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Summary CAB5 Finance
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This summary covers the finance content for the CAB5 exam
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Summary of Managerial Finance by Zutter & Smart (ISBN: 9781292261614)
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Summary of Financial Accounting Chapters 5, 10 & 11 (ISBN: 9781292261515)
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Summary Principles of Managerial Finance( chapter 1), Global Edition, ISBN: 9781292261515 principals of managerial finance (Finc301)
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Chapter 1• Finance is the science and art of how individuals and firms raise, allocate, and invest money.
• Managerial finance concerns the duties of the financial manager in a business.
A firm is a business organization that sells goods/services. Exists because investors want access to risky
investment opportunities. Firms bring together investors and risky investment opportunities.
What is the goal of the firm:
1. Maximize shareholder wealth → Should be the primary goal of managers. Best measure of
shareholder wealth is the share price (amount it would cost to buy one share). In most instances this
is equivalent to maximizing the share/stock price. Ethical behavior is necessary for achieving the
firm’s goal of owner wealth maximization.
2. Maximize profit → Corporations often measure profits in terms of earnings per share (EPS), which
represent the amount earned during the period on behalf of each outstanding share of stock.
Maximizing profit often does not lead to highest share price:
- Timing → Receipt of funds sooner than later is preferred. Can be reinvested.
- Cash flows → Sometimes a positive profit is shown even when cash outflows exceed cash
inflows. Earnings increases accompanied by increases in future cash flows are what produce
higher stock prices.
- Risk → Chance that actual outcomes may differ from those expected. Stockholders are risk
averse, meaning they are willing to bear risk only if they expect compensation. Differences in risk
can affect the value of different investments. Return and risk are the key determinants of share
price, representing wealth of the firm’s owners.
3. Maximize stakeholders’ welfare → Individuals who are not owners of the firm but who have some
economic interest in it. Flaws in neglecting shareholder wealth maximization:
- Maximizing shareholder wealth does not in any way imply that managers should ignore the
interests of everyone connected to a firm who is not a shareholder.
- To maximize shareholder value, managers must necessarily assess the long-term consequences
of their actions.
- The stakeholder perspective is intrinsically difficult to implement, and advocates of the idea that
managers should consider all stakeholders’ interests along with those of shareholders do not
typically indicate how managers should carry it out. Goal of shareholder maximization clarifies
what actions managers should take.
- Many people misinterpret the statement that managers should maximize shareholder wealth as
implying that managers should take any actions, including illegal of unethical actions, that
increases the stock price.
Financial managers advise all their peers in other functions on the financial consequences of their decisions.
Financial managers’ key decisions are:
, 1. Investment decisions → Focus on how a company will spend its financial resources on long-term
projects that ultimately determine whether the firm successfully creates value for its owners. Most
important decisions.
2. Capital budgeting decisions → A technique that helps managers decide which projects create the
most value for shareholders (investment opportunities where benefits exceed costs).
3. Financing decisions → Determine how companies raise the money they need to pursue investment
opportunities. Ways to raise money:
- Capital → Money raised by firms to finance their activities → Capital structure decisions.
- Working capital decisions → Refer to the management of a firm’s short term resources.
Resources that a firm invests in items such as cash and inventory are working capital.
Five key principles of great importance in managerial finance:
1. Time value of money → Having money today is better than later because money on hand can be
invested and earn a return. Dollar today is worth more now than in the future.
2. Tradeoff between return and risk → Investors who want to earn higher returns must be willing to
accept greater risk.
3. Cash is king → Cash flow matters more than profit because this pays investors.
4. Competitive financial markets → Managers should pay close attention to the market.
5. Incentives important → Often managers’ incentives are not properly aligned with the interests of
shareholders.
- Principal-agent problem → Problem that arises because the owners of a firm and its managers
are not the same people and the agent does not act in the interest of the principal.
Relationship to accounting:
1. Emphasis on cash flows → Accountant prepares financial statements:
- Accrual basis: Recognizes revenue at time of sale and expenses when incurred.
- Cash basis: Recognizes revenue and expenses only with respect to actual inflows and outflows.
2. Decision making: Accountants devote most attention to collection and presentation of financial data
and financial managers evaluate the statements and make decisions based on their assessment of
associated returns and risks.
Types of organizations:
1. Sole proprietorship → Business owned by one person and operated for his or her own profit.
- Raises capital from personal resources or by borrowing
- Responsible for all business decisions
- No taxes paid on income as separate entities, taxed at personal level
- Unlimited liability → Liabilities are the entrepreneur’s responsibility
2. Partnership → Business owned by two or more people and operated for profit.
- Unlimited liability for all partners
- Income taxed at personal level
, - Can raise more funds than sole proprietorships
3. Corporation → Business entity owned by individuals but the corporation itself is a legal entity distinct
from its owners.
- Has legal power of an individual, can sue and be sued
- Can raise money to expand easier by selling new stock to investors
- The stockholders enjoy limited liability, not liable for the firm’s debts
- Enhances business’ credibility
- Most enduring legal business structure
- Downside → Double taxation, expensive, extra paperwork and lack of ownership
Types of investors:
1. Individual investors → Own relatively small quantities of shares to meet personal investment goals.
2. Institutional investors → Professionals such as banks that are paid to manage and hold large
quantities of securities on behalf of others.
, Chapter 2
Learning goal 1
Financial institutions serve as intermediaries by channeling savings of individuals, businesses, and
governments into loans or investments.
• Individuals are net suppliers, save more than they borrow
• Firms are net demanders, they borrow more than they save
Types of financial institutions:
1. Commercial banks → Provide savers with a secure place to invest their funds and that offer loans to
individual and business borrowers. Taking in and paying interest on savings deposits
2. Investment banks → Assist companies in raising capital, advise firms on major transactions and
engage in trading and market-making activities
3. Shadow banking system → Group of institutions that engage in lending activities, much like traditional
banks, but that do not accept deposits and therefore are not subject to the same regulations
Learning goal 2 and 3
Financial markets are forums in which suppliers and demanders of funds can transact business directly:
1. Money market → A market where investors trade highly liquid securities with maturities of 1 year or
less. Brings together suppliers and demanders of short-term funds
- Marketable securities → Short-term debt instruments, assets that can be easily bought and sold
- Investors generally consider marketable securities the least risky investments
2. Capital market → Enables suppliers and demanders of long-term funds to make transactions.
Securities traded here fall into two broad categories:
1. Debt → Loan that borrower must repay → Main type is a bond (long-term debt instrument used to
raise large sums of money, generally from a diverse group of lenders)
2. Equity → A security issued by a business that provides a stake in the firm → Main type is common
stock (unit of ownership, or equity, in a corporation)
- Preferred stock → Special form of ownership having a fixed periodic dividend that must
be paid prior to payment of any dividends to common stockholders
- Common stock fluctuates more because there is no fixed dividend
To raise money firms can use:
1. Private placement → The sale of a new security directly to an investor or group of investors
2. Public offering → The sale of either bonds or stocks to the general public
Two markets:
1. Primary market → Here securities are issued, only market in which the issuer is directly involved
2. Secondary market → Where investors trade securities that were originally issued in primary market.
High liquidity, quick buying and selling without having impact on the price
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