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.
© 2019 Pearson Education, Inc.
, 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.
© 2019 Pearson Education, Inc.
, 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
proper metric for this goal is the price of the firm’s stock. Other things equal, an increasing price per
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
periods (i.e., focusing on current profit overlooks the time value of money); (2) activities that generate
higher accounting profits today may not result in higher cash flows to stockholders; and (3) activities
that lead to high profits today may involve higher risk, which could result in significant future losses.
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,
other things equal, an increase in the risk of cash flows to shareholders will depress firm stock price
while higher average cash flows to shareholders will increase stock price.
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.
That said, customers prefer lower prices for firm output, firm employees prefer higher wages, and firm
suppliers prefer higher prices for the input goods and services they provide. So actions that produce the
highest price of the firm’s stock cannot simultaneously maximize customer, employee, and supplier
satisfaction.
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
projects while financing decisions concern the funding of those projects. Working-capital decisions, in
contrast are related to the firm’s management of short-term financial resources.
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
actions to reduce the chance cash flows will be low or negative also tend to reduce average cash flows
over time. Understanding this tradeoff is important because shareholders are risk averse. That is, they
will only accept larger swings in a firm’s cash flows only if compensated over time with higher average
cash flows.
© 2019 Pearson Education, Inc.
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.
© 2019 Pearson Education, Inc.
, 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.
© 2019 Pearson Education, Inc.
, 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
proper metric for this goal is the price of the firm’s stock. Other things equal, an increasing price per
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
periods (i.e., focusing on current profit overlooks the time value of money); (2) activities that generate
higher accounting profits today may not result in higher cash flows to stockholders; and (3) activities
that lead to high profits today may involve higher risk, which could result in significant future losses.
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,
other things equal, an increase in the risk of cash flows to shareholders will depress firm stock price
while higher average cash flows to shareholders will increase stock price.
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.
That said, customers prefer lower prices for firm output, firm employees prefer higher wages, and firm
suppliers prefer higher prices for the input goods and services they provide. So actions that produce the
highest price of the firm’s stock cannot simultaneously maximize customer, employee, and supplier
satisfaction.
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
projects while financing decisions concern the funding of those projects. Working-capital decisions, in
contrast are related to the firm’s management of short-term financial resources.
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
actions to reduce the chance cash flows will be low or negative also tend to reduce average cash flows
over time. Understanding this tradeoff is important because shareholders are risk averse. That is, they
will only accept larger swings in a firm’s cash flows only if compensated over time with higher average
cash flows.
© 2019 Pearson Education, Inc.
