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Chapter 1

The Role and


Environment
of Managerial
Finance

Learning Goals
1. Define finance, its major areas and
opportunities available in this field, and the
legal forms of business organization.
2. Describe the managerial finance function and
its relationship to economics and accounting.
3. Identify the primary activities of the
financial manager.
4. Explain the goal of the firm, corporate
governance, the role of ethics, and
the agency issue.
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Learning Goals (cont.)


5. Understand financial institutions and
markets, and the role they play in
managerial finance.
6. Discuss business taxes and their
importance in financial decisions.

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What is Finance?
Finance can be defined as the art and
science of managing money.

Finance is concerned with the process,


institutions, markets, and instruments
involved in the transfer of money among
individuals, businesses, and governments.

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Major Areas & Opportunities in


Finance: Financial Services
Financial Services is the area of finance
concerned with the design and delivery of
advice and financial products to
individuals, businesses, and government.
Career opportunities include banking,
personal financial planning, investments,
real estate, and insurance.

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Major Areas & Opportunities in


Finance: Managerial Finance
Managerial finance is concerned with
the duties of the financial manager in the
business firm.
The financial manager actively manages the
financial affairs of any type of business, whether
private or public, large or small, profit-seeking or
not-for-profit.
They are also more involved in developing
corporate strategy and improving the firms
competitive position.
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Major Areas & Opportunities in


Finance: Managerial Finance (cont.)
Increasing globalization has complicated
the financial management function by
requiring them to be proficient in
managing cash flows in different
currencies and protecting against the risks
inherent in international transactions.
Changing economic and regulatory
conditions also complicate the financial
management function.
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Legal Forms of Business Organization

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Corporate Organization

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Other Limited Liability Organizations

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Career Opportunities

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The Managerial Finance Function


The size and importance of the managerial
finance function depends on the size of the firm.
In small companies, the finance function may
be performed by the company president or
accounting department.
As the business expands, finance typically
evolves into a separate department linked to the
president as was previously described in
Figure 1.1.
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The Managerial Finance Function:


Relationship to Economics
The field of finance is actually an
outgrowth of economics.

In fact, finance is sometimes referred to as


financial economics.
Financial managers must understand the
economic framework within which they
operate in order to react or anticipate to
changes in conditions.
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The Managerial Finance Function:


Relationship to Economics (cont.)
The primary economic principal used by
financial managers is marginal costbenefit analysis which says that financial
decisions should be implemented only
when added benefits exceed added costs.

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The Managerial Finance Function:


Relationship to Accounting
The firms finance (treasurer) and
accounting (controller) functions are
closely-related and overlapping.
In smaller firms, the financial manager
generally performs both functions.

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The Managerial Finance Function:


Relationship to Accounting (cont.)
One major difference in perspective and
emphasis between finance and
accounting is that accountants generally
use the accrual method while in finance,
the focus is on cash flows.

The significance of this difference


can be illustrated using the following
simple example.
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The Managerial Finance Function:


Relationship to Accounting (cont.)
The Nassau Corporation experienced the
following activity last year:
Sales

$100,000 (1 yacht sold, 100% still uncollected)

Costs

$ 80,000 (all paid in full under supplier terms)

Now contrast the differences in


performance under the accounting method
versus the cash method.
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The Managerial Finance Function:


Relationship to Accounting (cont.)
INCOME STATEMENT SUMMARY
ACCRUAL
Sales
Less: Costs
Net Profit/(Loss)

$100,000

CASH
$

(80,000)

(80,000)

$ 20,000

$(80,000)

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The Managerial Finance Function:


Relationship to Accounting (cont.)
Finance and accounting also differ with respect
to decision-making.
While accounting is primarily concerned with the
presentation of financial data, the financial
manager is primarily concerned with analyzing
and interpreting this information for decisionmaking purposes.
The financial manager uses this data as a vital
tool for making decisions about the financial
aspects of the firm.
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Primary Activities of
the Financial Manager

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Goal of the Firm: Maximize Profit???


Which Investment is Preferred?
Earnings per share (EPS)
Investment

Year 1

Year 2

Year 3

Total (years 1-3)

Rotor

1.40 $

1.00 $

0.40 $

2.80

Valve

0.60 $

1.00 $

1.40 $

3.00

Profit maximization fails to account for differences in the


level of cash flows (as opposed to profits), the timing of
these cash flows, and the risk of these cash flows.

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Goal of the Firm:


Maximize Shareholder Wealth!!!
Why?
Because maximizing shareholder wealth properly
considers cash flows, the timing of these cash flows,
and the risk of these cash flows.
This can be illustrated using the following simple stock
valuation equation:
level & timing
of cash flows

Share Price = Future Dividends


Required Return
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risk of cash
flows
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Goal of the Firm:


Maximize Shareholder Wealth!!! (cont.)
The process of shareholder wealth
maximization can be described using the
following flow chart:

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Goal of the Firm:


What About Other Stakeholders?
Stakeholders include all groups of individuals who have
a direct economic link to the firm including employees,
customers, suppliers, creditors, owners, and others who
have a direct economic link to the firm.
The "Stakeholder View" prescribes that the firm make a
conscious effort to avoid actions that could be
detrimental to the wealth position of its stakeholders.
Such a view is considered to be "socially responsible."

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Corporate Governance
Corporate Governance is the system used to
direct and control a corporation.
It defines the rights and responsibilities of key
corporate participants such as shareholders, the
board of directors, officers and managers, and
other stakeholders.
The structure of corporate governance was
previously described in Figure 1.1.

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Individual versus Institutional Investors


Individual investors are investors who purchase
relatively small quantities of shares in order to earn a
return on idle funds, build a source of retirement income,
or provide financial security.
Institutional investors are investment professionals who
are paid to manage other peoples money.
They hold and trade large quantities of securities for
individuals, businesses, and governments and tend to
have a much greater impact on corporate governance.

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The Sarbanes-Oxley Act of 2002


The Sarbanes-Oxley Act of 2002 (commonly called
SOX) eliminated many disclosure and conflict of interest
problems that surfaced during the early 2000s.

SOX:
established an oversight board to monitor the
accounting industry;
tightened audit regulations and controls;
toughened penalties against executives who commit
corporate fraud;
strengthened accounting disclosure requirements;
established corporate board structure guidelines.

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The Role of Ethics: Ethics Defined


Ethics is the standards of conduct or
moral judgmenthave become an
overriding issue in both our society and
the financial community
Ethical violations attract
widespread publicity
Negative publicity often leads to negative
impacts on a firm
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The Role of Ethics: Considering Ethics


Robert A. Cooke, a noted ethicist, suggests that
the following questions be used to assess the
ethical viability of a proposed action:
Does the action unfairly single out an individual
or group?
Does the action affect the morals, or legal rights of
any individual or group?
Does the action conform to accepted
moral standards?
Are there alternative courses of action that are less
likely to cause actual or potential harm?
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The Role of Ethics:


Considering Ethics (cont.)
Cooke suggests that the impact of a proposed decision
should be evaluated from a number of perspectives:
Are the rights of any stakeholder being violated?

Does the firm have any overriding duties to any stakeholder?


Will the decision benefit any stakeholder to the detriment of
another stakeholder?
If there is a detriment to any stakeholder, how should it be
remedied, if at all?
What is the relationship between stockholders
and stakeholders?

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The Role of Ethics:


Ethics & Share Price
Ethics programs seek to:

reduce litigation and judgment costs


maintain a positive corporate image
build shareholder confidence
gain the loyalty and respect of
all stakeholders

The expected result of such programs is


to positively affect the firm's share price.
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The Agency Issue:


The Agency Problem
Whenever a manager owns less than 100% of the firms
equity, a potential agency problem exists.
In theory, managers would agree with shareholder
wealth maximization.
However, managers are also concerned with their
personal wealth, job security, fringe benefits,
and lifestyle.
This would cause managers to act in ways that do not
always benefit the firm shareholders.

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The Agency Issue:


Resolving the Problem
Market Forces such as major
shareholders and the threat of a hostile
takeover act to keep managers in check.
Agency Costs are the costs borne by
stockholders to maintain a corporate
governance structure that minimizes
agency problems and contributes to the
maximization of shareholder wealth.
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The Agency Issue:


Resolving the Problem (cont.)
Examples would include bonding or
monitoring management behavior, and
structuring management compensation to
make shareholders interests their own.
A stock option is an incentive allowing
managers to purchase stock at the market
price set at the time of the grant.

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The Agency Issue:


Resolving the Problem (cont.)
Performance plans tie management
compensation to measures such as EPS
growth; performance shares and/or cash
bonuses are used as compensation under
these plans.

Recent studies have failed to find a strong


relationship between CEO compensation
and share price.
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Financial Institutions & Markets


Firms that require funds from external
sources can obtain them in three ways:
through a bank or other financial institution
through financial markets
through private placements

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Financial Institutions & Markets:


Financial Institutions
Financial institutions are intermediaries that
channel the savings of individuals, businesses,
and governments into loans or investments.
The key suppliers and demanders of funds are
individuals, businesses, and governments.
In general, individuals are net suppliers of
funds, while businesses and governments are
net demanders of funds.

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Financial Institutions & Markets:


Financial Markets
Financial markets provide a forum in which
suppliers of funds and demanders of funds can
transact business directly.
The two key financial markets are the money
market and the capital market.
Transactions in short term marketable securities
take place in the money market while
transactions in long-term securities take place in
the capital market.
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Financial Institutions & Markets:


Financial Markets (cont.)
Whether subsequently traded in the money or
capital market, securities are first issued through
the primary market.
The primary market is the only one in which a
corporation or government is directly involved in
and receives the proceeds from the transaction.

Once issued, securities then trade on the


secondary markets such as the New York
Stock Exchange or NASDAQ.
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The Relationship between Financial


Institutions and Financial Markets

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The Money Market


The money market exists as a result of the
interaction between the suppliers and
demanders of short-term funds (those having
a maturity of a year or less).
Most money market transactions are made in
marketable securities which are short-term
debt instruments such as T-bills and
commercial paper.
Money market transactions can be executed
directly or through an intermediary.
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The Money Market (cont.)


The international equivalent of the
domestic (U.S.) money market is the
Eurocurrency market.

The Eurocurrency market is a market for


short-term bank deposits denominated in U.S.
dollars or other marketable currencies.
The Eurocurrency market has grown rapidly
mainly because it is unregulated and because it
meets the needs of international borrowers
and lenders.
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The Capital Market


The capital market is a market that enables suppliers
and demanders of long-term funds to make transactions.
The key capital market securities are bonds (long-term
debt) and both common and preferred stock (equity).
Bonds are long-term debt instruments used by
businesses and government to raise large sums of
money or capital.
Common stock are units of ownership interest or equity
in a corporation.

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Major Securities Exchanges:


Organized Exchanges
Organized securities exchanges are tangible
secondary markets where outstanding securities
are bought and sold.
They account for about 46% of the total dollar
volume of domestic shares traded.
Only the largest and most profitable companies
meet the requirements necessary to be listed
on the New York Stock Exchange.

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Major Securities Exchanges:


Organized Exchanges (cont.)
Only those that own a seat on the
exchange can make transactions on the
floor (there are currently 1,366 seats).
Trading is conducted through an auction
process where specialists make a
market in selected securities.
As compensation for executing orders,
specialists make money on the spread
(bid price ask price).
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Major Securities Exchanges:


Over-the-Counter Exchange
The over-the-counter (OTC) market is an
intangible market for securities transactions.
Unlike organized exchanges, the OTC is both a
primary market and a secondary market.
The OTC is a computer-based market where
dealers make a market in selected securities
and are linked to buyers and sellers through the
NASDAQ System.
Dealers also make money on the spread.
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Major Securities Exchanges:


International Capital Markets
In the Eurobond market, corporations and
governments typically issue bonds denominated
in dollars and sell them to investors located
outside the United States.
The foreign bond market is a market for
foreign bonds, which are bonds issued by a
foreign corporation or government that is
denominated in the investors home currency
and sold in the investors home market.
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Major Securities Exchanges:


International Capital Markets (cont.)
Finally, the international equity market
allows corporations to sell blocks of
shares to investors in a number of
different countries simultaneously.
This market enables corporations to raise
far larger amounts of capital than they
could raise in any single national market.

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The Role of Securities Exchanges

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Business Taxes
Both individuals and businesses must pay taxes
on income.
The income of sole proprietorships and partnerships is
taxed as the income of the individual owners, whereas
corporate income is subject to corporate taxes.
Both individuals and businesses can earn two types of
incomeordinary income and capital gains income.
Under current law, tax treatment of ordinary income and
capital gains income change frequently due frequently
changing tax laws.
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Business Taxes: Ordinary Income


Ordinary income is earned through the sale of a
firms goods or services and is taxed at the rates
depicted in Table 1.4 on the following slide.
Example
Calculate federal income taxes due if taxable income is $80,000.
Tax = .15 ($50,000) + .25 ($25,000) + .34 ($80,000 - $75,000)
Tax = $15,450

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Business Taxation: Ordinary Income

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Business Taxation:
Average & Marginal Tax Rates
A firms marginal tax rate represents the
rate at which additional income is taxed.

The average tax rate is the firms taxes


divided by taxable income.
Example
What is the marginal and average tax rate for the previous example?

Marginal Tax Rate

= 34%

Average Tax Rate

= $15,450/$80,000 = 19.31%

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Business Taxation:
Tax on Interest & Dividend Income
For corporations only, 70% of all dividend
income received from an investment in the stock
of another corporation in which the firm has less
than 20% ownership is excluded from taxation.
This exclusion is provided to avoid triple
taxation for corporations.
Unlike dividend income, all interest income
received is fully taxed.

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Business Taxation:
Debt versus Equity Financing
In calculating taxes, corporations may deduct operating
expenses and interest expense but not dividends paid.
This creates a built-in tax advantage for using debt
financing as the following example will demonstrate.
Example
Two companies, Debt Co. and No Debt Co., both
expect in the coming year to have EBIT of $200,000.
During the year, Debt Co. will have to pay $30,000 in
interest expenses. No Debt Co. has no debt and will
pay not interest expenses.
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Business Taxation:
Debt versus Equity Financing (cont.)

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Business Taxation:
Debt versus Equity Financing (cont.)
As the example shows, the use of debt
financing can increase cash flow and
EPS, and decrease taxes paid.
The tax deductibility of interest and other
certain expenses reduces their actual
(after-tax) cost to the profitable firm.
It is the non-deductibility of dividends paid
that results in double taxation under the
corporate form of organization.
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Business Taxation: Capital Gains


A capital gain results when a firm sells an asset
such as a stock held as an investment for more
than its initial purchase price.
The difference between the sales price and the
purchase price is called a capital gain.
For corporations, capital gains are added to
ordinary income and taxed like ordinary income
at the firms marginal tax rate.

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