Role and Environment of Managerial Finance (CH1) Finance is concerned with the process, institutions, markets, and instruments involved in the transfer of money The knowledge of finance provides a chance to make better financial decisions

Major areas in Finance: Financial services (banks, brokerage firms..) Managerial finance (duties of the financial manager)

Managerial finance function and its relationship to economics and accounting The size of the firm determines the function of the managerial finance. (small firms – finance function performer by the accounting department, Huge corporations – special department/s). Included – financial planning, fund raising, making capital expenditure decisions, managing cash (chief financial manager), corporate accounting, tax management, cost accounting (chief accountant)

Relationship to Economics – must respect the economic framework, marginal cost-benefit analysis (financial decision, added benefits must exceed the added costs) Relationship to Accounting – generally overlap, differences – accrual basis x CF basis, presentation of data x evaluating and interpreting of data Primary activities of financial manager – making investment decisions, making financing decisions

Goal of the firm Maximize profit x maximize the wealth of the owners? EPS (is not equal to dividend, unrelated to expected CFs - timing, does not measure risk) x Stock Price (in theory increase when all relevant measures are in equilibrium) The Role of Ethics – effective ethics program is believed to enhance corporate value

Agency problem – connected with ethics = the likelihood that managers may place personal goals ahead of corporate/owners’ goals Minimizing agency problem: Market forces (existence of major shareholder, the threat of takeover) Agency costs (costs of maintaining a corporate governance structure that monitors management behavior, and gives managers incentive to maximize share price..)

Financial Market Fund raising: Financial institutions Financial markets Private placement Financial institutions serve as intermediaries by channeling the savings of individuals (net suppliers of funds) into loans and investment, provided to businesses and governments (both are net demanders of funds)

Financial Market Is divided in Money market (short-term securities) Capital market (long-term securities) Primary market Secondary market Financial Institutions actively participate in the financial market as both suppliers and demanders of funds (banks, investment companies, brokerage firms, pension funds, insurance companies..)

Capital Market Key securities: Bonds, Stocks Organizations that provide the marketplace in which firms can raise funds, and investors can resell securities, are securities exchanges Two types of securities exchanges: Organized securities exchanges (NYSE, AMEX) The over-the-counter exchange (OTC) The role of SE is to create liquid markets in which firms can obtain needed financing

Taxes Types of income: Ordinary income (earned through the sale of goods and services) Capital Gains (difference between the sale price and the purchase price, are added to ordinary income) Tax-deductible Expenses Operating expenses Interest expenses

Taxes Average tax rate = Taxes / Taxable income Marginal tax rate represents the rate at which additional income is taxed. It is given by the Corporate Tax Rate Schedule Tax calculation: Taxes = Base tax + Marginal rate*Amount over base bracket Range of taxable income is derived from the Corporate Tax Rate Schedule

Financial Statements The Income Statement (financial summary of the firm‘s operating result during a specified period) The Balance Sheet (summary statement of the firm‘s financial position at a given point in time) The Statement of Cash Flows (summary of the cash flows over a specified period) The Statement of Retained Earnings (abbreviated form of the statement of stockholders´ equity)

The Balance Sheet Balances the firm‘s assets against its financing (debt or equity) Short-term x Long-term assets and liabilities: Shotr-term (current assets and liabilities) – they are expected to be converted into cash or paid within 1 year or less. Long-term (fixed assets, equity, long term debt) – they are expected to remain on the firm‘s books for more than 1 year.

Liabilities and Equity The Balance Sheet As is customary, the assets are listed from the most liquid (cash) down to the least liquid. Assets Current assets Fixed assets Liabilities and Equity Current liabilities Long term debt / liabilities Equity

The Income Statement Provides a financial summary of the firm‘s operating result during a specified period. Most common are income statements covering a 1-year period ending December 31. Monthly statements are prepared for use by management. Quarterly statements must be made available to the stockholders of publicly owned corporations.

The Income Statement Revenue -Cost of goods sold = Gross profit -Operating expenses = Operating profit (EBIT) -Financial cost = Net profit before taxes (EBT) -Taxes = Net profit after taxes (EAT)

The Statement of Cash Flow Analyses the firm’s ability to generate cash and cash equivalents Statement of CF shows: Where did the cash come from? What was it used for? What was the change in the cash balance? Operating, Investing and Financing activities Sources vs. Usage of funds

The Statement of Retained Earnings reconciles the net income earned during a given year, and any dividends paid, with change in retained earnings between the start and the end of that year Retained earnings balance (beginning of the year) + EAT - Dividends paid = Retained earnings balance (end of the year)

Exercise 1 - 2 You are a treasurer at AIMCO, who develops technology for video conferencing •Manager of a division asks you to authorize a capital expenditure of $10,000 •The funds are for a project on which $2,5 million had been spent over the past years •He admits though that the technology concept developed has been surpassed •Use marginal cost-benefit analysis

Exercise 1 – 2 Solution Sunk costs – ignored by marginal benefit analysis = $2,5m are irrelevant Will the $10,000 additional investment generate a revenue exceeding $10,000? - Compare to other possible projects - Competitors, industry, new technology

Exercise 1 - 3 The end of the year party The treasurer’s staff contends that the firm is running low on cash and might have trouble paying its bills. The controller’s staff disagrees as the firm continues to be very profitable. Who is right? Can both sides be right?

Exercise 1 – 3 Solution Cash Flow vs. Accrued Profits Expenses have shorter due date than expected revenues Short term financing is needed to meet debt obligations before the revenue arrives Cash crunch, company experience, employee morale

Problem 1 - 2 Marginal cost benefit analysis Benefits from new robotics $560,000 Benefits from old robotics $400,000 Cost of new equipment $220,000 Sale of old equipment $70,000 Calculate marginal benefits, costs, net benefit. What do you recommend that the company do? Why? What other factors should you consider?

Problem 1 – 2 Solution Marginal benefits = 560,000 - 400,000 = 160,000 Marginal cost = 220,000 - 70,000 = 150,000 Net benefits = MB - MC = 10,000 Net benefits are positive = recommend replacement Other factors affecting expected return - timing, cash flow and risk

Problem 1 – 3 Accrual income versus cash flow Value of books shipped $760,000 Collected in cash $690,000 Cost of books $300,000 Using accrual accounting show the firm’s net profit Using cash accounting show the firm’s net cash flow Which of the statements is more useful to the financial manager and why?

Problem 1 – 3 Solution Net profit = Sales - Cost of goods sold = 760,000 - 300,000 = 460,000 Net cash flow = Cash receipts - Cost of goods sold = 690,000 - 300,000 = 390,000 Cash flow statement is more useful to financial manager

Problem 1 - 5 Corporate Taxes EBIT = $92,500 $75,000 to $100,000 – Base tax 13,750 + 34% * amount over $75,000 Calculate firm’s tax liability. How much are after tax earnings? What was the firm’s average tax rate? What was the firm’s marginal tax rate?

Problem 1 – 5 Solution Total taxes due = 13,750+[0.34*(92,500-75,000)] = = 13,750+5,950 = 19,700 After tax earnings: 92,500 - 19,700 = 72,800 Average tax rate: 19,700 / 92,500 = 21,3% Marginal tax rate: 34%

Problem 1 - 9

Problem 1 - 9 (a) EBIT $40,000 Less: Interest expense 10,000 Earnings before taxes $30,000 Less: Taxes (40%) 12,000 Earnings after taxes* $18,000 * This is also earnings available to common stockholders. (b) EBIT $40,000 Less: Taxes (40%) 16,000 Earnings after taxes $24,000 Less: Preferred dividends 10,000 Earnings available for common stockholders $14,000

Problem 1 - 11

Problem 1 – 11 Solution

Problems 2-2, 2-3, 2-4, 2-5 See book or PDF(moodle)

Thank You for Your attention Questions?