The Role and Environment

of Managerial Finance
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 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 firm’s
competitive position.
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MAJOR AREAS & OPPORTUNITIES IN FINANCE:
MANAGERIAL FINANCE (CONT.)
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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LEGAL FORMS OF BUSINESS ORGANIZATION

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CORPORATE ORGANIZATION

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CAREER OPPORTUNITIES

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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 firm’s 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)

Now contrast the$differences
Costs 80,000in(all
performance under
paid in full the accounting
under supplier terms)
method versus the cash method.

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 THE MANAGERIAL FINANCE FUNCTION:
RELATIONSHIP TO ACCOUNTING (CONT.)
INCOME STATEMENT SUMMARY

ACCRUAL CASH
Sales $100,000 $ 0
Less: Costs (80,000) (80,000)
Net Profit/(Loss) $ 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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PRIMARY ACTIVITIES OF
THE FINANCIAL MANAGER

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 GOAL OF THE FIRM: MAXIMIZE PROFIT???
Which Investment is Preferred?

Earnings per share (EPS)

Investment Year 1 Year 2 Year 3 Total (years 1-3)
Rotor $ 1.40 $ 1.00 $ 0.40 $ 2.80
Valve $ 0.60 $ 1.00 $ 1.40 $ 3.00

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
risk of cash
Required Return
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:

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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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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 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.

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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 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

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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 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.

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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 (CONT.)

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.
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THE RELATIONSHIP BETWEEN FINANCIAL
INSTITUTIONS AND FINANCIAL MARKETS

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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 short-term 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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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.

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MAJOR SECURITIES EXCHANGES:
ORGANIZED EXCHANGES (CONT.)
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).

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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.
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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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.

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MAJOR SECURITIES EXCHANGES: 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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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 firm’s
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

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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.

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 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.

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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.
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:
DEBT VERSUS EQUITY FINANCING (CONT.)

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BUSINESS TAXATION:
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 firm’s marginal tax rate.

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