Chapter 1 Introduction

1. Chapter 1 Introduction

2. Areas of Opportunity in Finance • Financial Services: • Banking • Personal financial planning • Investments • Real estate • insurance • Managerial Finance: • Corporate financial management • Multinational financial management

4. 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.

5. 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.

6. 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 80,00080,000 Net Profit (Loss) $ 20,000 $(80,000)

7. 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 Required Return risk of cash flows

8. 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

9. 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.

10. 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.

11. 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

12. 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.

13. 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.

14. 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.

15. Securities Exchanges Organized Exchanges • Organized securities exchanges aretangible 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.

16. 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”.

17. 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.

18. 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.

19. 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.

20. Business Taxes Debt versus Equity Financing

21. 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.

22. 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.