Chapter The Role and Environment of Managerial Finance Learning Goals Define finance, its major areas and opportunities available in this field, and the legal forms of business organization Describe the managerial finance function and its relationship to economics and accounting Identify the primary activities of the financial manager Explain the goal of the firm, corporate governance, the role of ethics, and the agency issue Copyright © 2006 Pearson Addison-Wesley All rights reserved 1-2 Learning Goals (cont.) Understand financial institutions and markets, and the role they play in managerial finance Discuss business taxes and their importance in financial decisions Copyright © 2006 Pearson Addison-Wesley All rights reserved 1-3 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 Copyright © 2006 Pearson Addison-Wesley All rights reserved 1-4 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 Copyright © 2006 Pearson Addison-Wesley All rights reserved 1-5 Major Areas & Opportunities in Finance: 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 Copyright © 2006 Pearson Addison-Wesley All rights reserved 1-6 Major Areas & Opportunities in Finance: 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 Copyright © 2006 Pearson Addison-Wesley All rights reserved 1-7 Legal Forms of Business Organization Copyright © 2006 Pearson Addison-Wesley All rights reserved 1-8 Corporate Organization Copyright © 2006 Pearson Addison-Wesley All rights reserved 1-9 Other Limited Liability Organizations Copyright © 2006 Pearson Addison-Wesley All rights reserved 1-10 Major Securities Exchanges: Organized Exchanges • Organized securities exchanges are tangible secondary markets where outstanding securities are bought and sold • They account for about 46% of the total 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 Copyright © 2006 Pearson Addison-Wesley All rights reserved 1-44 Major Securities Exchanges: Organized Exchanges (cont.) • Only those that own a seat on the exchange can make transactions on the floor (there are currently 1,366 seats) • 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) Copyright © 2006 Pearson Addison-Wesley All rights reserved 1-45 Major 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.” Copyright © 2006 Pearson Addison-Wesley All rights reserved 1-46 Major Securities Exchanges: 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 Copyright © 2006 Pearson Addison-Wesley All rights reserved 1-47 Major Securities Exchanges: 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 Copyright © 2006 Pearson Addison-Wesley All rights reserved 1-48 The Role of Securities Exchanges Copyright © 2006 Pearson Addison-Wesley All rights reserved 1-49 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 Copyright © 2006 Pearson Addison-Wesley All rights reserved 1-50 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 Copyright © 2006 Pearson Addison-Wesley All rights reserved 1-51 Business Taxation: Ordinary Income Copyright © 2006 Pearson Addison-Wesley All rights reserved 1-52 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% Copyright © 2006 Pearson Addison-Wesley All rights reserved 1-53 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 Copyright © 2006 Pearson Addison-Wesley All rights reserved 1-54 Business Taxation: 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 Copyright © 2006 Pearson Addison-Wesley All rights reserved 1-55 Business Taxation: Debt versus Equity Financing (cont.) Copyright © 2006 Pearson Addison-Wesley All rights reserved 1-56 Business Taxation: 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 Copyright © 2006 Pearson Addison-Wesley All rights reserved 1-57 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 Copyright © 2006 Pearson Addison-Wesley All rights reserved 1-58 ... 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. .. economics and accounting Identify the primary activities of the financial manager Explain the goal of the firm, corporate governance, the role of ethics, and the agency issue Copyright © 2006... 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 Copyright