01 the role and environment of managerial finance

Understand financial institutions and markets, and the role they play in managerial finance.. • Finance is concerned with the process, institutions, markets, and instruments involved

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

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.

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.

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.

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 firm’s

competitive position

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.

Legal Forms of Business Organization

Corporate Organization

Other Limited Liability Organizations

Career Opportunities

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

The Managerial Finance Function:

The Managerial Finance Function:

Relationship to Economics (cont.)

• The primary economic principal used by

financial managers is marginal

cost-benefit analysis which says that financial

decisions should be implemented only

when added benefits exceed added costs.

The Managerial Finance Function:

Relationship to Accounting

• The firm’s finance (treasurer) and

accounting (controller) functions are

closely-related and overlapping.

• In smaller firms, the financial manager

generally performs both functions.

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.

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

The Managerial Finance Function:

Relationship to Accounting (cont.)

• The Nassau Corporation experienced the following activity last year:

• Now contrast the differences in

performance under the accounting method versus the cash method.

INCOME STATEMENT SUMMARY

Less: Costs (80,000) (80,000)

Net Profit/(Loss) $ 20,000 $(80,000)

The Managerial Finance Function:

Relationship to Accounting (cont.)

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

Primary Activities of

the Financial Manager

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

Earnings per share (EPS)

Which Investment is Preferred?

Goal of the Firm: Maximize Profit???

• 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.

Share Price = Future Dividends

Required Return

level & timing

of cash flows risk of cash

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:

Goal of the Firm:

Maximize Shareholder Wealth!!! (cont.)

• The process of shareholder wealth

maximization can be described using the following flow chart:

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."

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

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 people’s 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.

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.

The Role of Ethics: Ethics Defined

• Ethics is the standards of conduct or

moral judgment—have become an

overriding issue in both our society and

the financial community

• Ethical violations attract

widespread publicity

• Negative publicity often leads to negative

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

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

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.

The Agency Issue:

The Agency Problem

• Whenever a manager owns less than 100% of the firm’s

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.

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.

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.

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.

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

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.

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

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

The Relationship between Financial

Institutions and Financial Markets

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

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

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.

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

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).

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.”

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 investor’s home currency

and sold in the investor’s home market

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.

The Role of Securities Exchanges

• Both individuals and businesses can earn two types of

income—ordinary income and capital gains income.

• Under current law, tax treatment of ordinary income and capital gains income change frequently due frequently

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

Business Taxes: Ordinary Income

• Ordinary income is earned through the sale of a firm’s goods or services and is taxed at the rates depicted in Table 1.4 on the following slide

Business Taxation: Ordinary 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%

Business Taxation:

Average & Marginal Tax Rates

• A firm’s marginal tax rate represents the

rate at which additional income is taxed.

• The average tax rate is the firm’s taxes

divided by taxable income.