Chapter 1

The Role and

Environment
of Managerial
Finance
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 Learning Goals
1. Define finance and its major areas and opportunities.

2. Describe the managerial finance function and its

relationship to accounting and economics.

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 relates to it.
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 Learning Goals
5. Understand the relationship between financial

institutions and markets, and the role and operations

of the money and capital markets.

6. Discuss the fundamentals of business taxation of

ordinary income and capital gains, and the treatment

of tax losses.

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 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.
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 What is Finance?
Macro Finance
ABC Company
Balance Sheet
As of December 31, 19xx

Assets: Liabilities & Equity:

Current Assets Current Liabilities
Working Cash & M.S. Accounts payable
Working
Capital Accounts receivable Notes Payable
Inventory Total Current Liabilities Capital
Total Current Assets Long-Term Liabilities
Fixed Assets: Total Liabilities
Gross fixed assets Equity:
Investment Less: Accumulated dep. Common Stock Financing
Decisions Goodw ill Paid-in-capital
Decisions
Other long-term assets Retained Earnings
Total Fixed Assets Total Equity
Total Assets Total Liabilities & Equity
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 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.
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 Areas of Opportunity in Finance
• Financial Services:
– Banking
– Personal financial planning
– Investments
– Real estate
– insurance
• Managerial Finance:
– Corporate financial management
– Multinational financial management
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 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.
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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.
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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

• The primary economic principal used by financial

managers is marginal analysis which says that

financial decisions should be implemented only when

benefits exceed 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
• 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
• Thomas Yachts experienced the following activity last
year:

Sales: $100,000 (sold on account - still uncollected)

Cost of Goods: $ 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

Income Statement
Thomas Yachts
For the year ended 12/31

Accounting View Financial View

(accrual basis) (cash basis)
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
• 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?

EPS ($)
Investm ent Year 1 Year 2 Year 3 Total
A $ 2.80 $ - $ - $ 2.80
B $ - $ - $ 3.00 $ 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
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!!!

• It can also be described using the following flow chart:

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 Goal of the Firm
Economic Value Added (EVA)
• EVA is Used to determine whether an investment
positively contributes to owner 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
value and those with negative EVAs decrease
shareholder value.
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 Goal of the Firm
What About 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."
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 The Role of Ethics
Ethics Defined
• Ethics - 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
Opinions
• A wide majority (94%) of business school deans,
business leaders, and members of Congress
responding to a recent survey felt that the business
community is troubled by ethical issues
• A majority (63%) of the respondents perceived that a
firm strengthens its competitive position by maintaining
high ethical standards
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 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?
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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 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 may be incurred to ensure management

acts in shareholders interests.

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 The Agency Issue
Resolving the Problem
• 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.
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 Financial Institutions and Markets
• Most successful firms have ongoing needs for funds.
• Funds can be obtained from external sources in three
ways:
– Through financial institutions
– Through financial markets
– Through private placements
• Because of the unstructured nature of private
placements, this text will focus on only the first two
sources.
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 Financial Institutions
• Financial institutions serve as intermediaries by
channeling the savings of individuals, businesses, and
governments into loans or investments.
• Some institutions pay savers directly for deposited
funds while others may provide services for a fee.
• Some institutions accept customers’ deposits and lend
it to other customers; others invest customers’ savings
in earning assets such as real estate or stocks or
bonds.
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Key Customers of Financial Institutions
• The key suppliers and demanders of funds to financial
institutions are individual consumers, businesses, and
governments.
• As a group, individuals are net suppliers of funds –
saving more than they borrow.
• Businesses and governments, however, are net
demanders of funds – borrowing more from financial
institutions than they save.

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 Financial Markets
• Financial markets are forums in which suppliers and
demanders of funds can transact directly.
• Two key financial markets are the money market and
the capital market.
• To raise money, firms can use either private
placements or public offerings.
• All securities are initially issued through the primary
market but are subsequently traded in the secondary
market.
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 The Relationship between Financial
Institutions and Financial Markets

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 Claims to Wealth
• While real assets include the direct ownership of
tangible assets such as land or buildings, financial
assets represent claims against the income and
assets of those who issued the claims.
• Types of financial assets include stocks, bonds, and
bank deposits.
• Some financial assets, such as stocks and bonds, can
be traded in the secondary markets while others, such
as bank deposits, cannot.
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 Claims to Wealth
• Marketable financial assets can be further
categorized according to whether they trade in the
primary market or the secondary market.
• Primary markets are where new securities are
issued.
• Secondary markets are where securities are bought
and sold after initially issued in the primary
markets.
• In addition, financial assets may be money market
instruments or capital market instruments.
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 Money and Capital Markets
• The money market is created by the relationship
between suppliers and demanders of short-term funds
with maturities of one year or less.
• Most money market transactions are made in
marketable securities.
• The capital market is a market that allows suppliers
and demanders of long-term funds to make
transactions.
• The backbone of the capital market is formed by the
various securities exchanges.
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 Money and Capital Markets
• Examples of money market and capital market
instruments include the following:

Money Market Instruments Capital Market Instruments

U.S. Treasury Bills U.S. Treasury Notes & Bonds
Negotiable CDs U.S. Government Agency Bonds
Bankers Acceptances State & Local Government Bonds
Federal Funds Corporate Bonds
Commercial Paper Corporate Stocks
Repurchase Agreements Real Estate Mortgages

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 Securities Exchanges
Organized Exchanges
• Organized securities exchanges are tangible
secondary markets where outstanding securities are
bought and sold.

• They account for over 60% of the 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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 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).
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 Securities Exchanges
Organized Exchanges

Requirements NYSE AMEX

shares held by public 1,100,000 400,000

stockholders with 100+ shares 2,000 1,200

pretax income (latest year) $2,500,000 $750,000

pretax income (prior 2 years) $2,000,000 N/A

MV of public shares held $18,000,000 $300,000

tangible assets $16,000,000 $4,000,000

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 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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 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 and capital gains.
• Under current law, tax treatment of ordinary income
and capital gains differs for individuals, but not for
corporations.
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 Business Taxes
Ordinary Income

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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 4.4 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 Taxes
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 Taxes
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 Taxes
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
A firm with 100,000 shares outstanding needs to raise an
additional 500,000 in capital. They can do so by selling
bonds that pay 6% interest or by issuing 10,000 additional
shares at $50/share. The firm pays $3.00 in dividends for
each share outstanding.
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 Business Taxes
Debt versus Equity Financing

Debt Equity
Financing Financing
Operating Profit (EBIT) $ 700,000 $ 700,000
Less: Interest Expense 30,000 -
Earnings Before Taxes $ 670,000 $ 700,000
Less: Taxes (40%) 268,000 280,000
Earnings After Taxes $ 402,000 $ 420,000

Difference Earnings After Taxes $18,000

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 Business Taxes
Debt versus Equity Financing

• As the example shows, the use of debt financing can

increase cash flow and decrease taxes paid.
•The tax deductibility of interest and other certain
expenses reduces a company’s actual (after-tax) cost
of financing.
• It is the non-deductibility of dividends paid that results
in double taxation under the corporate form of
organization.
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 Business Taxes
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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