Chapter 1 & 2

The Role of Environment and Financial Market

Environment

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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 the agency issue.
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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.

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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 deals with management of
money for individuals, business and government
and includes the design and advice and financial
products.
Career opportunities include banking, personal
financial planning, investments, real estate, and
insurance.

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Table 1.3 Career Opportunities in

Managerial Finance

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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 includes:

Developing financial plan and budget

Extend credit to customers
Evaluate proposed large expenditures
Raise money to fund firms operations

They are also more involved in developing corporate

strategy and improving the firms competitive position.
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Legal Forms of Business

Organization
A sole proprietorship is a business owned by one
person and operated for his or her own profit.
A partnership is a business owned by two or more
people and operated for profit.
A corporation is an entity created by law. Corporations
have the legal powers of an individual in that it can sue
and be sued, make and be party to contracts, and
acquire property in its own name.

Proprietorships
Advantages
Ease of formation
Subject to few regulations
No corporate income taxes

Disadvantages
Difficult to raise capital
Unlimited liability
Limited life

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Partnership
Advantages
Able to raise more funding from sole proprietorship
Income tax on personal tax return
More brain power and managerial skills

Disadvantages

Owner have unlimited liability

May have to cover partners debt
Partnership dissolves upon partnership dies
Difficult to liquidate and transfer ownership
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Corporation
Advantages

Unlimited life
Easy transfer of ownership
Limited liability
Ease of raising capital
Employ professional managers
Able to obtain better financing

Disadvantages
More regulations
Taxed at corporate rate- higher
Cost of set-up and report filing
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Table 1.1 Strengths and Weaknesses of the

Common Legal Forms of Business Organization

Matter of Fact

Figure 1.1 Corporate Organization

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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 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.
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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.

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The Managerial Finance Function:

Relationship to Accounting
The firms finance (treasurer) and 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 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.

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The Managerial Finance Function:

Relationship to Accounting (cont.)
The Nassau 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.

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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 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 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 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:

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!!! (cont.)
The process of shareholder wealth 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?
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."

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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 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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Violations of Ethics
Example:

Creative Accounting
Earnings Management
Misleading Financial Forecast
Insider Trading
Fraud
Excessive Executive Compensation
Bribery and Kickbacks
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Corporate Governance
Corporate Governance refers to the rules, processes and
laws by which companies operated, controlled and
regulated.
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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Governance and Agency:

Government Regulation
Government regulation generally shapes the corporate
governance of all firms.
During the recent decade, corporate governance has
received increased attention due to several high-profile
corporate scandals involving abuse of corporate power
and, in some cases, alleged criminal activity by
corporate officers.

Sarbanes and Oxley Act

An act aim at eliminating corporate disclosure
and conflict of interest problems.
Contain provision about corporate financial
disclosure and relationship among the
corporations, analyst, auditors, attorneys,
directors, officers, and shareholders

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Governance and Agency:

Government Regulation
The Sarbanes-Oxley Act of 2002:

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 and ethical guidelines for
corporate officers;
established corporate board structure and membership guidelines;
established guidelines with regard to analyst conflicts of interest;
mandated instant disclosure of stock sales by corporate executives;
increased securities regulation authority and budgets for auditors and
investigators.

Governance and Agency:

The Agency Issue
A principal-agent relationship is an arrangement in
which an agent acts on the behalf of a principal. For
example, shareholders of a company (principals) elect
management (agents) to act on their behalf.
Agency problems arise when managers place personal
goals ahead of the goals of shareholders.
Shareholder incurs agency cost when managers make
poor decisions and have to be monitored to ensure the
best investment decision is made

The Agency Issue:

Management Compensation Plans
In addition to the roles played by corporate boards,
institutional investors, and government regulations,
corporate governance can be strengthened by ensuring
that managers interests are aligned with those of
shareholders.
A common approach is to structure management
compensation to correspond with firm performance.

The Agency Issue:

Management Compensation Plans
Incentive plans are management compensation plans
that tie management compensation to share price; one
example involves the granting of stock options.
Performance plans tie management compensation to
measures such as EPS or growth in EPS. Performance
shares and/or cash bonuses are used as compensation
under these plans.

Matter of FactForbes.com
CEO Performance vs. Pay

The Agency Issue: The Threat of

Takeover
When a firms internal corporate governance structure
is unable to keep agency problems in check, it is likely
that rival managers will try to gain control of the firm.
The threat of takeover by another firm, which believes
it can enhance the troubled firms value by restructuring
its management, operations, and financing, can provide
a strong source of external corporate governance.

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 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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Commercial Banks, Investment Banks, and

the Shadow Banking System
Commercial banks are institutions that provide savers
with a secure place to invest their funds and that offer
loans to individual and business borrowers.
Investment banks are institutions that assist companies
in raising capital, advise firms on major transactions
such as mergers or financial restructurings, and engage
in trading and market making activities.

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Commercial Banks, Investment Banks, and

the Shadow Banking System (cont.)
The Glass-Steagall Act was an act of Congress in 1933
that created the federal deposit insurance program and
separated the activities of commercial and investment
banks.
Repealed in the late 1990s.

The shadow banking system describes a group of

institutions that engage in lending activities, much like
traditional banks, but these institutions do not accept
deposits and are therefore not subject to the same
regulations as traditional banks.
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Matter of Fact
Consolidation in the U.S. Banking Industry:
The U.S. banking industry has been going through a long
period of consolidation.
According to the FDIC, the number of commercial banks
in the United States declined from 11,463 in 1992 to
8,012 at the end of 2009, a decline of 30%.
The decline is concentrated among small, community
banks which larger institutions have been acquiring at a
rapid pace.
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Financial Institutions & Markets:

Financial Markets
Financial markets are forums in which suppliers of funds
and demanders of funds can transact business directly.
Transactions in short term marketable securities take place
in the money market while transactions in long-term
securities take place in the capital market.
A private placement involves the sale of a new security
directly to an investor or group of investors.
Most firms, however, raise money through a public offering
of securities, which is the sale of either bonds or stocks to
the general public.
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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 longterm securities take place in the capital market.
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Financial Institutions & Markets:

Financial Markets (cont.)
The primary market is the financial market in which
securities are initially issued; the only market in which
the issuer is directly involved in the transaction.
Secondary markets are financial markets in which
preowned securities (those that are not new issues) are
traded.

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Figure 1.4 Flow of Funds

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The Money Market

The money market is created by a financial relationship
between suppliers and demanders of short-term funds.
Most money market transactions are made in marketable
securities which are short-term debt instruments, such as
U.S. Treasury bills, commercial paper, and negotiable
certificates of deposit issued by government, business, and
financial institutions, respectively.
Investors generally consider marketable securities to be
among the least risky investments available.
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Malaysian Money Market

NID or Negotiable Instrument of Deposit: In
denomination more than RM100K.
Repurchase Agreement or Repo: Issued by banks for
duration from 1 day to 1 year.
MTB or Malaysian Treasury Bills are short-term
securities issued by the Government of Malaysia to raise
short-term funds for Government's working capital. Bills
are sold at discount through competitive auction,

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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, or ownership).
Bonds are long-term debt instruments used by businesses and
government to raise large sums of money, generally from a diverse
group of lenders.
Common stock are units of ownership interest or equity in a
corporation.
Preferred stock is a special form of ownership that has features of
both a bond and common stock.

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Malaysian Capital Market

BNMN or Bank Negara Monetary Notes are
securities issued by BN for purpose of managing
liquidity in the conventional financial market
MGS or Malaysian Government Securities are longterm bonds issued by the Government of Malaysia for
financing developmental expenditure.
It is being auctioned annually with the size between RM1 to
RM4.5 billion depending on the government financial
requirement. The duration of the terms are 3, 5, 7 or 10 years.

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Broker Markets and

Dealer Markets
Broker markets are securities exchanges on which the
two sides of a transaction, the buyer and seller, are
brought together to trade securities.
Trading takes place on centralized trading floors.
Examples include: NYSE Euronext, American Stock
Exchange

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Broker Markets and

Dealer Markets (cont.)
Dealer markets are markets in which the buyer and seller are
not brought together directly but instead have their orders
executed by securities dealers that make markets in the given
security.
A market where dealers are assigned for specific securities. The
dealers create liquid markets by purchasing and selling against
personal inventory.
The Nasdaq market is one example

As compensation for executing orders, market makers make

money on the spread (bid price ask price).
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Matter of Fact
NYSE Euronext is the Worlds Largest Stock Exchange
According to the World Federation of Exchanges, NYSE
Euronext is the largest stock market in the world, as measured
by the total market value of securities listed on that market.
NYSE Euronext has listed securities worth more than $11.8
trillion in the U.S. and $2.9 trillion in Europe.
Next largest is the London Stock Exchange with securities
valued at 1.7 trillion, which is equivalent to $2.8 trillion
given the exchange rate between pounds and dollars prevailing
at the end of 2009.

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International Capital Markets

A Eurobond is an international bond that is denominated in a
currency not native to the country where it is issued. It can be
categorised according to the currency in which it is issued. London
is one of the centers of the Eurobond market, but Eurobonds may be
traded throughout the world - for example in Singapore or Tokyo.
In the Eurobond market, corporations and governments
typically issue bonds denominated in dollars or yens and sell
them to investors located outside the home country
The foreign bond market is a market for 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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The Role of Capital Markets

From a firms perspective, the role of capital markets is to be a
liquid market where firms can interact with investors in order to
obtain valuable external financing resources.
From investors perspectives, the role of capital markets is to be
an efficient market that allocates funds to their most productive
uses.
An efficient market allocates funds to their most productive
uses as a result of competition among wealth-maximizing
investors and determines and publicizes prices that are believed
to be close to their true value.
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The Role of Capital Markets

(cont.)
Advocates of behavioral finance, an emerging field that
blends ideas from finance and psychology, argue that stock
prices and prices of other securities can deviate from their
true values for extended periods.
These people point to episodes such as the huge run up and
subsequent collapse of the prices of Internet stocks in the late
1990s, or the failure of markets to accurately assess the risk
of mortgage-backed securities in the more recent financial
crisis, as examples of the principle that stock prices
sometimes can be wildly inaccurate measures of value.

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The Financial Crisis: Financial

Institutions and Real Estate Finance
Securitization is the process of pooling mortgages or
other types of loans and then selling claims or securities
against that pool in a secondary market.
Mortgage-backed securities represent claims on the cash
flows generated by a pool of mortgages and can be
purchased by individual investors, pension funds, mutual
funds, or virtually any other investor.
A primary risk associated with mortgage-back securities is
that homeowners may not be able to, or may choose not
to, repay their loans.
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The Financial Crisis: Falling Home Prices

and Delinquent Mortgages (Figure 2.2)

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The Financial Crisis: Crisis of

Confidence in Banks (Figure 2.3)

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The Financial Crisis: Spillover Effects

and the Great Recession
As banks came under intense financial pressure in 2008,
they tightened their lending standards and dramatically
reduced the quantity of loans they made.
Corporations found that they could no longer raise money
in the money market, or could only do so at
extraordinarily high rates.
As a consequence, businesses began to hoard cash and
cut back on expenditures, and economic activity
contracted.
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Regulation of Financial Institutions and Markets:

Regulations Governing Financial Institutions

The Glass-Steagall Act (1933) established the Federal Deposit

Insurance Corporation (FDIC) which provides insurance for
deposits at banks and monitors banks to ensure their safety and
soundness.
The Glass-Steagall Act also prohibited institutions that took
deposits from engaging in activities such as securities
underwriting and trading, thereby effectively separating
commercial banks from investment banks.

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Regulation of Financial Institutions and Markets:

Regulations Governing Financial Institutions

The Gramm-Leach-Bliley Act (1999) allows business combinations

(e.g. mergers) between commercial banks, investment banks, and
insurance companies, and thus permits these institutions to compete
in markets that prior regulations prohibited them from entering.
Some leaders have argued that Congress should reenact GlassSteagall, which would effectively mandate the breakup of large
financial conglomerates.
Others have proposed the implementation of new regulations,
particularly on the large financial institutions that received the most
assistance from the government during the financial crisis.

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Regulation of Financial Institutions and Markets:

Regulations Governing Financial Markets

The Securities Act of 1933 regulates the sale of securities to the

public via the primary market.
Requires sellers of new securities to provide extensive disclosures to the
potential buyers of those securities.

The Securities Exchange Act of 1934 regulates the trading of

securities such as stocks and bonds in the secondary market.
Created the Securities Exchange Commission, which is the primary
government agency responsible for enforcing federal securities laws.
Requires ongoing disclosure by companies whose securities trade in
secondary markets (e.g., 10-Q, 10-K).
Imposes limits on the extent to which insiders can trade in their firms
securities.

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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 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.

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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 Deductibility):

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.
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.)

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Business Taxation (Tax Deductibility):

Debt versus Equity Financing (cont.)
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.

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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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