C1 THE ROLE AND ENVT OF MANAGERIAL FINANCE Gitman - PPT - CH01

Chapter 1
The Role and

Environment
of Managerial
Finance
Copyright © 2009 Pearson Prentice Hall. All rights reserved.

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.
Copyright © 2009 Pearson Prentice Hall. All rights reserved. 1-2

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.

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.

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.

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.

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.

Table 1.1 Strengths and Weaknesses of the
Common Legal Forms of Business Organization

Figure 1.1 Corporate Organization

Table 1.2 Other Limited Liability
Organizations

Table 1.3 Career Opportunities in
Managerial Finance

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.

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.

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.

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.

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.

• The Nassau Corporation experienced the following

activity last year:
Sales $100,000 (1 yacht sold, 100% still uncollected)

Costs $ 80,000 (all paid in full under supplier terms)
• Now contrast the differences in performance under the

accounting method versus the cash method.

INCOME STATEMENT SUMMARY
ACCRUAL CASH
Sales $100,000 $ 0
Less: Costs (80,000) (80,000)
Net Profit/(Loss) $ 20,000 $(80,000)

• 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.

Figure 1.2 Financial Activities

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.

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

Goal of the Firm:
Maximize Shareholder Wealth!!! (cont.)
• The process of shareholder wealth maximization

can be described using the following flow chart:
Figure 1.3 Share Price Maximization

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."

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.

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.

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.

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

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?

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?

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.

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.

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.

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.

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.

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

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.

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.

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.

Figure 1.4 Flow of Funds

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.

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.

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.

Broker Markets and Dealer Markets
• Broker markets consists of national and regional

securities exchanges, which are organizations that
provide a marketplace in which firms can raise funds
the sale of new securities and purchasers can resell
securities
• Dealer markets consist of both the Nasdaq market
and and the over-the-counter (OTC) market, where
the (unlisted) shares of smaller firm shares are sold
and traded.
(continued)
• The key difference between broker and dealer markets

is a technical point dealing with the way trades are
executed.
• When a trade occurs in a broker market, buyers and
sellers are brought together and the trade takes place on
the floor of the exchange.
• In contrast, buyers and sellers are never actually
brought together in a dealer – transactions are executed
by securities dealers that make markets in certain
securities.

(cont.)
• The New York Stock Exchange (NYSE) is the most

famous of all broker markets and accounts for about
60% of the value of shares traded in the U.S. stock
markets.
• 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).

(cont.)
• 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.”

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.

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.

The Role of Securities Exchanges
Figure 1.5 Supply and Demand

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.

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

Business Taxation: Ordinary Income
Table 1.4 Corporate Tax Rate Schedule

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%

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.

Business Taxation (Tax Deductibility):
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.

Debt versus Equity Financing (cont.)

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.

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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Chapter 1

The Role and

Copyright © 2009 Pearson Prentice Hall. All rights reserved.

1. Define finance, its major areas and opportunities

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 1-2

5. Understand financial institutions and markets,

6. Discuss business taxes and their importance in

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 1-3

• Finance can be defined as the art and science of

• Finance is concerned with the process,

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 1-4

• Financial Services is the area of finance

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 1-5

• Managerial finance is concerned with the duties of the

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 1-6

• Increasing globalization has complicated the

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 1-7

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 1-8

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 1-9

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 1-10

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 1-11

• The size and importance of the managerial finance

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 1-12

• The field of finance is actually an outgrowth of

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 1-13

• The primary economic principal used by

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 1-14

• The firm’s finance (treasurer) and accounting

• In smaller firms, the financial manager generally

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 1-15

• One major difference in perspective and

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 1-16

• The Nassau Corporation experienced the following

Sales $100,000 (1 yacht sold, 100% still uncollected)

• Now contrast the differences in performance under the

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 1-17

INCOME STATEMENT SUMMARY

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 1-18

• Finance and accounting also differ with respect to

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 1-19

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 1-20

Which Investment is Preferred?

Earnings per share (EPS)

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 1-21

level & timing

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 1-22

• The process of shareholder wealth maximization

Figure 1.3 Share Price Maximization

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 1-23

• Stakeholders include all groups of individuals who

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 1-24

• Corporate Governance is the system used to direct and

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 1-25

• Individual investors are investors who purchase relatively small

• Institutional investors are investment professionals who are paid

• They hold and trade large quantities of securities for individuals,

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 1-26

• The Sarbanes-Oxley Act of 2002 (commonly called SOX)

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 1-27

• Ethics is the standards of conduct or moral

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 1-28

• Robert A. Cooke, a noted ethicist, suggests that the

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 1-29