Student Publications
Author: Jonathan Phiri
Title: Managerial Finance

Area:
Country: United States
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Avialable for Download: Yes

Definition

Managerial finance is the branch of finance that concerns itself with the managerial significance of finance techniques. It is focused on assessment rather than technique.

The difference between a managerial and a technical approach can be seen in the questions one might ask of annual reports. One concerned with technique would be primarily interested in measurement. They would ask: are moneys being assigned to the right categories? Were generally accepted accounting principles (GAAP) followed?

One concerned with management though would want to know what the figures mean.

They might compare the returns to other businesses in their industry and ask: are we performing better or worse than our peers? If so, what is the source of the problem? Do we have the same profit margins? If not why? Do we have the same expenses? Are we paying more for something than our peers?

They may look at changes in asset balances looking for red flags that indicate problems with bill collection or bad debt.

They will analyze working capital to anticipate future cash flow problems.

This financial Management module explores the well being of the firm and its shareholders by investigating the management of long-term and working capital, the financial measurement and choice of projects to invest in, and the overall financial strategy of a business as will be later discussed.

Managerial finance is an interdisciplinary approach that borrows from both managerial accounting (the provisions and use of accounting information to managers within the organization) and corporate finance (an area of finance dealing with the financial decisions corporations make and the tools and analysis used to make these decisions).

The Role of Managerial Accounting

A) To interpret financial results in the manner described above, managers use financial analysis techniques. Financial analysis refers to an assessment of the viability, stability and profitability of a business, sub-business or project.

It is performed by professionals who prepare reports using ratios that make use of information taken from financial statements and other reports. These reports are usually presented to top management as one of their bases in making business decisions. Based on these reports, management may:

Continue or discontinue its main operation or part of its business;

Make or purchase certain materials in the manufacture of its product;

Acquire or rent/lease certain machineries and equipments in the production of its goods;

Issue stocks or negotiate for a bank loan to increase its working capital.

other decisions that allow management to make an informed selection on various alternatives in the conduct of its business.

Financial analysts often assess the firm's:

1. Profitability- its ability to earn income and sustain growth in both short-term and long-term. A company's degree of profitability is usually based on the income statement, which reports on the company's results of operations;

2. Solvency- its ability to pay its obligation to creditors and other third parties in the long-term;
3. Liquidity- its ability to maintain positive cash flow, while satisfying immediate obligations;

Both 2 and 3 are based on the company's balance sheet, which indicates the financial condition of a business as of a given point in time.

4. Stability- the firm's ability to remain in business in the long run, without having to sustain significant losses in the conduct of its business. Assessing a company's stability requires the use of both the income statement and the balance sheet, as well as other financial and non-financial indicators.

B) Managers also need to look at how resources are allocated within an organization. They need to know what each activity costs and why. These questions require managerial accounting techniques such as activity based costing. This is a method of assigning the organization's resource costs through activities to the products and services provided to its customers. It is generally used as a tool for understanding product and customer cost and profitability. As such, ABC (Activity based Costing) has predominantly been used to support strategic decisions such as pricing, outsourcing and identification and measurement of process improvement initiatives. The concepts of ABC were developed in the manufacturing sector of the United States during the 1970s and 1980s. During this time, the Consortium for Advanced Manufacturing-International, now known simply as CAM-I, provided a formative role for studying and formalizing the principles that have become more formally known as Activity-Based Costing.

Like manufacturing industries, financial institutions also have diverse products and customers which can cause cross-product cross-customer subsidies. Since personnel expenses represent the largest single component of non-interest expense in financial institutions, these costs must also be attributed more accurately to products and customers. Activity based costing, even though originally developed for manufacturing, may even be a more useful tool for doing this.

C) Managers also need to anticipate future expenses. To get a better understanding of the accuracy of the budgeting process, they may use variable budgeting-In budgeting (or management accounting in general), a variance is the difference between a budgeted, planned or standard amount and the actual amount incurred/sold. Variances can be computed for both costs and revenues.

The concept of variance is intrinsically connected with planned and actual results and effects of the difference between those two on the performance of the entity or company.

Variances can be divided according to their effect or nature of the underlying amounts.

When effect of variance is concerned, there are two types of variances:

When actual results are better than expected results given variance is described as favorable variance. In common use favorable variance is denoted by the letter F - usually in parentheses (F).

When actual results are worse than expected results given variance is described as adverse variance, or unfavorable variance. In common use adverse variance is denoted by the letter A or the letter U - usually in parentheses (A).

The second typology (according to the nature of the underlying amount) is determined by the needs of users of the variance information and may include e.g.:

Variable cost variances

Direct material variances

Direct labor variances

Variable production overhead variances

Fixed production overhead variances

Sales variances

The Role of Corporate Finance

Managerial finance is also interested in determining the best way to use money to improve future opportunities to earn money and minimize the impact of financial shocks. To accomplish these goals managerial finance uses the following techniques borrowed from corporate finance:

Valuation - In finance, valuation is the process of estimating the market value of a financial asset or liability. Valuations can be done on assets (for example, investments in marketable securities such as stocks, options, business enterprises, or intangible assets such as patents and trademarks) or on liabilities (e.g., Bonds issued by a company). Valuations are required in many contexts including investment analysis, capital budgeting, merger and acquisition transactions, financial reporting, taxable events to determine the proper tax liability, and in litigation.

Portfolio theory - Modern portfolio theory (MPT) proposes how rational investors will use diversification to optimize their portfolios, and how a risky asset should be priced. The basic concepts of the theory are Markowitz diversification, the efficient frontier, capital asset pricing model, the alpha and beta coefficients, the Capital Market Line and the Securities Market Line.

MPT models an asset's return as a random variable, and models a portfolio as a weighted combination of assets; the return of a portfolio is thus the weighted combination of the assets' returns. Moreover, a portfolio's return is a random variable, and consequently has an expected value and a variance. Risk, in this model, is the standard deviation of the portfolio's return.

Hedging - In finance, a hedge is an investment that is taken out specifically to reduce or cancel out the risk in another investment. Hedging is a strategy designed to minimize exposure to an unwanted business risk, while still allowing the business to profit from an investment activity. Typically, a hedger might invest in a security that he believes is under-priced relative to its "fair value" (for example a mortgage loan that he is then making), and combine this with a short sale of a related security or securities. Thus the hedger is indifferent to the movements of the market as a whole, and is interested only in the performance of the 'under-priced' security relative to the hedge. Holbrook Working, a pioneer in hedging theory, called this strategy "speculation in the basis," where the basis is the difference between the hedge's theoretical value and its actual value (or between spot and futures prices in Working's time).

Some form of risk taking is inherent to any business activity. Some risks are considered to be "natural" to specific businesses, such as the risk of oil prices increasing or decreasing is natural to oil drilling and refining firms. Other forms of risk are not wanted, but cannot be avoided without hedging. Someone who has a shop, for example, expects to face natural risks such as the risk of competition, of poor or unpopular products, and so on. The risk of the shopkeeper's inventory being destroyed by fire is unwanted, however, and can be hedged via a fire insurance contract. Not all hedges are financial instruments: a producer that exports to another country, for example, may hedge its currency risk when selling by linking its expenses to the desired currency. Banks and other financial institutions use hedging to control their asset-liability mismatches, such as the maturity matches between long, fixed-rate loans and short-term (implicitly variable-rate) deposits

Capital structure - In finance, capital structure refers to the way a corporation finances its assets through some combination of equity, debt, or hybrid securities. A firm's capital structure is then the composition or 'structure' of its liabilities. For example, a firm that sells $20bn dollars in equity and $80bn in debt is said to be 20% equity financed and 80% debt financed. The firm's ratio of debt to total financing, 80% in this example is referred to as the firm's leverage.

The Modigliani-Miller theorem, proposed by Franco Modigliani and Merton Miller, forms the basis for modern thinking on capital structure, though it is generally viewed as a purely theoretical result since it assumes away many important factors in the capital structure decision. The theorem states that, in a perfect market, the value of a firm is unaffected by how that firm is financed. This result provides the base with which to examine real world reasons why capital structure is relevant, that is, a company's value is affected by the capital structure it employs. These other reasons include bankruptcy costs, agency costs and asymmetric information. This analysis can then be extended to look at whether there is in fact an 'optimal' capital structure: the one which maximizes the value of the firm.

Mergers and Acquisitions

Part of the objectives of managerial finance is the measurement and choice of projects to invest in, and the overall financial strategy of a business. The phrase mergers and acquisitions (abbreviated M&A) refers to the aspect of corporate strategy, corporate finance and management dealing with the buying, selling and combining of different companies that can aid, finance, or help a growing company in a given industry grow rapidly without having to create another business entity.

A merger is a tool used by companies for the purpose of expanding their operations often aiming at an increase of their long term profitability. There are 15 different types of actions that a company can take when deciding to move forward using M&A. Usually mergers occur in a consensual (occurring by mutual consent) setting where executives from the target company help those from the purchaser in a due diligence process to ensure that the deal is beneficial to both parties. Acquisitions can also happen through a hostile takeover by purchasing the majority of outstanding shares of a company in the open market against the wishes of the target's board. In the United States, business laws vary from state to state whereby some companies have limited protection against hostile takeovers. One form of protection against a hostile takeover is the shareholder rights plan, otherwise known as the "poison pill".

Historically, mergers have often failed to add significantly to the value of the acquiring firm's shares. Corporate mergers may be aimed at reducing market competition, cutting costs (for example, laying off employees, operating at a more technologically efficient scale, etc.), reducing taxes, removing management, "empire building" by the acquiring managers, or other purposes which may or may not be consistent with public policy or public welfare.

An acquisition, also known as a takeover, is the buying of one company (the ‘target’) by another. An acquisition may be friendly or hostile. In the former case, the companies cooperate in negotiations; in the latter case, the takeover target is unwilling to be bought or the target's board has no prior knowledge of the offer. Acquisition usually refers to a purchase of a smaller firm by a larger one. Sometimes, however, a smaller firm will acquire management control of a larger or longer established company and keep its name for the combined entity. This is known as a reverse takeover.

Types of acquisition

The buyer buys the shares, and therefore control, of the target company being purchased. Ownership control of the company in turn conveys effective control over the assets of the company, but since the company is acquired intact as a going business, this form of transaction carries with it all of the liabilities accrued by that business over its past and all of the risks that company faces in its commercial environment.

The buyer buys the assets of the target company. The cash the target receives from the sell-off is paid back to its shareholders by dividend or through liquidation. This type of transaction leaves the target company as an empty shell, if the buyer buys out the entire assets. A buyer often structures the transaction as an asset purchase to "cherry-pick" the assets that it wants and leave out the assets and liabilities that it does not. This can be particularly important where foreseeable liabilities may include future, unquantified damage awards such as those that could arise from litigation over defective products, employee benefits or terminations, or environmental damage. A disadvantage of this structure is the tax that many jurisdictions, particularly outside the United States, impose on transfers of the individual assets, whereas stock transactions can frequently be structured as like-kind exchanges or other arrangements that are tax-free or tax-neutral, both to the buyer and to the seller's shareholders.

The terms "demerger", "spin-off" and "spin-out" are sometimes used to indicate a situation where one company splits into two, generating a second company separately listed on a stock exchange

In business or economics a merger is a combination of two companies into one larger company. Such actions are commonly voluntary and involve stock swap or cash payment to the target. Stock swap is often used as it allows the shareholders of the two companies to share the risk involved in the deal. A merger can resemble a takeover but result in a new company name (often combining the names of the original companies) and in new branding; in some cases, terming the combination a "merger" rather than an acquisition is done purely for political or marketing reasons.

Classifications of mergers

Horizontal mergers take place where the two merging companies produce similar product in the same industry.

Vertical mergers occur when two firms, each working at different stages in the production of the same good, combine.

Congeneric mergers occur where two merging firms are in the same general industry, but they have no mutual buyer/customer or supplier relationship, such as a merger between a bank and a leasing company. Example: Prudential's acquisition of Bache & Company.

Conglomerate mergers take place when the two firms operate in different industries.

A unique type of merger called a reverse merger is used as a way of going public without the expense and time required by an IPO(Initial Public Offering).

The contract vehicle for achieving a merger is a "merger sub".

The occurrence of a merger often raises concerns in antitrust circles. Devices such as the Herfindahl index can analyze the impact of a merger on a market and what, if any, action could prevent it. Regulatory bodies such as the European Commission, the United States Department of Justice and the U.S. Federal Trade Commission may investigate anti-trust cases for monopolies dangers, and have the power to block mergers.

Accretive mergers are those in which an acquiring company's earnings per share (EPS) increase. An alternative way of calculating this is if a company with a high price to earnings ratio (P/E) acquires one with a low P/E.

Dilutive mergers are the opposite of above, whereby a company's EPS decreases. The company will be one with a low P/E acquiring one with a high P/E.

The completion of a merger does not ensure the success of the resulting organization; indeed, many mergers (in some industries, the majority) result in a net loss of value due to problems. Correcting problems caused by incompatibility—whether of technology, equipment, or corporate culture— diverts resources away from new investment, and these problems may be exacerbated by inadequate research or by concealment of losses or liabilities by one of the partners. Overlapping subsidiaries or redundant staff may be allowed to continue, creating inefficiency, and conversely the new management may cut too many operations or personnel, losing expertise and disrupting employee culture. These problems are similar to those encountered in takeovers. For the merger not to be considered a failure, it must increase shareholder value faster than if the companies were separate, or prevent the deterioration of shareholder value more than if the companies were separate.

Business valuation

The five most common ways to valuate a business are asset valuation, historical earnings valuation, future maintainable earnings valuation, Earnings Before Interest Taxes Depreciation and Amortization (EBITDA) valuation and Shareholder's Discretionary Cash Flow (SDCF) valuation. Professionals who valuate businesses generally do not use just one of these methods but a combination of some of them, as well as possibly others that are not mentioned above, in order to obtain a more accurate value. These values are determined for the most part by looking at a company's balance sheet and/or income statement and withdrawing the appropriate information. The information in the balance sheet or income statement is obtained by one of three accounting measures: a Notice to Reader, a Review Engagement or an Audit.

Accurate business valuation is one of the most important aspects of M&A as valuations like these will have a major impact on the price that a business will be sold for. Most often this information is expressed in a Letter of Opinion of Value (LOV) when the business is being valuated for interest's sake. There are other, more detailed ways of expressing the value of a business. These reports generally get more detailed and expensive as the size of a company increases, however, this is not always the case as there are many complicated industries which require more attention to detail, regardless of size.

Financing M&A

Mergers are generally differentiated from acquisitions partly by the way in which they are financed and partly by the relative size of the companies. Various methods of financing an M&A deal exist:

Cash

Payment by cash. Such transactions are usually termed acquisitions rather than mergers because the shareholders of the target company are removed from the picture and the target comes under the (indirect) control of the bidder's shareholders alone.

A cash deal would make more sense during a downward trend in the interest rates. Another advantage of using cash for an acquisition is that there tends to lesser chances of EPS dilution for the acquiring company. But a caveat in using cash is that it places constraints on the cash flow of the company.

Financing

Financing capital may be borrowed from a bank, or raised by an issue of bonds. Alternatively, the acquirer's stock may be offered as consideration. Acquisitions financed through debt are known as leveraged buyouts if they take the target private, and the debt will often be moved down onto the balance sheet of the acquired company.

Hybrids

An acquisition can involve a combination of cash and debt, or a combination of cash and stock of the purchasing entity

Motives behind M&A

These motives are considered to add shareholder value:

Synergy: This refers to the fact that the combined company can often reduce duplicate departments or operations, lowering the costs of the company relative to the same revenue stream, thus increasing profit.

Increased revenue/Increased Market Share: This motive assumes that the company will be absorbing a major competitor and thus increase its power (by capturing increased market share) to set prices.

Cross selling: For example, a bank buying a stock broker could then sell its banking products to the stock broker's customers, while the broker can sign up the bank's customers for brokerage accounts. Or, a manufacturer can acquire and sell complementary products.

Economies of Scale: For example, managerial economies such as the increased opportunity of managerial specialization. Another example is purchasing economies due to increased order size and associated bulk-buying discounts.

Taxes: A profitable company can buy a loss maker to use the target's loss as their advantage by reducing their tax liability. In the United States and many other countries, rules are in place to limit the ability of profitable companies to "shop" for loss making companies, limiting the tax motive of an acquiring company.

Geographical or other diversification: This is designed to smooth the earnings results of a company, which over the long term smoothens the stock price of a company, giving conservative investors more confidence in investing in the company. However, this does not always deliver value to shareholders (see below).

Resource transfer: resources are unevenly distributed across firms (Barney, 1991) and the interaction of target and acquiring firm resources can create value through either overcoming information asymmetry or by combining scarce resources.

These motives are considered to not add shareholder value:

Diversification: While this may hedge a company against a downturn in an individual industry it fails to deliver value, since it is possible for individual shareholders to achieve the same hedge by diversifying their portfolios at a much lower cost than those associated with a merger.

Manager's hubris: manager's overconfidence about expected synergies from M&A which results in overpayment for the target company.

Empire building: Managers have larger companies to manage and hence more power.

Manager's compensation: In the past, certain executive management teams had their payout based on the total amount of profit of the company, instead of the profit per share, which would give the team a perverse incentive to buy companies to increase the total profit while decreasing the profit per share (which hurts the owners of the company, the shareholders); although some empirical studies show that compensation is linked to profitability rather than mere profits of the company.

Vertical integration: Companies acquire part of a supply chain and benefit from the resources. However, this does not add any value since although one end of the supply chain may receive a product at a cheaper cost , the other end now has lower revenue. In addition, the supplier may find more difficulty in supplying to competitors of its acquirer because the competition would not want to support the new conglomerate.

M&A Market Place Difficulties

No marketplace currently exists for the mergers and acquisitions of privately owned small to mid-sized companies. Market participants often wish to maintain a level of secrecy about their efforts to buy or sell such companies. Their concern for secrecy usually arises from the possible negative reactions a company's employees, bankers, suppliers, customers and others might have if the effort or interest to seek a transaction were to become known. This need for secrecy has thus far thwarted the emergence of a public forum or marketplace to serve as a clearinghouse for this large volume of business.

At present, the process by which a company is bought or sold can prove difficult, slow and expensive. A transaction typically requires six to nine months and involves many steps. Locating parties with whom to conduct a transaction forms one step in the overall process and perhaps the most difficult one. Qualified and interested buyers of multimillion dollar corporations are hard to find. Even more difficulties attend bringing a number of potential buyers forward simultaneously during negotiations. Potential acquirers in an industry simply cannot effectively "monitor" the economy at large for acquisition opportunities even though some may fit well within their company's operations or plans.

An industry of professional "middlemen" (known variously as intermediaries, business brokers, and investment bankers) exists to facilitate M&A transactions. These professionals do not provide their services cheaply and generally resort to previously-established personal contacts, direct-calling campaigns, and placing advertisements in various media. In servicing their clients they attempt to create a one-time market for a one-time transaction. Certain types of merger and acquisitions transactions involve securities and may require that these "middlemen" be securities licensed in order to be compensated. Many, but not all, transactions use intermediaries on one or both sides. Despite best intentions, intermediaries can operate inefficiently because of the slow and limiting nature of having to rely heavily on telephone communications. Many phone calls fail to contact with the intended party. Busy executives tend to be impatient when dealing with sales calls concerning opportunities in which they have no interest. These marketing problems typify any private negotiated markets. Due to these problems and other problems like these, brokers who deal with small to mid-sized companies often deal with much more strenuous conditions than other business brokers. Mid-sized business brokers have an average life-span of only 12-18 months and usually never grow beyond 1 or 2 employees. Exceptions to this are few and far between. Some of these exceptions include The Sundial Group, Geneva Business Services and Robbinex.

The market inefficiencies can prove detrimental for this important sector of the economy. Beyond the intermediaries' high fees, the current process for mergers and acquisitions has the effect of causing private companies to initially sell their shares at a significant discount relative to what the same company might sell for were it already publicly traded. An important and large sector of the entire economy is held back by the difficulty in conducting corporate M&A (and also in raising equity or debt capital). Furthermore, it is likely that since privately held companies are so difficult to sell they are not sold as often as they might or should be.

Previous attempts to streamline the M&A process through computers have failed to succeed on a large scale because they have provided mere "bulletin boards" - static information that advertises one firm's opportunities. Users must still seek other sources for opportunities just as if the bulletin board were not electronic. A multiple listings service concept was previously not used due to the need for confidentiality but there are currently several in operation. The most significant of these are run by the California Association of Business Brokers (CABB) and the International Business Brokers Association (IBBA) These organizations have effectively created a type of virtual market without compromising the confidentiality of parties involved and without the unauthorized release of information.

One part of the M&A process which can be improved significantly using networked computers is the improved access to "data rooms" during the due diligence process however only for larger transactions. For the purposes of small-medium sized business, these data rooms serve no purpose and are generally not used. Reasons for frequent failure of M&A was analyzed by Thomas Straub in "Reasons for frequent failure in mergers and acquisitions - a comprehensive analysis", DUV Gabler Edition, 2007.

Cross Border M&A

The rise of globalization has exponentially increased the market for cross border M&A. In 1996 alone there were over 2000 cross border transactions worth a total of approximately $256 billion. This rapid increase has taken many M&A firms by surprise because the majority of them never had to consider acquiring the capabilities or skills required to effectively handle this kind of transaction. In the past, the market's lack of significance and a more strictly national mindset prevented the vast majority of small and mid-sized companies from considering cross border intermediation as an option which left M&A firms inexperienced in this field. This same reason also prevented the development of any extensive academic works on the subject.

Due to the complicated nature of cross border M&A, the vast majority of cross border actions have unsuccessful results. Cross border intermediation has many more levels of complexity to it then regular intermediation seeing as corporate governance, the power of the average employee, company regulations, political factors customer expectations, and countries' culture are all crucial factors that could spoil the transaction.

Major M&A in the 1990s

Top 10 M&A deals worldwide by value (in mil. USD) from 1990 to 1999:

Major M&A from 2000 to present

Top 9 M&A deals worldwide by value (in mil. USD) since 2000:

Bibliography

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