Chapter 1
The Role of
Managerial
Finance
Copyright © 2012 Pearson Prentice Hall.
All rights reserved.
COURSE DESCRIPTION
Business Finance is an examination of the
principles, theory and techniques of
modern corporate financial management.
Topics such as risk, return, valuation of
securities and projects, long-term financing
and the financial environment are
explored.
COURSE MATERIALS
Textbooks
– Gitman, Lawrence J., Chad J. Zutter, (2012) Principles of Managerial
Finance (13th ed.) Addison-Wesley, Reading MA.
– MyFinance Lab add-in
Supplemental Materials
– Notes and homework documents are accessed from MYTMC.
Computing / Software
– It is assumed that all students have a basic understanding of the use of
Excel spreadsheet.
– There is an Excel spreadsheet to download from the Handout section of
MYTMC.
– All individual homework and exams are completed via MyFinance LAB
EVALUATION CRITERIA /
GRADING POLICY
(70 - 100%) = Pass
(69 % or less)= F
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GRADE COMPOSITION
(TRADITIONAL)
Quizzes
50%
Homework
50%
Grades are based on the total number of
correct points achieved out of the total
possible.
The above percentages represent an
approximate distribution of the grading.
Career Opportunities in
Finance: Managerial Finance
• Managerial finance is concerned with the duties of the financial
manager working in a business.
• Financial managers administer the financial affairs of all types of
businesses—private and public, large and small, profit-seeking and
not-for-profit.
• They perform such varied tasks as developing a financial plan or
budget, extending credit to customers, evaluating proposed large
expenditures, and raising money to fund the firm’s operations.
•
Very involved with strategic planning and implementation
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1-6
Managerial Finance (cont.)
• The recent global financial crisis and subsequent
responses by governmental regulators, increased global
competition, and rapid technological change also increase
the importance and complexity of the financial manager’s
duties.
• Increasing globalization has increased demand for
financial experts who can manage cash flows in different
currencies and protect against the risks that naturally arise
from international transactions.
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1-7
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.
• Finance theories and techniques apply to all.
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1-8
What is the Goal of the firm?
• Is there a benchmark that serves as an
appropriate measure of whether an action
should proceed or not?
• Maximize profit
• Minimize expenses
• Maximize marketing share
• Maximize share price
• Maximize stakeholder wealth
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1-9
Goal of the Firm:
Maximize Shareholder Wealth
Decision rule for managers: only take actions that are
expected to increase the share price.
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1-10
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 is primarily what the owners want
This can be illustrated using the following simple stock
valuation equation:
level & timing
Share Price = Future Dividends
Required Return
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of cash flows
risk of cash
flows
1-11
Goal of the Firm:
What About Stakeholders?
• Stakeholders are groups such as employees, customers,
suppliers, creditors, owners, and others who have a direct
economic link to the firm.
• A firm with a stakeholder focus consciously avoids
actions that would prove detrimental to stakeholders. The
goal is not to maximize stakeholder well-being but to
preserve it.
• Such a view is considered to be "socially responsible."
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1-12
The Role of Business Ethics
• Business ethics are the standards of conduct or moral
judgment that apply to persons engaged in commerce.
• Violations of these standards in finance involve a variety
of actions: “creative accounting,” earnings management,
misleading financial forecasts, insider trading, fraud,
excessive executive compensation, options backdating,
bribery, and kickbacks.
• Negative publicity often leads to negative impacts on a
firm
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1-13
The Role of Business Ethics:
Ethics and 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.
Is there a place in business for the “Golden Rule”??
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1-14
Managerial Finance Function:
Relationship to Economics
• Financial managers must understand the economic
framework and be alert to the consequences of varying
levels of economic activity and changes in economic
policy.
• They must also be able to use economic theories as
guidelines for efficient business operation.
• Marginal cost–benefit analysis is the economic principle
that states that financial decisions should be made and
actions taken only when the added benefits exceed the
added costs
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1-15
Managerial Finance Function:
Relationship to Accounting
• The firm’s finance and accounting activities are closelyrelated and generally overlap.
• In small firms accountants often carry out the finance
function, and in large firms financial analysts often help
compile accounting information.
• 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.
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1-16
Managerial Finance Function:
Relationship to Accounting (cont.)
Finance and accounting also differ with respect to decisionmaking:
– Accountants devote most of their attention to the collection and
presentation of financial data.
– Financial managers evaluate the accounting statements, develop
additional data, and make decisions on the basis of their
assessment of the associated returns and risks.
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1-17
Governance and Agency:
Corporate Governance
• Corporate governance refers to the rules, processes, and
laws by which companies are operated, controlled, and
regulated.
• It defines the rights and responsibilities of the corporate
participants such as the shareholders, board of directors,
officers and managers, and other stakeholders, as well as
the rules and procedures for making corporate decisions.
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1-18
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.
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1-19
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.
• Agency costs arise from agency problems that are borne
by shareholders and represent a loss of shareholder
wealth.
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1-20
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 might not
always benefit the firm shareholders.
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1-21
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.
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1-22
Options
• Option is the right to buy a stock at a certain
price within a certain period of time.
– Creates another place for people to acquire
company stock.
You have an option
to buy a share of
stock at $50. The
current price is $35.
Where would you buy?
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You have an option to buy a
share of stock at $50. After
several years of good
management the price has
risen to $65.
Where would you buy?
1-23
Matter of Fact—Forbes.com
CEO Performance vs. Pay
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1-24
The Agency Issue: The Threat
of Takeover
• When a firm’s 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 firm’s value by restructuring its
management, operations, and financing, can provide a
strong source of external corporate governance.
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1-25
Chapter 2 Financial
Market Environment
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1-26
Commercial Banks, Investment Banks,
and the Shadow Banking System
• 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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2-27
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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2-28
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.
• IPO
• Seasoned Shares
• Only time issuer gets funds from investors
• Secondary markets are financial markets in which preowned securities (those that are not new issues) are traded.
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2-29
Markets
• The money market is created by a financial relationship
between suppliers and demanders of short-term funds.
• marketable securities
• among the least risky investments available.
• The capital market is a market that enables suppliers and
demanders of long-term funds to make transactions.
• The key securities are bonds and both common and preferred
stock.
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2-30
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.
– NYSE
Dealer markets are markets in which the buyer and seller
are brought together indirectly via computers
– no centralized trading floors.
– The Nasdaq market is one example
– OTC
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2-31
The Role of Capital Markets
• From a firm’s 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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2-32
Exchanges
• NYSE
• http://www.youtube.com/watch?v=TPUDPhpCec
A&feature=player_detailpage
• CBOE
• http://www.youtube.com/watch?v=_UXomMnQK
T4&feature=player_detailpage
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2-33
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 firm’s
securities.
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2-34
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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2-35
Table 2.1
Corporate Tax Rate Schedule
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2-36
Calculate corporate taxes
Taxable income = 78,000
13,750 + .34 * 3,000 = 14,770
Average tax rate = 14,770 / 78,000 = 18.9%
Marginal tax rate = 34%
Taxable income = 17,000,000
5,150,000 + .38 * 2,000,000 = 5,910,000
Average tax rate = 5,910,000 / 17,000,000 = 34.7%
Marginal tax rate = 38%
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2-37
Chapter 3 Statements
and Ratios
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1-38
The Stockholders’ Report
• Generally accepted accounting principles (GAAP) are
the practice and procedure guidelines used to prepare and
maintain financial records and reports;
• The Sarbanes-Oxley Act of 2002, passed to eliminate the
many disclosure and conflict of interest problems of
corporations
• More Countries Adopt International Financial Reporting
Standards
– International Financial Reporting Standards (IFRS) are
established by the International Accounting Standards Board
(IASB).
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3-39
The Four Key Financial Statements:
The Income Statement
• The income statement provides a financial summary of a
company’s operating results during a specified period.
• Although they are prepared quarterly for reporting
purposes, they are generally computed monthly by
management and quarterly for tax purposes.
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3-40
Table 3.1 Bartlett Company
Income Statements ($000)
Concentrate on control issue
• Gross profit – control
expenses of production
• Operating profit – control
of the expenses of
“running” the company
• Net income – remaining
profits after all expenses
paid
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3-41
The Four Key Financial
Statements: The Balance Sheet
• The balance sheet presents a summary of a firm’s
financial position at a given point in time.
• The statement balances the firm’s assets (what it owns)
against its financing, which can be either debt (what it
owes) or equity (what was provided by owners).
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3-42
Table 3.2a Bartlett Company
Balance Sheets ($000)
Represents the assets that management has purchased
and uses to achieve it’s mission and goals.
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3-43
Table 3.2b Bartlett Company
Balance Sheets ($000)
Represents how
management
gets the $$ to
purchase the
assets of the
firm.
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3-44
The Four Key Financial Statements:
Statement of Retained Earnings
The statement of retained earnings reconciles the net
income earned during a given year, and any cash dividends
paid, with the change in retained earnings between the start
and the end of that year.
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3-45
The Four Key Financial Statements:
Statement of Cash Flows
• The statement of cash flows provides a summary of the
firm’s operating, investment, and financing cash flows and
reconciles them with changes in its cash and marketable
securities during the period.
• This statement not only provides insight into a company’s
investment, financing and operating activities, but also ties
together the income statement and previous and current
balance sheets.
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3-46
Table 3.4 Bartlett Company Statement of
Cash Flows ($000) for the Year Ended
December 31, 2012
The cash flow statement
illustrates the primary
decisions that managers
make.
• Managers make decisions
on how to run the
business (operations)
• Managers decide what
kinds of assets to buy
(investment)
• Managers decide where
to get the $$ to run the
business (financing)
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3-47
Using Financial Ratios: Cautions
about Using Ratio Analysis
1. Ratios that reveal large deviations from the norm merely indicate
the possibility of a problem.
2. A single ratio does not generally provide sufficient information
from which to judge the overall performance of the firm.
3. The ratios being compared should be calculated using financial
statements dated at the same point in time during the year.
4. It is preferable to use audited financial statements.
5. The financial data being compared should have been developed in
the same way.
6. Results can be distorted by inflation.
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3-48
Table 3.5 Financial Ratios for Select Firms
and Their Industry Median Values
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3-49
Molson Coors (TAP)
Year
Net Sales
Cost of Goods Sold
Gross Profit
Other Op Expenses
EBIT (Op Income)
Interest Exp (neg)
Interest Income
EBT (Earn Before Taxes)
Taxes (neg)
NI from Recurring Op
Extraordinary
Net Income
Fully Diluted EPS
Dividends per Share
Stock Price (end of yr)
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2002
$3,776
$2,415
$1,361
$1,063
$298
-$70
$28
$256
-$94
$162
$122
$40
$4.420
$0.820
$56.850
2003
$4,000
$2,587
$1,413
$1,106
$307
-$81
$27
$253
-$79
$174
-$137
$311
$4.770
$0.820
$52.900
2004
$4,305
$2,741
$1,564
$1,216
$348
-$72
$32
$308
-$95
$213
-$77
$290
$5.190
$0.820
$72.220
2005
$5,506
$3,307
$2,199
$1,777
$422
-$131
$4
$295
-$50
$245
$21
$224
$1.690
$1.280
$65.230
Financial Statement Analysis
2006
$5,844
$3,481
$2,363
$1,782
$581
-$143
$34
$472
-$82
$390
-$273
$663
$4.170
$1.280
$75.880
3-50
Year
2002
2003
2004
2005
2006
$59
$19
$123
$39
$182
Account Receivable
$704
$656
$832
$828
$828
Inventory
$184
$209
$234
$314
$319
Misc CA
$106
$194
$79
$287
$129
Total Current Assets
$1,053
$1,078
$1,268
$1,468
$1,458
Net Fixed Assets
$1,380
$1,450
$1,445
$2,305
$2,421
Intangibles
$1,256
$1,348
$1,471
$7,294
$7,363
$608
$568
$473
$732
$361
$4,297
$4,444
$4,657
$11,799
$11,603
Accounts Payable
$334
354
326
371
419
Other CL
$813
$779
$850
$1,865
$1,381
$1,147
$1,133
$1,176
$2,236
$1,800
LT Debt
$2,168
$2,044
$1,843
$4,154
$3,939
Total Debt
$3,315
$3,177
$3,019
$6,390
$5,739
Retained Earnings
$1,086
$1,231
$1,398
$1,422
$1,673
-$104
$36
$240
$3,987
$4,191
Total Liabilities and Equity
$4,297
$4,444
$4,657
$11,799
$11,603
Outstanding Shares
36.566
36.596
37.909
80.036
86.656
Cash & Mkt Sec.
Other Non-Current Assets
Total Assets
Total Current Liabilities
Notes Payable (LT)
Common Stock
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3-51
Year
2002
2003
2004
2005
2006
Net Cash from Op Activities
$244
$528
$499
$422
$833
Derpreciation
$230
$242
$267
$414
$441
Net Cash from Investing
-$1,570
-$214
-$67
-$312
-$294
Net Cash from Financing
$1,291
-$357
-$335
-$188
-$401
-$35
-$43
$97
-$78
$138
Net Change in Cash
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3-52
Malt Beverage Industry
Year
Liquidity
2002
2003
2004
2005
2006
Current Ratio (CR)
Quick Ratio (QR)
Asset Management
Days Sales Outstand DSO
Days Carry Inv DCI
Days Payable Outstand DPO
Fixed Asset Turnover FAT
Total Asset Turnover TAT
Leverage Ratios
LTD / NW (DE)
TD / TA (DR)
FA / NW
Times Int Earned (TIE)
Financial Leverage (FLM)
Profitability Ratios
Gross Profit (GPM)
Operating Profit (OPM)
EBT / TA ("ROA")
BEP
EBT / Tang. NW ("ROE")
EBT / Sales
1.60
0.70
1.20
0.60
1.50
0.90
1.30
0.60
1.40
0.70
23.00
32.00
28.00
2.20
1.50
17.00
41.00
29.00
3.00
1.40
21.00
39.00
28.00
1.60
1.10
23.00
42.00
29.00
2.40
1.50
22.00
40.00
31.00
2.10
1.40
200.00%
56.40%
160.00%
3.300
2.29
230.00%
63.00%
210.00%
1.900
2.70
180.00%
57.40%
180.00%
2.200
2.35
140.00%
57.50%
130.00%
2.900
2.35
140.00%
66.50%
160.00%
3.800
2.99
38.40%
6.20%
5.90%
9.30%
22.40%
4.10%
36.70%
4.20%
4.80%
5.88%
18.10%
2.60%
40.30%
5.10%
3.10%
5.61%
8.60%
3.10%
37.30%
5.60%
5.90%
8.40%
19.50%
3.80%
36.90%
7.10%
7.40%
9.94%
24.20%
6.00%
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3-53
Liquidity ratios
Measures the ability of the firm to pay current obligations
Use both if inventory is a large portion of the company’s
current assets
Current Assets
CR 
Current Liabilities
Current Assets  Inventory
QR 
Current Liabilities
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3-54
Matter of Fact
The importance of inventories:
– From Table 3.5:
Company
Current ratio
Quick ratio
Dell
1.3
1.2
Home Depot
1.3
0.4
Lowes
1.3
0.2
– All three firms have current ratios of 1.3. However, the quick
ratios for Home Depot and Lowes are dramatically lower than
their current ratios, but for Dell the two ratios are nearly the
same. Why?
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3-55
Liquidity Ratios
1.800
1.600
1.400
TAP Current ratio
1.200
Industry Current Ratio
TAP Quick Ratio
1.000
Industry Quick Ratio
0.800
0.600
0.400
2002
2003
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2004
2005
2006
3-56
Asset mgt ratios (Activity)
Inventory
CGS DCI  Days Carry Inventory 
IT =
Cost of Goods Sold / 365
INV
Average number of days inventory on the shelf
Accounts Receivable
DSO  Days Sales Outstandin g 
Sales / 365
sales
A / R turnover =
A /R
Average number of days for customers to pay
for their accounts
DPO  Days Payables Outs tan ding 
Accounts Payable
Cost of Goods Sold / 365
Average number of days it takes us to pay our accounts
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3-57
50.000
45.000
40.000
TAP Days Carry Inventory
35.000
Industry Days Carry Inventory
30.000
25.000
20.000
2002
2003
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2004
2005
2006
3-58
80.000
70.000
60.000
50.000
TAP Days Sales Outstanding
40.000
Industry Days Sales Outstanding
30.000
20.000
10.000
0.000
2002
2003
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2004
2005
2006
3-59
Leverage ratios
Degree of indebtedness (how much)
– cannot say whether good or bad
– Mgt chooses a level of debt
– NW = common equity
= Total Assets – Total Liabilities
Ability to pay interest
Financial leverage - use of other peoples
money to make a higher return
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3-60
leverage ratios
Total Debt
Debt Ratio 
Total Assets
Times Interest Earned 
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Earnings Before Interest and Taxes
Interest
3-61
90.000%
85.000%
80.000%
75.000%
70.000%
TAP Debt Ratio
65.000%
Industry Debt Ratio
60.000%
55.000%
50.000%
45.000%
40.000%
2002
2003
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2004
2005
2006
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6.000
5.000
4.000
TAP Times Interest Earned
3.000
Industry Times Interest Earned Ratio
2.000
1.000
0.000
2002
2003
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2004
2005
2006
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Profitability ratios
Gross Pr ofit
Gross Pr ofit M arg in 
Sales
Earnings Before Interest and Taxes
Operating Profit Margin 
Sales
Earnings Before Taxes / Sales 
Net Profit Margin 
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Earnings Before Taxes
Sales
Net Income from Recurring Operations
Sales
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45.000%
40.000%
35.000%
30.000%
TAP Gross Profit Margin
25.000%
Industry GPM
TAP Operating Profit MArgin
20.000%
Industry OPM
15.000%
10.000%
5.000%
0.000%
2002
2003
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2004
2005
2006
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12.000%
10.000%
8.000%
TAP Operating Profit MArgin
Industry OPM
6.000%
TAP EBT / Sales
Industry EBT / Sales
4.000%
2.000%
0.000%
2002
2003
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2004
2005
2006
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Profitability ratios
Basic Earning Power 
Re turn on Assets 
EPS 
Earnings Before Interest and Taxes
Total Assets
Net Income Available to Shareholde rs
Total Assets
Net Income Available to Shareholde rs
# Outstandin g Shares
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25.000%
20.000%
15.000%
TAP Basic Earning Power
Industry Basic Earning Power
10.000%
5.000%
0.000%
2002
2003
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2004
2005
2006
3-68
Market Based Ratios
Pr ice Earnings 
Book Value per shr. 
Mkt price
EPS
CE
TA  TL  pfd equity

# shares
# shares
mkt price
mkt to book 
BPS
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3-69
DuPont System of Analysis
• The DuPont system of analysis is used to dissect the
firm’s financial statements and to assess its financial
condition.
• It merges the income statement and balance sheet into two
summary measures of profitability.
• The Modified DuPont Formula relates the firm’s ROA to
its ROE using the financial leverage multiplier (FLM),
which is the ratio of total assets to common stock equity:
• ROA and ROE as shown in the series of equations on the
following slide.
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3-70
DuPont System of Analysis
• The DuPont system first brings together the net profit
margin, which measures the firm’s profitability on sales,
with its total asset turnover, which indicates how
efficiently the firm has used its assets to generate sales.
ROA = Net profit margin  Total asset turnover
• Substituting the appropriate formulas into the equation and
simplifying results in the formula given earlier,
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3-71
How does a firm create returns
for owners?
Receive
payment
Buy
inventory
AND / OR
$$$$
Sell a
product
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Make a
product
Borrow money!!
3-72
Company
EBT / Sales
TAT
ROA
FLM
Approx EOE
2002
6.780%
0.879
5.958%
4.376
26.069%
2003
6.325%
1.111
7.027%
3.507
24.647%
2004
7.154%
1.082
7.739%
2.843
22.004%
2005
5.358%
2.143
11.481%
2.181
25.045%
2006
8.077%
1.985
16.036%
1.979
31.730%
Company
EBT / Sales
TAT
ROA
FLM
Approx EOE
2002
5.900%
1.500
8.850%
2.294
20.298%
2003
4.800%
1.400
6.720%
2.703
18.162%
2004
3.100%
1.100
3.410%
2.347
8.005%
2005
5.900%
1.500
8.850%
2.353
20.824%
2006
7.400%
1.400
10.360%
2.985
30.925%
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