Chapter 1
Introduction
Slide 1-1
Areas of Opportunity in Finance
• Financial Services:
– Banking
– Personal financial planning
– Investments
– Real estate
– insurance
• Managerial Finance:
– Corporate financial management
– Multinational financial management
Slide 1-2
Slide 1-3
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.
Slide 1-4
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.
Slide 1-5
The Managerial Finance Function
Relationship to Accounting
Income Statement
Thomas Yachts
For the year ended 12/31
Accounting ViewFinancial View
(accrual basis)
(cash basis)
Sales
$100,000
$
0
Less: Costs
80,000
80,000
Net Profit (Loss)
$ 20,000
$(80,000)
Slide 1-6
Goal of the Firm
• Why?
Maximize Shareholder Wealth!!!
• Because maximizing shareholder wealth properly
considers cash flows, the timing of these cash flows,
and the risk of these cash flows.
• This can be illustrated using the following simple
valuation equation:
Share Price = Future Dividends
Required Return
level & timing
of cash flows
risk of cash
flows
Slide 1-7
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
Slide 1-8
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.
Slide 1-9
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.
Slide 1-10
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
Slide 1-11
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.
Slide 1-12
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.
Slide 1-13
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.
Slide 1-14
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.
Slide 1-15
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”.
Slide 1-16
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.
Slide 1-17
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.
Slide 1-18
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.
Slide 1-19
Business Taxes
Debt versus Equity Financing
Operating Profit (EBIT)
$
Less: Interest Expense
Earnings Before Taxes
Difference Earnings After Taxes
Equity
Financing
Financing
700,000
$
30,000
$
Less: Taxes (40%)
Earnings After Taxes
Debt
670,000
$
268,000
$
402,000
700,000
700,000
280,000
$
420,000
$18,000
Slide 1-20
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.
Slide 1-21
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.
Slide 1-22