Understanding Managerial Finance:

An Overview Of The First Ten Chapters

Of Gitman’s Principles Of Managerial Finance

Contrary to what others think, financial management is relevant not only in business but also in the personal management of investments, time, etc. whereby knowledge of which helps every financial manager and lay person alike to effectively manage their affairs (Brigham 5). Thus, this paper will try to explore basic concepts on financial management and its implication on one’s decision making. This paper, however, is limited only to those basic concepts found in the first ten (10) chapters of the book ‘Principles of Managerial Finance’ by Lawrence Gitman, these are 1) role and management of managerial finance, 2) financial statements and analysis, 3) cash flow and financial planning, 4) time value of money, 5) risk and return, 6) interest rates and bond valuation, 7) stock valuation, 8) capital budgeting and cash flows, 9) capital budgeting techniques and 10) risk and refinements in capital budgeting.

Thus, an overview of each chapter shall be henceforth discussed.

Chapter 1: Role And Management Of Managerial Finance

Gitman defines finance as the art of managing money (4). Management, on the other hand, is defined as the art of overseeing and making decisions (“management”). Further, management involves, planning, leading, organizing and controlling (Gemmy). Thus, financial management, as this paper’s author understands it, deals with making decisions, — particularly for the purposes of planning, leading, organizing and controlling a firm— through the use of financial or money related information.

In financial management, the end view of the firm is to always maximize shareholder’s wealth (Brigham 14). This can be done, according to Gitman, through the use of economic value added measure to determine whether the investment positively contributes to the shareholder’s wealth. Further, the discussion of financial management will not be complete without mentioning the role of financial institutions and markets as the two goes hand in hand. It is also important to emphasize that financial institutions and markets are the main sources of external funds from which the company may draw funds from, hence the impact of borrowing from these intermediaries are factors which every prudent manager must consider. Likewise, business taxes should not be overlooked as investment decisions have corresponding tax implications which may affect the attractiveness of the said investment.

From the foregoing, it is easy to conclude that to be an effective financial manager one must first understand that financially managing a firm can never be done in isolation as several factors, both externally and internally, should be considered in making decisions for the company to effectively maximize the shareholder’s wealth.

Chapter 2: Financial Statements And Analysis

Considering that the underlying reason for financial management is to maximize shareholder’s wealth, there are reports which must be given to the stockholders for the latter to determine whether indeed the management is doing its job effectively. Thus, the minimum financial statements given to them are: 1) income statement, 2) balance sheet, 3) statement of retained earnings and 4) statement of cash flows. These financial statements are of great significance as the information therein is used to compute for ratios which consequently give light to the firm’s efficiency. More so, these ratios can effectively show the firms’ performance on four key aspects — 1) liquidity, 2) activity, 3) debt and 4) profitability.

Liquidity ratios are important to help a person determine whether the firm can satisfy its short-term obligations as they come due (Brigham 71). Thus net working capital, and current and acid test ratios are used to determine whether the firm is liquid or not. Activity or management ratios are those ratios used to measure the ability of the firm to convert accounts into sales or cash. This answers the question ‘is the total amount of asset too high in view of the projected sales?’ (ibid 72). Some of these activity ratios are inventory turnover, average collection period, and total asset turnover. Debt ratios are used either to measure the degree of indebtedness of the firm or the ability of the firm to make contractual payments on time. Thus ratios such as debt, times-interest earned, and fixed-payment coverage are used. Profitability ratios are those used to evaluate the firm’s earnings with respect to a given level of sales, assets and investments. Hence, common size statements, gross profit margin, return on total assets, earnings per share, price earnings ratio and the like are used.

It must be remembered, however, that these ratios are relative, meaning, they will only be of importance if one has something to compare it to i.e. industry performance, competitor performance and previous year’s performance. Otherwise, the derived ratios will not give the financial manager or the stockholder a good assessment of the firm’s overall performance.

Chapter 3: Cash Flow And Financial Planning

According to Gitman, cash flow is the life-blood of the firm. Thus, financial managers should take time in evaluating the firm’s cash flow as it will show possible sources of inefficiencies which may drain the firm’s resources. Though cash flows only deals will variables which affect the cash position of the firm, depreciation are still taken into account. Considering that depreciation is the decrease in value of the fixed asset from wear and tear and that depreciation is generally deductible for tax purposes (“depreciation” Wikipedia par. 20), the corresponding savings derived from this activity is accounted as a cash inflow. There are several methods of depreciation are available for the firm to choose from depending on their strategy — these are straight line, double declining balance, sum of the year’s digits and modified accelerated cost recovery system. In practice, one would easily recognize that firms usually employ a different method of depreciation for their financial reports and another method for tax reporting. Curiously, this practice is allowed by the government.

The statement of cash flow summarizes the firm’s cash flow over a given period of time. This cash flow is subdivided into three activities, these are: operating, investment and financing. In the same chapter, students are taught how to prepare pro forma balance sheets and income statements. This is primarily done through forecasting — i.e. sales and cash disbursements.

It bears stressing that financial planning is very helpful in the management of the cash affairs of the firm, especially when it is in dire need of funds. As previously stated, the statement of cash flows is a source of information when it comes to the determination of which asset or activity used so much funds than needed. More so, problems such as credit collection, and inventory related problems will be easily determined through the evaluation of the cash flow statement. For cash strapped firms, financial planning of cash flow will help the firm realize whether they will be able to service its debts and whether it will still have sufficient funds for its operations. This way, unnecessary activities may be discontinued to free some of the firm’s cash.

Financial planning, however, is criticized primarily on its assumption that past financial conditions is an accurate indicator of the firm’s future performance.

Chapter 4: Time Value of Money

The time value of money centers on the principle that a dollar today is worth more than a dollar to be received at some future date. Thus the concepts on present value (PV) and future values (FV) of money. In computing for present and future values, the prevailing interest rate is always factored in as the interest rate affects the value of money in the future. These values (present and future) are computed depending on the mode of receipt or payment of the cash flow. Thus, when the cash flow is received in lump sum, the future value of a dollar is computed simply by multiplying the present value with that of the compounded interest over a specified period of time (the formula for present value can be easily derived from this).[1] When the income stream is an annuity or stream of equal cash flows, a different formula is be used.[2] One, however, must be wary in computing for annuity as it can be an annuity due or an ordinary annuity, thus adjustments must be thereby made to consider the timing of the receipt or payment of the cash flow — either at the beginning or at the end of the period. A different formula, likewise, is needed when the interest rate is growing[3] or when the income stream is not equal (also known as mixed stream)[4] or when the cash flow is paid or received perpetually.[5]

Chapter 5: Risk And Return

In deciding to invest on some undertaking, it is worthwhile to first consider its corresponding risk and return. Risk deals with the probability of financial loss, while return is the gain or loss that will be derived from that particular undertaking (“risk” Wikipedia par. 1). Risk is measured by using two statistical tools — standard deviation and coefficient of variation. The former measures the deviation around the mean or expected value (“standard deviation” Wikipedia par. 3) while the latter measures the relative dispersion of a distribution (“coefficient of variation Return” Wikipedia par. 1). Return, on the other hand, is calculated by dividing the change of price of the asset plus the cash flow with the old price of the asset.[6] Both risk and return are measured to determine the attractiveness of the single asset or the portfolio, comprising of several assets, as a whole.

To minimize risk, it is always encouraged that financial managers diversify or combine assets that have negative correlation or those assets which are completely unrelated to each other. This way, when an asset in the portfolio posed a negative return, the portfolio return will not be greatly affected as there are other assets which can offset the decline in the return of that specific asset.

Another important concept found in this chapter is the capital asset pricing model or CAPM. Measuring CAPM is very important as it links all of the asset’s risk and return. The underlying concept in the CAPM is the fact that only relevant risk is the non-diversifiable, as diversifiable risk can be eliminated through diversification. The use of CAPM to measure return, the author believes, is very practical as it uses a beta or an index which measures the degree of movement of an asset’s return in response to a change in the market return. This makes the model very realistic as it incorporates market factors through the use of beta. According to Gitman, CAPM, however, is criticized for several reasons —i.e. reliance on historical data and hence it may not reflect the future variability of return, it assumes that the market is efficient with investors having the same information and expectations, it disregards restrictions on investment, taxes and transaction costs, and that it presupposes that all investors are rational and risk averse always preferring higher return with lower risk.

Chapter 6: Interest Rates And Bond Valuation

This chapter emphasized that there are two types of interest — nominal and real. The latter differs with the former primarily since it incorporates inflationary expectations. More so, the chapter discussed that there are three theories which explains the yield curve — these are expectations, liquidity preference and market segmentation theories.

The discussion on interest will never be complete without applying its effect on required return. Gitman states that the risk is negatively correlated with return as when risk increases return on the other hand, decreases. This phenomenon, under normal conditions, will always be observed in the valuation process.

The basic valuation model is founded on the concept of present value as the value (cost) of an asset is computed by discounting all the future cash flows received (paid) over a specific period of time. Thus, in computing for the value of bonds, this underlying concept is repeatedly used. The decision to sell the bond at a discount or premium primarily depends on whether the required return of bonds differs with the bond’s coupon rate. Thus when the required return is greater than the coupon interest rate, bond value will be less than its par value, hence the bond will be sold at a discount. When the required return is less than the coupon interest rate, the bond therefore will be sold at a premium since the bond value will be greater than the par.

Chapter 7: Stock Valuation

The chapter started by differentiating debt from equity capital. Gitman states that both deals with long-term assets, but debt capital primarily deals with long-term borrowing, whereas, equity capital relates to the long-term funds infused by the stockholders. An example of a debt capital is a bond while equity capital’s example is a common stock.

The book also differentiated common stock from preferred stock. It says that holders of the former have voting rights while holders of the latter do not. More so, preferred stock holders are paid first before the holders of the common stock.

It is important to note that stockholders sell their stocks when they believe that it is overvalued and buys the stock when it is undervalued. Stock value assessment, however, presupposes that the market is efficient. When the market is efficient, under the market efficiency theory, the market behavior can be described as — 1) securities being typically in equilibrium, 2) securities fully reflecting all public information available and that 3) there is no point in searching for mispriced securities.

Similar to bond valuation, the concept of present value is likewise used in stock valuation. Thus, stockholders are able to assess the value of the stock they hold by discounting all the dividends received through time. Adjustments, however, should be made when the dividends received are growing at a constant rate,[7] or when it is growing at varying rate.[8] Other methods, according to Gitman, may likewise be used to measure the value of the stocks — these are through the use of the book value, liquidation value and price/earnings multiples approaches. Book value approach simply measures the amount of share of common stock that would be received in case all the firm’s assets are sold for its book value. Liquidation approach is similar to that of the book value, except that the assets are assumed to be sold at its market value instead of book value. Price earnings approach, on the other hand, computes the value of the common stock by estimating the firm’s share value.[9]

Chapter 8: Capital Budgeting And Cash Flows

Capital budgeting, by its name, deals with the expansion, replacement, or renewal of long-term assets. Considering that capital expenditures requires a great sum of money, capital budgeting or the process of evaluating investment in view of the firm’s goal to maximize share holder’ wealth, comes into play especially whenever the funds are scarce. Thus, the firm will always try to assess investments which will yield the most return. Of course, the amount of investment should likewise be considered in determining whether the undertaking is acceptable or not.

In evaluating capital expenditure alternatives, the relevant cash flows are those incremental after-tax cash flows — i.e. initial investment and operating and terminal cash flows. In calculating the initial investments, the cost of the asset, its installation cost, after tax proceeds of the sale of the old asset and the change in the net working capital are measured. Also, in computing for operating cash flows, only the incremental cash flows are considered— i.e. after tax benefits and costs as these affect the operating cash flows. Terminal cash flows are computed by taking into account all the after-tax cash flow occurring at the terminal year of the proposed project. This includes the after-tax proceeds from the sale of the assets and the change in the net working capital.

Chapter 9: Capital Budgeting Techniques

As previously emphasized, funds are scarce. Thus, in view of the end goal of maximizing shareholder’s wealth, it is important to choose only those projects which will ultimately maximize the wealth. Hence, techniques such as payback, net present value, and internal rate of return are used to determine whether a project is acceptable. The last two are also used to rank projects when such are mutually exclusive projects or those projects which compete with one another in terms of funds.

Payback period simply measures the exact amount of time needed for the firm to recover its initial investment. Thus, if the payback period is less than the maximum acceptable payback period, the firm should accept the project. Otherwise, it should be rejected. This method, however is criticized for its failure to take into account the time value of money and to recognize cash flows received after the payback period. Another method is the net present value (NPV) which considers time value of money by summing all the discounted cash flows received minus the amount of initial investment. If NPV yields a positive value, then the project should be accepted. Otherwise, it should be rejected. The last method is the internal rate of return (IRR). This equates the present value of the cost of the initial investment with that of the present value of all the cash inflows of the project. Thus, when the IRR is greater than the cost of capital, the project should be accepted otherwise, it should be rejected.

There are instances, however, when the NPV and the IRR yield varying ranking results. When this happens, Gitman espouses that NPV results should be followed. Differences in results, he added, are caused by the differences in the size and the timing of the cash flows. Moreover, conflicting ranking is caused by the varying reinvestment cost used as NPV assumes that intermediate cash flows are reinvested at the cost of capital, while IRR assumes that intermediate costs are reinvested at the computed IRR.

Chapter 10: Risk And Refinements In Capital Budgeting

There are instances, however, when the environment is uncertain. Hence, these uncertainties should be duly considered in assessing the return of the project, otherwise, the firm may find accepting a project which should have been unacceptable. There are two approaches in dealing with risk, these are the behavioral and the quantitative. Under the behavioral approach, the two most commonly used approaches are— the sensitivity and the scenario analysis. In sensitivity analysis, a number of possible values for a given variable are used to assess its impact on the firm’s return. This is widely known as the use of pessimistic, most likely and optimistic values that a variable may have. Whereas, scenario analysis considers the impact of various circumstances on the firm’s return — i.e. cash flows and cost of capital are simultaneously considered.

To quantitatively evaluate risk and determine its effect on return, the certainty equivalents (CE) and risk-adjusted discount rates (RADR) are used. In practice, however, though CE is theoretically superior than the RADR, the latter is preferred due its simplicity in computation.

Aside from environmental factors which may affect the outcome of the return, international risks are likewise considered when the firm is a multinational corporation — i.e. exchange rate risks and political risks.

This chapter also addressed the problem of comparing projects of unequal lives through the use of annualized net present value approach. Likewise, when the firm is faced with projects which are all acceptable but the firm is unable to fund all of them, capital rationing must be used. This way, through the use of either NPV or IRR approach, the firm will be able to achieve its goal of maximizing shareholder’s wealth while working on its budget.

Conclusion

The course on financial management, through time, has grown into significance as managers are consistently faced with financial decisions, whether short-term or long-term, which can significantly affect the company’s standing. Thus, various concepts are linked together and interpreted in a simple manner to guide the financial managers in their day-to-day decision-making.

No matter how the course gets complicated as the student treads on, it is very useful to always understand the basics. Thus, concepts on time value of money, risk and return and its relationship, and stock and bond valuation should always be at the tip of one’s fingers. More so, it will prove to be very helpful in the future when the student will be able to make and forecast financial statements and interpret the same as these skills will always enlighten one in its financial decision-making.

Cited Works

Brigham, Eugene. Fundamentals of Financial Management. 8th. New York: The Dryden Press, 1998.

“Coefficient of Variation.” Wikipedia: The Free Encyclopedia. N/a. 29 November 2006. <http://en.wikipedia.org/wiki/Coefficient_of_variation>

“Depreciation.” Wikipedia: The Free Encyclopedia. N/a. 29 November 2006. <http://en.wikipedia.org/wiki/Depreciation>

Gemmy, Allen. “Managerial Functions.” Supervision 2002 29 November 2006 <http://telecollege.dcccd.edu/mgmt1374/book_contents/1overview/managerial_functions/mgrl_functions.htm>.

Gitman, Lawrence. Principles of managerial Finance. 11th Ed. United States: Addison Wesley Longman, 2006.

“Management.” Webster’s New Encyclopedic Dictionary. 1993.

“Risk.” Wikipedia: The Free Encyclopedia. N/a. 29 November 2006. <http://en.wikipedia.org/wiki/Risk>

“Standard Deviation.” Wikipedia: The Free Encyclopedia. N/a. 29 November 2006. <http://en.wikipedia.org/wiki/Standard_deviation>

“Time Value of Money.” Wikipedia: The Free Encyclopedia. N/a. 29 November 2006. <http://en.wikipedia.org/wiki/Time_value_of_money>.

[1] FVn=PV(1 +i), where i=interest and PV = FV/(1+i) (Brigham 215)

[2] FVA= PMT*FVIFA and PVA=PMT* 1/FVIFA, where A= annuity and FVIFA=Future value interest factor for annuity and PMT-payment (Brigham 219,221)

[3] PVGA= [CF/(i-g)] *[1-(1+g)n/(1+i)n], where G= growth rate (“Time value of Money” Wikipedia par. 16).

[4] FVn=summation of CF*FVIF and PVn= summation of CF*PVIF, where CF= cash flow, FVIF =future value interest factor for i, and PVIF= present value interest factor for i (Brigham 227, 225)

[5] PV(perpetuity)=PMT/i (Brigham 223).

[6] Kt= (Pt-Pt-l + CFt)/Pt-1, where K= expected return and t= time

[7] P0=D1/(ks-g), where ks = required return on common stock, P0=initial price and D1= value of dividends at t=1

[8] P0 = summation of {[D0*(1+g1)t]/(1+ks)t} + [1/ (1+ks)N]*[(DN+1)/Ks-g2)], where N= time when growth rate shifts

[9] Price/earnings multiples= EPS* P/E, where EPS= expected earnings per share and P/E= price/earnings ratio of the industry