Chapter 1

The Role and Environment

of Managerial Finance
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.

• 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.

• 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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 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: 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.

• 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.

• 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.

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• The significance of this difference
can be illustrated using the following simple example.

• 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

ACCRUAL CASH

Sales $100,000 $ 0

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

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

• 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 decision-making
purposes.

• The financial manager uses this data as a vital tool for making
decisions about the financial aspects of the firm.

• 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:

• Share Price = Future Dividends

Required Return

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.

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• 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;

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 – strengthened accounting disclosure requirements;

– Established corporate board structure guidelines.

• 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 impacts on a firm

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?

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 – 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?

• 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?

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

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• 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.

The Agency Issue:

Resolving the Problem

• 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.

• 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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• 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.

• 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.

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• 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.

• 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 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 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.

The Capital Market

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• 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 stocks 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.

• 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.

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• 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.

• 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.

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 income—

ordinary income and capital gains income.

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

• 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.

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• 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 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.

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

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.

• 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.

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• It is the non-deductibility of dividends paid that results in double
taxation under the corporate form of organization.

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 firm’s marginal tax rate.

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