing a firm's money and must weigh those options in a way that maximizes value for the company. First, financial managers have to consider risk when choosing a financial security. One of the issues that may be important to a company is what tax implications will result from a particular type of security. In addition, the value and cost of an investment over time can impact whether or not the investment is selected for short or long term.

Choosing a Financial Instrument

The financial instrument that is best depends on your point of view. Financial managers will have to discover whether or not an investment is worthwhile from the issuer's or the investor's point of view (Besley & Brigham, 2001). Some characteristics of bonds include fixed interest payments and an interest expense that is deductible. However, they do not provide ownership and there may be some restrictions on dividends. Preferred stock may have disadvantages tax-wise by providing for higher after-tax costs because its dividends are not deductible. An advantage of preferred stock is the guarantee of a fixed payment though payouts on these fixed payments are not guaranteed. Common stock also doesn't have an obligation for companies to pay dividends but stockholders may have voting rights and some control.

International Markets

International markets offer opportunity for investment as global financial investing increases and as returns on global securities grow. Some examples of global investing include American depository receipts (ADRs) which are stocks in foreign countries where the stock is held in trust by that country's banks. There are foreign debt instruments and Eurodebt (Eurobonds, eurocredits, euro-commercial paper) available for investing. Foreign equity products include eurostock or stock that is traded in other countries or Yankee stock which is stock issued for foreign companies and traded in the U.S. (Besley & Brigham, 2001).

Financial Markets

Financial markets are the network and system of institutions, individuals, financial instruments, policies and procedures that allow borrowers and investors to get together. Financial flow can occur when a company sells its stock directly to the purchaser or when there is indirect transfer of funds through banks or intermediaries. Financial managers can choose from money markets or capital markets when investing. Money markets are for financial instruments that are typically mature within one year or less. Capital markets are markets with instruments that have maturities of greater than one year.

Preliminary Actions

There are many decisions to make when trying to raise capital for a company. Financial managers have to initially decide on the optimal amount of money needed. The type of securities required to raise the level of capital needed must also be considered. Investment bankers must be consulted to assist in navigating the market. Before setting the offer price of securities, the costs related to the offer must be itemized. A rather complex selling process involves registration with the Securities and Exchange Commission and preparing a prospectus for investors. Banks agree to underwrite the newly issued securities. The company's investment banker assists in setting up a secondary market for the securities. The Securities and Exchange Commission (SEC) is a governmental agency that regulates any issuing or trading of stocks and bonds. The SEC wants to make sure companies are not committing fraud and that investors are being given an accurate picture of what they are investing in and how. The reason for this close regulation is to prevent insider trading and manipulation of the market.

The Cost of Money

Financial managers always have to consider the cost of money. This can include interest rates on loans as well as equity to stockholders in terms of dividends and capital gains. When analyzing an opportunity, financial managers consider cost and whether or not the cost is reasonable based on what the company is allowed to invest in with money. Money can also be affected by the risk of investing in a depreciating asset that quickly loses value or inflation which makes things worth less over time. There are several categories of risk associated with cost of money decisions. These include the default risk premium which is the difference between interest rates on corporate bonds and U.S. treasury bonds. Inflation and liquidity premiums are premiums or add-ons to securities based on inflation or for securities that are not able to be made into liquid assets quickly. Interest rate risk affects investors with possible loss if the interest rates are fluctuating. Financial managers have to stay abreast of current financial information and cannot make decisions simply based on company strategy or company policy. External financial pressures can be exerted by Federal Reserve policy, changes in industries, the federal deficit or a dramatic change in business activity in the marketplace (Besley & Brigham, 2001).

Internal Managerial Finance Activities

While financial managers are well served to monitor financial news and updates, there are many activities that are central to managerial finance that take place within the confines of a company. Managerial finance often means the analysis of financial reports. Some of the reports issued by firms are consumed externally. These include the annual report which includes the basic financial statements such as the income statement, balance sheet, statement of retained earnings, cash flow statements and notes.

• An income statement is a summary of the revenues brought into the company and the expenses that were incurred by the company over the quarter or year.
• Balance sheets show the company's financial position as a snapshot of a period in time.
• The statement of cash flows shows the impact of the firm's activities such as operational cash flows, flows related to investing or financing over a certain period of time.

Knowing how much cash a company has is only part of the picture. It is important to see how the cash is used as well. Financial managers may perform ratio analysis to understand the company's liquidity position and may show how well a company manages its assets. Financial managers use ratio analysis to analyze how debt is being used and how much financing activity is taking place. Ratio analysis can also tell how profitable a company is and what the earnings are in relation to other companies in similar industries or of similar size. Although ratio analysis provides a lot of information, it can be misleading if the company has several different business units that operate in different or multiple industries. It can be complex to extract an accurate picture and extrapolate that to financial decision making.

Finally, financial managers are responsible for financial planning and control. The planning aspect involves projecting the sales and income based on the company's sales efforts and current production levels. In addition, financial managers must determine the resources needed to implement financial plans. Control is monitoring that takes place to make sure the companies activities are in line with plans and to make adjustments where needed. Monitoring and planning are assisted by automation and are ongoing processes that are subject to change based on internal or external forces.

Terms & Concepts

Abandonment Option: When the choice is made to abandon an investment instead of waiting for the investment to produce a return.

Bankruptcy Risk: Sometimes called insolvency risk. The risk for companies associated with having liabilities that exceed assets. Also called negative net worth.

Debt: A relationship where a borrower receives funds from a lender and is obligated to pay back the lending amount plus interest.

Debt Financing: Raising capital by selling debt financial instruments such as notes, bills and bonds to individuals or institutions.

Equity: Ownership in a company.

Equity Financing: Raising capital by selling shares of stock.

Net Present Value: The current value of cash flow in the future minus cost.

Pecking-order: Preferred order of financing options.

Present Value: The value of a dollar today that is equal to the value of a dollar in the future.

Bibliography

Baker, M. & Wurgler, J. (2002). Market timing and capital structure. Journal of Finance, 57, 1. Retrieved October 1, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=5889290&site=ehost-live

Besley, S. & Brigham, E.F. (2001). Principles of finance (2nd ed.). Boston: Southwest College Publishing.

Faulkender, M. & Wang, R. (2006). Corporate financial policy and the value of cash. Journal of Finance, 61, 1957-1990. Retrieved October 1, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=21796398&site=ehost-live

French, N. (2013). The discounted cash flow model for property valuations: Quarterly cash flows. Journal of Property Investment & Finance, 31, 208-212. Retrieved on November 15, 2013, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=85804861&site=ehost-live

Ghahremani, M., Aghaie, A., & Abedzadeh, M. (2012). Capital budgeting technique selection through four decades: With a great focus on real option. International Journal of Business & Management, 7, 98-119. Retrieved on November 15, 2013, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=80037203&site=ehost-live

Gordon, R. & Lee, Y. (2007) Interest rates, taxes and corporate financial policies. National Tax Journal, 60, 65-84. Retrieved October 1, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=24699957&site=ehost-live

Morgenson, G. & Harvey, C. R. (2002). The New York Times Dictionary of Money Investing. New York: Times Books.

Pagano, M.S. & Stout, D.E. (2004). Calculating a firm's cost of capital. Management Accounting Quarterly, 12, 243 — 256. Retrieved November 18, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=14027648&site=ehost-live

Schenk, R. (1997). Overview: financial markets. Retrieved November 21, 2007 from http://ingrimayne.com/econ/Financial/Overview8ma.html.

West, P. (2013). Thriving in the post-crisis economy: Managing a nexus of capabilities. Strategic Direction, 29, 3-6. Retrieved on November 15, 2013, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=86655297&site=ehost-live

Suggested Reading

Czurak, D. (2007). City getting a bond aid. Grand Rapids Business Journal, 25, 3-7. Retrieved November 18, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=27261837&site=ehost-live

Krishnan, C. N. V. (2007). Optimal wage contracts under asymmetric information and moral hazard when investment decisions are delegated. Journal of Economics & Finance, 31, 302-318. Retrieved November 18, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=27439574&site=ehost-live

Mankin, E. (2007). Measuring innovation performance. Research Technology Management, 50, 5-7. Retrieved November 18, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=27377099&site=ehost-live

Schoder, D. (2007). The flaw in customer lifetime value. Harvard Business Review, 85, 26. Retrieved November 18, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=27329791&site=ehost-live