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© 2015 Pearson Education, Inc.
Chapter 1
The Role of Managerial Finance
◼ Instructor’s Resources
Overview
This chapter introduces the students to the field of finance and explores career opportunities in both financial services
and managerial finance. The three basic legal forms of business organization (sole proprietorship, partnership, and
corporation) and their strengths and weaknesses are described. The managerial finance function is defined and
differentiated from economics and accounting. A discussion of the financial manager’s goals—maximizing
shareholder wealth and preserving stakeholder wealth—and the role of ethics in meeting these goals is presented.
The chapter then summarizes the three key activities of the financial manager: financial analysis and planning,
making investment decisions, and making financing decisions. The chapter includes discussion of the agency
problem—the conflict that exists between managers and owners in a large corporation.
This chapter, and all that follow, emphasizes how the chapter content plays a vital role in the student’s professional
and personal life. Each chapter includes an early discussion of the relevance of the topic to majors in accounting,
information systems, management, marketing, and operations. Throughout each chapter are detailed examples of
how the chapter’s topic relates to the student's financial life. These pedagogic tools should motivate students to
grasp quickly an understanding of the chapter content and employ it in both their professional and personal lives.
◼ Answers to Review Questions
1. Finance is the art and science of managing money. Finance affects all individuals, businesses, and
governments in the process of the transfer of money through institutions, markets, and instruments. At the
personal level, finance is concerned with an individual’s decisions regarding the spending and investing of
income. Businesses also have to determine how to raise money from investors, how to invest money in an
attempt to earn a profit, and how to reinvest profits in the business or distribute them back to investors.
2. Financial services is the area of finance concerned with the design and delivery of advice and financial
products to individuals, businesses, and governments. It involves a variety of interesting career opportunities
within the areas of banking, personal financial planning, investments, real estate, and insurance. Managerial
finance is concerned with the duties of the financial manager working in a business. Managerial finance
encompasses the functions of budgeting, financial forecasting, credit administration, investment analysis, and
funds procurement for a firm. Managerial finance is the management of the firm’s funds within the firm. This
field offers many career opportunities, including financial analyst, capital budgeting analyst, and cash
manager. (Note: Other answers are possible.)
3. Sole proprietorships are the most common form of business organization, while corporations are responsible
for the majority of business revenues. The majority of sole proprietorships operate in the wholesale, retail,
service, and construction industries. Although corporations engage in all types of businesses, manufacturing
firms account for the largest portion of corporate business receipts and net profits.

4 Gitman/Zutter Principles of Managerial Finance, Brief, Seventh Edition
4. Stockholders are the owners of a corporation, whose ownership, or equity, takes the form of common stock
or, less frequently, preferred stock. They elect the board of directors, which has the ultimate authority to
guide corporate affairs and set general policy. The board is usually composed of key corporate personnel and
outside directors. The president or chief executive officer (CEO) reports to the board. He or she is responsible
for day-to-day operations and carrying out the policies established by the board. The owners of the
corporation do not have a direct relationship with management but give their input through the election of board
members and voting on major charter issues. The owners of the firm are compensated through the receipt of
dividends paid by the firm or by realizing capital gains through increases in the price of their common stock
shares.
5. The most popular form of limited liability organizations other than corporations are:
• Limited partnerships—A partnership with at least one general partner with unlimited liability and one or
more limited partners who have limited liability. In return for the limited liability, the limited partners are
prohibited from active management of the partnership.
• S corporation—If certain requirements are met, the S corporation can be taxed as a partnership but
receive most of the benefits of the corporate form of organization.
• Limited liability company (LLC)—This form of organization is like an S corporation in that it is taxed as
a partnership but primarily functions like a corporation. The LLC differs from the S corporation in that it
is allowed to own other corporations and be owned by other corporations, partnerships, and non-U.S.
residents.
• Limited liability partnership (LLP)—A partnership form authorized by many states that gives the partners
limited liability from the acts of other partners, but not from personal individual acts of malpractice. The
LLP is taxed as a partnership. This form is most frequently used by legal and accounting professionals.
These firms generally do not have large numbers of owners. Most typically they have fewer than
100 owners.
6. Virtually every function within a firm is in some way connected with the receipt or disbursement of cash. The
cash relationship may be associated with the generation of sales through the marketing department, the
incurring of raw material costs through purchasing, or the earnings of production workers. Because finance
deals primarily with management of cash for operation of the firm, every person within the firm needs to be
knowledgeable of finance to work effectively with employees of the financial departments.
Individuals plan, monitor, and assess the financial aspects of their activities over a given period through the
consideration of cash inflows and outflows.
7. The goal of a firm, and therefore of all managers, is to maximize shareholder wealth. This goal is measured
by share price; an increasing price per share of common stock relative to the stock market as a whole
indicates achievement of this goal.
8. Profit maximization is not consistent with wealth maximization due to: (1) the timing, (2) earnings that do not
represent cash flows available to stockholders, and (3) a failure to consider risk.
9. Risk is the chance that actual outcomes may differ from expected outcomes. Financial managers must
consider both risk and return because of their inverse effect on the share price of the firm. Increased risk may
decrease the share price, while increased return is likely to increase the share price.
10. In recent years, the magnitude and severity of “white collar crime” has increased dramatically, with a
corresponding emphasis on prosecution by government authorities. As a result, the actions of all corporations
and their executives have been subjected to closer scrutiny. The increased scrutiny of this type of crime has
resulted in many firms establishing corporate ethics guidelines and policies to cover employee actions in
dealing with all corporate constituents. The adoption of high ethical standards by a corporation strengthens its
competitive position by reducing the potential for litigation, maintaining a positive corporate image, and

Chapter 1: The Role of Managerial Finance 5
building shareholder confidence. The result is enhancement of long-term value and a positive effect on share
price.
11. The treasurer or the chief financial manager typically manages a firm’s cash, investing surplus funds when
available and securing outside financing when needed. The treasurer also oversees a firm’s pension plans and
manages critical risks related to movements in foreign currency values, interest rates, and commodity prices.
The treasurer in a mature firm must make decisions with respect to handling financial planning, acquisition of
fixed assets, obtaining funds to finance fixed assets, managing working capital needs, managing the pension
fund, managing foreign exchange, and distribution of corporate earnings to owners.
12. Finance is often considered a form of applied economics. Firms operate within the economy and must be
aware of the economic principles, changes in economic activity, and economic policy. Principles developed
in economic theory are applied to specific areas in finance. The primary economic principle used in
managerial finance is marginal cost–benefit analysis, the principle that financial decisions should be made
and actions taken only when the added benefits exceed the added costs. Nearly, all financial decisions
ultimately come down to an assessment of their marginal benefits and marginal costs.
13. Accountants operate on an accrual basis, recognizing revenues at the point of sale and expenses when
incurred. The financial manager focuses on the actual inflows and outflows of cash, recognizing revenues
when actually received and expenses when actually paid.
Accountants primarily collect and present financial data; financial managers devote attention primarily to
decision making through analysis of financial data.
14. The two key activities of the financial manager as related to a firm’s balance sheet are
a. Making investment decisions: Determining both the most efficient level and the best mix of assets; and
b. Making financing decisions: Establishing and maintaining the proper mix of short- and long-term
financing and raising needed financing in the most economical fashion.
Investment decisions generally refer to the items that appear on the left-hand side of the balance sheet
(current and fixed assets). Financing decisions deal with the items that appear on the right-hand side of the
balance sheet (current liabilities, long-term debt, and stockholders’ equity).
15. Corporate governance refers to a system of organizational control that is used to define and establish lines of
responsibility and accountability among major participants in a corporation. These participants include the
shareholders, board of directors, officers and managers of the corporations, and other stakeholders. A
company’s organizational chart is an example of a broad arrangement of corporate governance. More detailed
responsibilities would be established within each branch of the organizational chart.
The Sarbanes-Oxley Act of 2002 is directed toward reducing the apparent conflicts of interest that exist in
many corporate structures. The act has many provisions, but the major thrust of the act is to reduce the
number of situations in which a conflict of interest can arise and to hold management more accountable for
the financial and operating information they communicate to the public.
16. Agency problems arise when managers deviate from the goal of maximization of shareholder wealth by
placing their personal goals ahead of the goals of shareholders. These problems in turn give rise to agency
costs. Agency costs are costs borne by shareholders due to the presence or avoidance of agency problems, and
in either case represent a loss of shareholder wealth. For example, shareholders incur agency costs when
managers fail to make the best investment decision or when managers have to be monitored to ensure that the
best investment decision is made, because either situation is likely to result in a lower stock price.
The agency problem and the associated agency costs can be reduced by a properly constructed and followed
corporate governance structure. The structure of the governance system should be designed to institute a
system of checks and balances to reduce the ability and incentives of management to deviate from the goal of
shareholder wealth maximization.

17. Structuring expenditures are currently the most popular way to deal with the agency problem—and also the
most powerful and expensive. Compensation plans can be either incentive or performance plans. Incentive
plans tie management performance to share price. Managers may receive stock options giving them the right
to purchase stock at a set price. This provides the incentive to take actions that maximize stock. This form of
compensation plan is not favorable because of market behavior, which has a significant effect on share price
and is not under management’s control. As a result, performance plans are more popular today. With these,
compensation is based on performance measures, such as earnings per share (EPS), EPS growth, or other
return ratios. Managers may receive performance shares and/or cash bonuses when stated performance goals
are reached.
In practice, recent studies have been unable to document any significant correlation between CEO
compensation and share price.
18. Market forces—for example, shareholder activism from large institutional investors—can reduce or avoid the
agency problem because these groups can use their voting power to elect new directors who support their
objectives and will act to replace poorly performing managers. In this way, these groups place pressure on
management to take actions that maximize shareholder wealth.
The threat of hostile takeovers also acts as a deterrent to the agency problem. Hostile takeovers occur when a
company or group not supported by existing management attempts to acquire the firm. Because the acquirer
looks for companies that are poorly managed and undervalued, this threat motivates managers to act in the
best interests of the firm’s owners.
Institutional investors are a powerful source of shareholder involvement in the monitoring of managers to
reduce the agency problem. Institutions hold large quantities of shares in many of the corporations in their
portfolio. Managers of these institutions should be active in the monitoring of management and vote their
shares for the benefit of the shareholders. The power of institutional investors far exceeds the voting power of
individual investors.
◼ Suggested Answer to Focus on Ethics Box: Critics See Ethical
Dilemmas in Google Glass
Is the goal of maximization of shareholder wealth necessarily ethical or unethical?
It is not the goal that makes maximization of shareholder wealth ethical or unethical; it is actions of financial
managers in pursuit of this goal.
What responsibility, if any, does Google have to protect the privacy of those who interact with other people
wearing Glass?
Google has a responsibility to ensure that its products and users of its product protect the privacy of those who
interact with the users of Google’s products. Google Glass poses an ethical challenge as users could seemingly
videotape or photograph others without their knowledge. It is Google’s responsibility to ensure that its devices
cannot be used to capture images of people inconspicuously. For example, in some countries like Germany, it is
legally prohibited to photograph a person in certain circumstances without the consent of the concerned person.
Google glass raise an ethical and legal concern as it allows for shooting pictures secretly in violations of law.

◼ Answers to Warm-Up Exercises
E1-1. Comparison of advantages and disadvantages of a partnership versus incorporation.
Answer: While Jack and Ann disagree over whether or not their firm should incorporate or remain as a
partnership, each form of business organization has its advantages and disadvantages. One advantage
of a partnership is that income is taxed at each partner’s individual tax rate that includes 10%, 15%,
25%, and higher rates up to a top rate of 35%, while corporate rates are 15%, 25%, and 34% with a top
rate of 39%. The corporation is allowed to retain accumulated taxable income, but for a personal
service corporation such as Jack and Ann’s tax preparation service, there is an additional tax, called an
accumulated earnings tax, of 15% for accumulated taxable income in excess of $150,000. If corporate
earnings are paid out as salary, Jack and Ann will pay their individual rates as they do on their
partnership earnings. If some of the income is paid out in the form of dividends, it will be taxed twice,
first as corporate income and then as dividend income (generally 5% or 15% depending upon the
individual’s tax bracket).
While taxation of income is a key factor in deciding which form of business organization to select, two
other factors are also important. In a partnership, each partner has unlimited liability and may have to
cover debts of other partners, while corporate owners have limited liability that guarantees that they
cannot lose more than they have invested in the corporation. The third major consideration is ease of
transfer of the business. Partnerships are harder to transfer and are technically dissolved when a
partner dies, while a corporation can have a very long life with ownership readily transferred through
the sale of stock.
If a third party was asked to decide which legal form of business A&J Tax Preparation should take, it
would be useful to have the following information:
• Marital status and tax situation of each partner
• Expectation of the longevity of the firm
• Age of the current owners
• Current plan of succession
• Risk tolerance of the owners
• Expectation of future tax law changes
• Capital needs of the firm
• Growth prospects of the firm
• Reasons for each partner’s view of the preferred form of ownership
E1-2 Timings of cash flows
Answer: Based on the information provided, the choice is not obvious. Even though the second project is expected
to provide the larger overall increase in earnings and, therefore, is the more profitable project, the goal of
the firm is to maximize value so timing, cash flow, and risk have to be considered to determine which
project is superior. Although it is often the case that profit maximization leads to value maximization, it is
definitely not always the case.
E1-3. Cash flow vs. accrued profits
Answer: It is not unusual for a firm to be profitable yet experience a cash crunch. The most common cause is when
expenses have a shorter due date than expected revenue. In such cases, the firm must arrange short-
term financing to meet its debt obligations before the revenue arrives. If the forthcoming cash crunch is
not a new situation for this firm, management should probably consider going ahead with the year-end
party if it is important for employee morale and the future success of the firm, as long as adequate
short-term funding can be arranged. On the other hand, if the firm has not experienced such a cash
crunch before, there may be larger problems looming ahead, and it would be unseemly to spend cash
on a party that would be better spent meeting the debt obligations of the firm.

E1-4. Sunk costs
Answer: Marginal cost-benefit analysis ignores sunk costs, so the $2.5 million dollars is irrelevant to the current
decision that must be made. At this point there are two questions that must be answered. First, will the
$10,000 additional investment generate a PV of expected revenue that will exceed the $10,000
investment? In other words, will the project generate a positive net present value? If it does, the project
must be considered further to see if it is the best use of capital. If the firm has a need to ration capital,
the project must then be compared to other projects competing for the limited capital to see if it is
viable. The fact that the project’s technology has been surpassed by new technology does not
immediately disqualify the project because new technology does not ensure a positive cost-benefit
result. In this case, a small $10,000 investment might avoid a heavy expenditure in new technology.
Depending upon the industry, however, failure to keep up with competitors can be devastating. The key
may well lie in the description “the project has little chance to be viable,” which indicates that
approving the $10,000 is likely to be throwing good money after bad.
E1-5. Agency costs
Answer: Agency costs are the costs borne by stockholders to maintain a governance structure that ensures
against dishonest acts of management, and gives managers the financial incentive to maximize share
price. One example of agency costs is stock options, which are used to provide an incentive for
managers to work diligently for the benefit of the firm. Tips are similar to stock options in that they are
offered as rewards for good service much as stock options are used to reward managers, presumably
based on their good performance—which subsequently leads to a higher stock price. The Donut Shop,
Inc., example does not represent a clear case of agency costs because it is the management itself that
has instituted the “No tips” policy and the employees have responded with reduced performance. By
banning tips, the management has created a situation where an agency cost may be necessary to provide
an incentive for employees to resume their former level of performance.
One solution that may work for Donut Shop, Inc., is to institute a profit-sharing plan that reaches down to
the employee level where the slowdown and inefficiency are occurring. A profit-sharing plan is designed
to motivate the employees and could alleviate the aggravation caused by the no-tip policy, but must be
clearly identified as the replacement to tipping in order to be effective. A profit-sharing plan is usually
viewed by the employees as a reward for good performance, but does not have the immediacy of the
positive effect that an employee gets from a tip.
It is unclear from the case whether the new no-tip policy is a company-wide policy or simply the
actions of a few branch managers. However, the real solution here is to recognize that the no-tip policy
has created an unnecessary backlash that can be alleviated by reversing management’s position without
incurring the additional costs of revising the current employee benefit plan and paying out a portion of
corporate profits.
◼ Solutions to Problems
P1-1. Liability comparisons
LG 2; Basic
a. Ms. Harper has unlimited liability.
b. Ms. Harper has unlimited liability.
c. Ms. Harper has limited liability, which guarantees that she cannot lose more than she invested.
P1-2. Accrual income vs. cash flow for a period
LG 4; Basic
a. Sales $760,000
Cost of goods sold 300,000
Net profit $460,000

b. Cash receipts $690,000
Cost of goods sold 300,000
Net cash flow $390,000
c. The cash flow statement is more useful to the financial manager. The accounting net income includes
amounts that will not be collected and, as a result, do not contribute to the wealth of the owners.
P1-3. Cash flow statement
LG 4; Intermediate
a. Total cash inflow: $450 + $4,500 = $4,950
Total cash outflow: $1,000 + $500 + $800 + $355 + $280 + $1,200 + $222 = $4,357
b. Net cash flow: Total cash inflows – Total cash outflows = $4,950 − $4,357 = $593
c. If Jane is facing a shortage, she could cut back on some of her discretionary items, including clothing,
dining out, and gas (i.e., travel less).
d. If Jane has a surplus in August, she should compare these cash flows to those of other months and
verify that August’s cash flows are typical. She may, for instance, observe the existence of large
automobile insurance bills or tendency to spend more during the Christmas holiday season. If she has
such needs, Jane will want to save the $593 in a money market security, where she is unlikely to face a
decline in investment. If her August net cash flow is not needed to pay anticipated bills, she should
invest in a diversified portfolio.
P1-4. Marginal cost-benefit analysis and the goal of the firm
PG 3, 5; Challenge
a. Marginal benefits of new robotics − Marginal benefits of original robotics = Marginal benefits of
proposed robotics
$560,000 − $400,000 = $160,000
b. Marginal cost of new robotics – Sales price of current robotics = Marginal cost of proposed robotics
$220,000 − $70,000 = $150,000
c. Net benefits of new robotics = Marginal benefits of proposed robotics − Marginal cost of proposed
robotics
$160,000 − $150,000 = $10,000
d. Ken Allen should recommend the new robotics be used on the heavy truck gear line. The marginal
benefits exceed the marginal costs.
e. Ken Allen should determine whether there will be additional training necessary with the new robotics,
possibility of availability of better robotics in a short while, and the energy consumption of the new
robotics.
P1-5. Identifying agency problems, costs, and resolutions
LG 4; Intermediate
a. In this case the employee is being compensated for unproductive time. The company must pay
someone to take her place during her absence. Installation of a time clock that must be punched by the
receptionist every time she leaves work and returns would result in either: (1) her returning on time or
(2) reducing the cost to the firm by reducing her pay for the lost work.
b. The costs to the firm are in the form of opportunity costs. Money budgeted to cover the inflated costs
of this project proposal is not available to fund other projects that may help to increase shareholder
wealth. Make the management reward system based on how close the manager’s estimates come to
the actual cost rather than having them come in below cost.

c. The manager may negotiate a deal with the merging competitor that is extremely beneficial to the
executive and then sell the firm for less than its fair market value. A good way to reduce the loss of
shareholder wealth would be to open the firm up for purchase bids from other firms once the manager
makes it known that the firm is willing to merge. If the price offered by the competitor is too low,
other firms will raise the price closer to its fair market value.
d. Generally, part-time or temporary workers are not as productive as full-time employees. These workers
have not been on the job as long to increase their work efficiency. Also, the better employees generally
need to be highly compensated for their skills. This manager is getting rid of the highest-cost employees
to increase profits. One approach to reducing the problem would be to give the manager performance
shares if he or she meets certain stated goals. Implementing a stock incentive plan tying management
compensation to share price would also encourage the manager to retain quality employees.
P1-6. Ethics Problem
LG 3; Intermediate
The phrase “ethical constraints” is quite broad. The company may be referring to legal issues, and the fact
that it will comply with laws. For example, it may be implying that it will not be using illegal immigrants and
paying them a reduced salary. It may refer to the use of substandard materials, which are less likely to hold
up over an extended period of time. Sometimes the use of substandard manufacturing facilities will
increase the chance of harm to employees or worse, as witnessed by the BP Gulf oil spill in April 2010.
◼ Case
Case studies are available on www.myfinancelab.com.
Assessing the Goal of Sports Products, Inc.
a. Maximization of shareholder wealth, which means maximization of share price, should be the primary goal of
the firm. Unlike profit maximization, this goal considers timing, cash flows, and risk. It also reflects the worth
of the owners’ investment in the firm at any time. It is the value they can realize should they decide to sell their
shares.
b. Yes, there appears to be an agency problem. Although compensation for management is tied to profits, it is not
directly linked to share price. In addition, management’s actions with regard to pollution controls suggest a
profit-maximization focus, which would maximize their earnings, rather than an attempt to maximize share
price.
c. The firm’s approach to pollution control seems to be questionable ethically. While it is unclear whether their acts
were intentional or accidental, it is clear that they are violating the law—an illegal act potentially leading to
litigation costs—and as a result are damaging the environment, an immoral and unfair act that has potential
negative consequences for society in general. Clearly, Sports Products has not only broken the law but also
established poor standards of conduct and moral judgment.
d. From the information given there appears to be a weak corporate governance system. The fact
that management is able to measure and reward their performance on profits indicates that no one
is watching out for the shareholders. Loren and Dale’s concerns indicate that employees apparently have an
interest in the long-run success of the firm. Allowing the continuation of pollution violations is also
apparently escaping the interest and control ability of others who should be monitoring the firm.
e. Some specific recommendations for the firm include:
• Tie management, and possibly employee, compensation to share price or a performance-based measure and
make sure that all involved own stock and have a stake in the firm. Being compensated partially on the basis of
share price or another performance measure and owning stock in the firm will more closely link the wealth
of managers and employees to the firm’s performance.

• Comply with all federal and state laws as well as accepted standards of conduct or moral judgment.
• Establish a corporate ethics policy, to be read and signed by all employees.
• Set up a corporate governance system that has as its basis the oversight and welfare of all the stakeholders
in the firm.
(Other answers are, of course, possible.)
◼ Spreadsheet Exercise
The answer to Chapter 1’s Monsanto spreadsheet problem is located on the Instructor’s Resource Center
at www.pearsonhighered.com/irc under the Instructor’s Manual.
◼ Group Exercise
Group exercises are available on www.myfinancelab.com.
Notes for Adopters
The motivation for these group exercises is to place the learning goals of each chapter within the context of a
fictitious firm while giving students a valuable set of teamwork skills. Creativity is encouraged, while the strong
links of each assignment to a real-world, shadow firm should ground each group’s work in reality. Any of these
assignments and their deliverables can be modified to better fit within an adopter’s course goals as they were
designed with an eye toward flexibility of use. The learning through these exercises should be something students
enjoy, being both applicable to the real world and less confining than traditional homework.
The first issue for adopters to address is group composition and size. Should students self-separate or be divided by
their instructor? How big should the groups be? This is a semester-long assignment and students will need to get
along with their fellow group members. If students choose their own groups it may, though not always, reduce the
incidence of intra-group squabbles. Diversity within the groups might then be sacrificed, however. One strategy is
to ask students to first pair-off. The instructor can then join the pairs into groups of four. This pairing of the pairs
could be done randomly through a number-in-the-hat selection process, as could the entire group setup.
Group size does matter and these exercises were designed for a workload spread across a minimum of three
students. Larger groups would lessen the homework load; however, the issue of free-riding is often more prevalent
in larger groups, where slackers can hide. Management of larger groups is also more challenging for the
participants. The suggested group size is between three and five students.
Group leadership is another issue. The best situation might be rotating the CEO/leader, where each group member
has several opportunities to be in charge. Last, these exercises were designed to allow students freedom but with
the responsibility of working somewhat independently of their instructor. In this vein, the instructions for each
assignment have been written to be relatively self-explanatory.
Chapter 1
This first chapter asks students to name their fictitious firm and describe its business. As this firm is going public,
students are asked to explain why it is appropriate for them to go public and also discuss different managerial roles
within the corporation. The group must choose a shadow firm to follow that is publicly held, allowing them to
gather a substantial amount of information about it on the Internet. This publicly traded firm should be in an
industry related to their fictitious firm.

The most important counsel students could get at the outset is to spend time making these initial decisions. Later
work is going to build on these choices, and careful choosing is paramount. For example, in choosing the shadow
firm, students should pick a well-established firm whose information, including financials, will be easily found.
This also impacts their decisions regarding their own fictitious firm. Throughout many of the subsequent chapters,
students will be taking real-world information from their shadow firm and applying it to their fictitious firm;
dressing their own firm with the clothes of the shadow firm. Students should feel comfortable in these clothes, so
encouraging them to choose industries they’re familiar with, or interested in, is helpful.

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