slide 1-1 chapter 1 introduction. slide 1-2 areas of opportunity in finance financial services:...

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Chapter 1

Introduction

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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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The Managerial Finance Function

• 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.

Relationship to Accounting

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• 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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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 80,000Net Profit (Loss) $ 20,000 $(80,000)

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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:

Share Price = Future Dividends

Required Return

level & timing of cash flows

risk of cash flows

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• 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

The Role of EthicsEthics Defined

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The Agency Issue

• 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.

The Problem

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The Agency Issue

• 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.

Resolving the Problem

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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

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• 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.

Financial Markets

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• 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.

Claims to Wealth

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• 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.

Money and Capital Markets

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Securities ExchangesOrganized 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 ExchangesOver-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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• 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.

Business Taxes

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Business TaxesTax 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 TaxesDebt versus Equity Financing

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.

• 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.

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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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• 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 TaxesCapital 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 1-1 chapter 1 introduction. slide 1-2 areas of opportunity in finance financial services:...

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