Chapter 1

The Role and Environment

of Managerial Finance

CFEA 2123 Financial Management

Learning Goals
1.

2.

3.

4.

Define finance, its major areas and

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

5.

6.

Understand financial institutions and

markets, and the role they play in
managerial finance.
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
Increasing globalization has complicated
(cont.)

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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Table 1.1 Strengths and Weaknesses

of the Common Legal Forms of Business
Organization

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Figure 1.1 Corporate

Organization

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Table 1.2 Other Limited Liability

Organizations

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Table 1.3 Career

Opportunities in Managerial
Finance

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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
The field of finance is actually an
Economics

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
The primary economic
Economics
(cont.) 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
The firms finance (treasurer) and
Accounting

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
One major difference
Accounting
(cont.)
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
The Nassau Corporation
Accounting
(cont.) 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
Finance and accounting
Accounting
(cont.)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.
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Figure 1.2 Financial

Activities

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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.

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Goal of the Firm:

Maximize Shareholder
Why?
Wealth!!!

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

risk of cash
flows
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Goal of the Firm:

Maximize Shareholder Wealth!!!
The process of shareholder wealth
(cont.)

maximization can be described using the

following flow chart:

Figure 1.3 Share Price Maximization

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Goal of the Firm:

What About Other
Stakeholders include all groups of individuals who
Stakeholders?

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
Whether subsequently traded in the
(cont.)

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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Figure 1.4 Flow of Funds

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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 shortterm 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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Broker Markets and Dealer

Markets

Broker markets consists of national and

regional securities exchanges, which are
organizations that provide a marketplace in
which firms can raise funds the sale of new
securities and purchasers can resell
securities

Dealer markets consist of both the Nasdaq

market and and the over-the-counter (OTC)
market, where the (unlisted) shares of
smaller firm shares are sold and traded.
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Broker Markets and

Dealer Markets
The key difference between broker and dealer
(continued)
markets is a technical point dealing with the

way trades are executed.

When a trade occurs in a broker market, buyers
and sellers are brought together and the trade
takes place on the floor of the exchange.
In contrast, buyers and sellers are never
actually brought together in a dealer market
transactions are executed by securities dealers
that make markets in certain securities.

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Broker Markets and Dealer

Markets (cont.)

The New York Stock Exchange (NYSE) is

the most famous of all broker markets and
accounts for about 60% of the value of
shares traded in the U.S. stock markets.
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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Broker Markets and Dealer

Markets (cont.)

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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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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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
Figure 1.5 Supply and Demand

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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
Table 1.4 Corporate Tax Rate Schedule

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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
For corporations only, 70% of all dividend
Income
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 (Tax

Deductibility):
In calculating
taxes,
corporations
may deduct operating
Debt
versus
Equity
Financing
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 (Tax

Deductibility):
Debt versus Equity Financing
(cont.)

1-57

Business Taxation (Tax

Deductibility):
As versus
Debt
Equity
the example
shows,Financing
the use of debt
financing
can
increase
cash
flow
and
EPS,
(cont.)
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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