1. Copyright © 2003 Pearson Education, Inc. Slide 1-0 Chapter 1 The Role and Environment of Managerial Finance

2. Copyright © 2003 Pearson Education, Inc. Slide 1-1 Learning Goals 1.Define finance, the major areas of finance, and the career 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 within the firm. 4.Explain why wealth maximization, rather than profit maximization, is the firm’s goal and how the agency issue is related to it.

3. Copyright © 2003 Pearson Education, Inc. Slide 1-2 Learning Goals 5.Understand the relationship between financial institutions and markets, as well as the role and operations of the money and capital markets. 6.Discuss the fundamentals of business taxation of ordinary income and capital gains, and explain the treatment of tax losses.

4. Copyright © 2003 Pearson Education, Inc. Slide 1-3 What is Finance? At the macro level, finance is the study of financial institutions and financial markets and how they operate within the financial system in both the U.S. and global economies. At the micro level, finance is the study of financial planning, asset management, and fund raising for businesses and financial institutions. Financial management can be described in brief using the following balance sheet.

5. Copyright © 2003 Pearson Education, Inc. Slide 1-4 What is Finance? Working Capital Working Capital Investment Decisions Financing Decisions Macro Finance

6. Copyright © 2003 Pearson Education, Inc. Slide 1-5 What is Finance? A well-developed financial system is a hallmark and essential characteristic of any modern developed nation. Financial markets, financial intermediaries, and financial management are the important components. Financial markets and financial intermediaries facilitate the flow of funds from borrowers to savers. Financial management involves the efficient use of financial resources in the production of goods.

7. Copyright © 2003 Pearson Education, Inc. Slide 1-6 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.

8. Copyright © 2003 Pearson Education, Inc. Slide 1-7 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. Increasing globalization has complicated the financial management function. Changing economic and regulatory conditions also complicate the financial management function.

9. Copyright © 2003 Pearson Education, Inc. Slide 1-8 Basic Forms of Business Organization

10. Copyright © 2003 Pearson Education, Inc. Slide 1-9 Corporate Organization

11. Copyright © 2003 Pearson Education, Inc. Slide 1-10 Other Limited Liability Organizations

12. Copyright © 2003 Pearson Education, Inc. Slide 1-11 Career Opportunities

13. Copyright © 2003 Pearson Education, Inc. Slide 1-12 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.

14. Copyright © 2003 Pearson Education, Inc. Slide 1-13 The Managerial Finance Function 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. Relationship to Economics

15. Copyright © 2003 Pearson Education, Inc. Slide 1-14 The Managerial Finance Function The primary economic principal used by financial managers is marginal analysis which says that financial decisions should be implemented only when benefits exceed costs. Relationship to Economics

16. Copyright © 2003 Pearson Education, Inc. Slide 1-15 The Managerial Finance Function The firm’s finance (treasurer) and accounting (controller) functions are closely-related and overlapping. In smaller firms, the financial manager generally performs both functions. Relationship to Accounting

17. Copyright © 2003 Pearson Education, Inc. Slide 1-16 The Managerial Finance Function 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. Relationship to Accounting

18. Copyright © 2003 Pearson Education, Inc. Slide 1-17 The Managerial Finance Function Relationship to Accounting The Nasau 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.

19. Copyright © 2003 Pearson Education, Inc. Slide 1-18 The Managerial Finance Function Relationship to Accounting INCOME STATEMENT SUMMARY ACCRUAL CASH Sales $100,000 $ 0 Less: Costs (80,000) (80,000) Net Profit/(Loss) $ 20,000 $(80,000)

20. Copyright © 2003 Pearson Education, Inc. Slide 1-19 The Managerial Finance Function 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. Relationship to Accounting

21. Copyright © 2003 Pearson Education, Inc. Slide 1-20 Key Activities of the Financial Manager

22. Copyright © 2003 Pearson Education, Inc. Slide 1-21 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.

23. Copyright © 2003 Pearson Education, Inc. Slide 1-22 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 valuation equation: Share Price = Future Dividends Required Return level & timing of cash flows risk of cash flows

24. Copyright © 2003 Pearson Education, Inc. Slide 1-23 Goal of the Firm Maximize Shareholder Wealth!!! It can also be described using the following flow chart:

25. Copyright © 2003 Pearson Education, Inc. Slide 1-24 Goal of the Firm Economic Value Added (EVA) Economic value added (EVA) is a popular measure used by many firms to determine whether an investment - proposed or existing - positively contributes to the owners wealth. EVA is calculated by subtracting the cost of funds used to finance an investment from its after-tax operating profits. Investments with positive EVAs increase shareholder wealth and those with negative EVAs reduce shareholder value.

26. Copyright © 2003 Pearson Education, Inc. Slide 1-25 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 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."

27. Copyright © 2003 Pearson Education, Inc. Slide 1-26 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 Ethics Defined

28. Copyright © 2003 Pearson Education, Inc. Slide 1-27 The Role of Ethics Considering Ethics To assess the ethical viability of a proposed action, ask: 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?

29. Copyright © 2003 Pearson Education, Inc. Slide 1-28 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 Role of Ethics Ethics & Share Price

30. Copyright © 2003 Pearson Education, Inc. Slide 1-29 The Agency Issue 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 Problem

31. Copyright © 2003 Pearson Education, Inc. Slide 1-30 The Agency Issue Market Forces such as major shareholders and the threat of a hostile takeover act to keep managers in check. Agency Costs may be incurred to ensure management acts in shareholders interests. Resolving the Problem

32. Copyright © 2003 Pearson Education, Inc. Slide 1-31 The Agency Issue Examples would include bonding or monitoring management behavior, and structuring management compensation to make shareholders interests their own. However, recent studies have failed to find a strong relationship between CEO compensation and share price. Resolving the Problem

33. Copyright © 2003 Pearson Education, Inc. Slide 1-32 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

34. Copyright © 2003 Pearson Education, Inc. Slide 1-33 Financial Institutions & Markets 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

35. Copyright © 2003 Pearson Education, Inc. Slide 1-34 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.

36. Copyright © 2003 Pearson Education, Inc. Slide 1-35 Financial Markets 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.

37. Copyright © 2003 Pearson Education, Inc. Slide 1-36 The Relationship between Financial Institutions and Financial Markets

38. Copyright © 2003 Pearson Education, Inc. Slide 1-37 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

39. Copyright © 2003 Pearson Education, Inc. Slide 1-38 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 Money Market

40. Copyright © 2003 Pearson Education, Inc. Slide 1-39 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. The Capital Market

41. Copyright © 2003 Pearson Education, Inc. Slide 1-40 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.

42. Copyright © 2003 Pearson Education, Inc. Slide 1-41 Securities Exchanges Organized Exchanges 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).

43. Copyright © 2003 Pearson Education, Inc. Slide 1-42 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”.

44. Copyright © 2003 Pearson Education, Inc. Slide 1-43 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.

45. Copyright © 2003 Pearson Education, Inc. Slide 1-44 Securities Exchanges International Capital Markets 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.

46. Copyright © 2003 Pearson Education, Inc. Slide 1-45 The Role of Securities Exchanges

47. Copyright © 2003 Pearson Education, Inc. Slide 1-46 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 and capital gains. Under current law, tax treatment of ordinary income and capital gains change frequently due frequently changing tax laws. Business Taxes

48. Copyright © 2003 Pearson Education, Inc. Slide 1-47 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. Business Taxes Ordinary Income 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

49. Copyright © 2003 Pearson Education, Inc. Slide 1-48 Business Taxation Ordinary Income

50. Copyright © 2003 Pearson Education, Inc. Slide 1-49 Business Taxation Average & Marginal Tax Rates 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% 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.

51. Copyright © 2003 Pearson Education, Inc. Slide 1-50 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.

52. Copyright © 2003 Pearson Education, Inc. Slide 1-51 Business Taxation Debt versus Equity Financing 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. 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.

53. Copyright © 2003 Pearson Education, Inc. Slide 1-52 Business Taxation Debt versus Equity Financing

54. Copyright © 2003 Pearson Education, Inc. Slide 1-53 Business Taxation Debt versus Equity Financing 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.

55. Copyright © 2003 Pearson Education, Inc. Slide 1-54 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.

56. Copyright © 2003 Pearson Education, Inc. Slide 1-55 Business Taxation Tax Loss Carrybacks and Carryforwards Corporations experiencing losses can obtain tax relief by using tax loss carrybacks/carryforwards. A tax loss carryback/carryforward allows corporations experiencing operating losses to carry tax losses back (in time) up to 2 years and forward (in time) for as many as 20 years. The law required that losses first be carried back, applying them to the earliest year allowable, and progressively moving forward until the loss has been fully recovered or the carryforward period has passed.