Part 1
Introduction to Managerial Finance
Chapters in This Part
Chapter 1 The Role of Managerial Finance
Chapter 2 The Financial Market Environment
Integrative Case 1: Merit Enterprise Corp.
Chapter 1 The Role of Managerial Finance 2
Chapter 1
The Role of Managerial Finance
Instructor’s Resources
Chapter Overview
This chapter introduces the field of finance through building-block terms and concepts. The discussion starts by
defining “firm” and stressing its principal goal—maximizing shareholder wealth. The importance of focusing on
shareholders rather than stakeholders broadly and stock price rather than current profits is explained. The
managerial-finance function is then described and differentiated from economics and accounting, with special
attention to the role ethics play in a financial manager’s efforts to maximize the firm’s stock price. Next, the
three basic legal forms of business organization (sole proprietorship, partnership, and corporation) are
discussed and the strengths and weaknesses of each form noted. The chapter concludes with an exploration of
the agency problem—the conflict arising when the managers and owners of the firm are not the same people
—and the private- and public-sector tools available to focus managerial attention on shareholder wealth.
This chapter and the ones to follow stress the important role finance vocabulary, concepts, and tools will play
in the professional and personal lives of students—even those choosing other majors, such as accounting,
economics information systems, management, marketing, or operations. Whenever possible, personal-finance
applications are provided to motivate and illustrate topics. This pedagogical approach should inspire students
to master chapter content quickly and easily.
NOTE: After this text went to press, Congress passed the Tax Cuts and Job Act of 2017, which dramatically
changed both corporate and personal tax rates. The first printing of this text did not reflect these tax changes,
but subsequent print runs do. For tax-related problems, we provide solutions under both the old and the new
tax law. Of particular relevance to this chapter, the corporate tax rate is now a flat 21%. Individuals still face a
progressive rate schedule, so there is still value in explaining the progressive nature of the old corporate
structure as well as the difference between marginal and average tax rates (which are essentially the same
under a flat-rate structure). The change in the corporate tax code—in particular the introduction of a lower,
flatter rate—can serve as a useful discussion point throughout this text. For example, instructors may wish to
discuss the impact of a lower tax rate on the NPV of investments or a firm’s optimal capital structure.
Suggested Answer to Opener-in-Review
Students learned the stock price of Brookdale Senior Living tumbled 36% in 2016 to $12.35 per share,
prompting Land and Buildings (a prominent stockholder) to urge the firm sell its real-estate holdings,
distribute the anticipated net sales proceeds ($21 cash) to shareholders, and then focus on managing its senior
living facilities. Students were asked whether the proposal would make Brookdale’s shareholders better off if
the expected cash proceeds were realized, but stock price dipped to $5 per share.
Chapter 1 The Role of Managerial Finance 3
Before restructuring, an investor with one Brookdale share had $12.35 in total wealth. Afterward, that same
investor had a share worth $5 and $21 in cash—total wealth of $26. The hypothetical shareholder reaped a
gain of $13.65 per share or 110.5%. Before the asset sale, with 185.45 million shares outstanding and a share
price of $12.35, total shareholder wealth was $2.29 billion. After the sale, with same shares outstanding and
wealth per share now $26, shareholder wealth rose to $4.82 billion– a net gain of $2.53 billion.
Here is a discussion question for the class to motivate future exploration of CEO compensation: Suppose
Brookdale’s CEO came up with the asset-sale idea rather than a prominent shareholder, and Brookdale’s
board rewarded him with a $1 million dollar bonus—a figure alone that would easily vault the CEO into the
top 1% of U.S. income earners. Is the CEO’s compensation excessive?
Answers to Review Questions
1.1. The goal of a firm, and therefore of all financial managers, is maximizing shareholder wealth. The
share of common stock relative to the stock market as a whole indicates achievement of this goal.
1-2 Actions that maximize the firm’s current profit may not produce the highest stock price because (1)
some firm activities that result in slightly lower profit today generate much larger profits in the future
1-3 Risk is the chance actual outcomes may differ from expected outcomes. Financial managers must
consider risk and return because the two factors tend to have an opposite effect on share price. That is,
1-4 Maximizing shareholder wealth does not mean overlooking or minimizing the welfare of other firm
stakeholders. Firms with satisfied employees, customers, and suppliers tend to produce higher (or less
risky) cash flows for their shareholders compared with companies that neglect non-owner stakeholders.
1-5 Broadly speaking, the decisions made by financial managers fall under three headings: (i) investment,
(ii) capital budgeting, and (iii) working capital. Investment decisions involve the firm’s long-term
1-6 Financial managers must recognize the tradeoff between risk and return because shareholders prefer
higher cash flows but dislike large swings in cash flows. And, as a general rule, actions that boost the
firm’s average cash flows also result in greater cash-flow greater volatility. Viewed another way, firm
Chapter 1 The Role of Managerial Finance 4
1-7 Finance is often considered applied economics. One reason is firms operate within the larger economy.
More importantly, the bedrock concept in economics—marginal benefit-marginal cost analysis—is also
1-8 Accountants and financial managers perform separate but equally important functions for the firm.
Accountants primarily collect and present financial data according to generally accepted financial
principles while financial managers make investment, capital-budgeting, and working-capital decisions
with financial data. In part because of their different functions, accountants and financial managers log
1-9 Like any economic actor, managers respond to incentives. Managers have a fiduciary duty to maximize
shareholder wealth, but as humans, they also have personal goals—such as maximizing their own
income, wealth, reputation, and quality of life. If the personal benefits of delivering for shareholders (or
the costs of slighting them) are small, a financial manager might opt to further his own interest at the
expense of shareholders. For example, CEOs of large firms—those with more sales, assets, employees,
1-10 Sole proprietorships are the most common form of business organization, while corporations tend to be
and facilitate acquisition of financial capital to fund growth.
1-11 Stockholders are the owners of a corporation. Their ownership (equity) takes the form of common
stock or, less frequently, preferred stock. Stockholders elect the board of directors, which has ultimate
responsibility for guiding corporate affairs and setting general policy. The board usually comprises key
1-12 Generally speaking, income from sole proprietorships and partnerships is taxed only once at the
individual level; the owner or owners pay personal income tax on their share of firm’s profits. In
Chapter 1 The Role of Managerial Finance 5
1-13 Agency problems arise when managers place personal goals ahead of their duty to shareholders to
maximize stock price. The attendant costs are called agency costs. Agency costs can be implicit or
explicit; either way they reduce shareholder wealth. An example of an “implicit” agency cost is the
structure. Such a structure will feature checks and balances that reduce management’s interest in and
ability to deviate from shareholder-wealth maximization. Like all corporate decisions, reducing agency
1-14 Firms most commonly try to mitigate agency problems by linking pay to metrics connected with
shareholder wealth. Incentive plans tie compensation to share price. For example, the CEO might
receive options offering the right to purchase stock at a set price (say current price) any time in the next
shareholder wealth, her options proved worthless because a bear market hammered the firm’s stock
price. This problem has made performance plans more popular. These plans link compensation with
1-15 If the board of directors fails to keep management focused on shareholder wealth, market forces can
apply the necessary pressure. Two such forces are activism by institutional investors (such as Land and
Buildings in the chapter opener) and the threat of hostile takeovers. Institutions typically hold large
stock price of $15, but that price could be $20 with bold action management is reluctant to take. The
lure of a $5 capital gain per share could tempt an outside individual, group of investors or firm not
Chapter 1 The Role of Managerial Finance 6
Suggested Answer to Focus on Ethics Box:
Do Corporate Executives Have a Social Responsibility?
How would Friedman view a sole proprietor’s use of firm resources to pursue social goals?
In a sole proprietorship, the owner and manager are one in the same. So a manager using firm resources to
support social goals would be doing exactly what the owner wanted. Put another way, Friedman would not
Suggested Answer to Focus on Practice Box:
Must Search Engines Screen Out Fake News?
Is the goal of maximizing shareholder wealth necessarily ethical or unethical?
The “end” of maximizing shareholder wealth is neither ethical nor unethical; it is neutral. But the means
What responsibility, if any, does Google have to help users assess the veracity of online content?
Management’s overriding concern should be shareholder wealth. Knowingly posting content a reasonable
person could see is fake harms shareholders by damaging the Google brand, so some due diligence is
Answers to Warm-Up Exercises
E1-1. Advantages and disadvantages of partnership versus incorporation (LG 5)
Answer: Each form of business organization has advantages and disadvantages. One advantage of a simple
partnership is that each partner’s income is taxed only once as personal income (i.e., subject to the
Taxation is a key factor in choosing the form of business organization, but two other factors are
also important. In a partnership, each partner has unlimited liability and may have to cover debts
Chapter 1 The Role of Managerial Finance 7
If a third party were asked to decide which legal form of business A&J Tax Preparation should
take, it would be useful to have the following information:
E1-2 Timing of cash flows (LG 4)
Answer: Based on the information provided, the choice is not obvious. Even though the second project is
expected to provide a larger overall increase in earnings, the goal of the firm is maximizing
E1-3. Cash flow vs. profits (LG 4)
Answer: It is not unusual for profitable firms to suffer a cash crunch. This typically happens when expenses
must be paid before revenue can be collected. In such cases, the firm must arrange financing to
plug the gap between cash inflows and outflows. If cash crunches are regular, management should
E1-4. Sunk costs (LG 5)
Answer: Marginal benefit-marginal cost analysis ignores sunk costs, so the $2.5 million dollars spent over
the past 15 years is irrelevant to the current decision. At this point, what matters is whether expected
revenues from additional investment exceed expected costs, after adjusting for the risk and timing of
E1-5. Agency costs (LG 6)
Answer: Agency costs arise when one party (principal) designates another party (agent) to act on her behalf
and the second party (agent) has latitude to pursue her own interest at the expense of the principal.
In a corporation, shareholders are principals and managers agents. If shareholders fail to monitor
In the Donut Shop, Inc. example, the principal is store management, and the agents are employees.
As normal humans, employees might prefer talking with other each or taking long breaks to
One potential solution for Donut Shop, Inc., is a profit-sharing plan that includes employees whose
behavior reduced customer satisfaction. For the new benefit to be effective, Donut Shop must sell
Chapter 1 The Role of Managerial Finance 8
E1-6. Corporate tax liability (LG 5)
Answer: Note to instructors: After the first print run of this text, Congress made major changes to corporate
taxes. A revised printing incorporated the newest tax changes, but some students may be using a
version of the text with a graduated corporate tax code rather than the current 21% flat tax. The
answer to this question under current law is that taxes are 21% of income, which is $500,000 plus