Role and Environment of Managerial Finance (CH1)

Finance is concerned with the process, institutions, markets, and instruments involved in the transfer of money

The knowledge of finance provides a chance to make better financial decisions

Major areas in Finance:

• Financial services (banks, brokerage firms..)

• Managerial finance (duties of the financial manager)

Managerial finance function and its relationship to economics and accounting

The size of the firm determines the function of the managerial finance. (small firms – finance function performer by the accounting department, Huge corporations – special department/s).

Included – financial planning, fund raising, making capital expenditure decisions, managing cash (chief financial manager), corporate accounting, tax management, cost accounting (chief accountant)

Relationship to Economics – must respect the economic framework, marginal cost-benefit analysis (financial decision, added benefits must exceed the added costs)

Relationship to Accounting – generally overlap, differences – accrual basis x CF basis, presentation of data x evaluating and interpreting of data

Primary activities of financial manager – making investment decisions, making financing decisions

Goal of the firm

Maximize profit x maximize the wealth of the owners?

• EPS (is not equal to dividend, unrelated to expected CFs - timing, does not measure risk) x

• Stock Price (in theory increase when all relevant measures are in equilibrium)

The Role of Ethics – effective ethics program is believed to enhance corporate value

Agency problem – connected with ethics = the likelihood that managers may place personal goals ahead of corporate/owners’ goals

Minimizing agency problem:

• Market forces (existence of major shareholder, the threat of takeover)

• Agency costs (costs of maintaining a corporate governance structure that monitors management behavior, and gives managers incentive to maximize share price..)

Financial MarketFund raising:

• Financial institutions

• Financial markets

• Private placement

Financial institutions serve as intermediaries by channeling the savings of individuals (net suppliers of funds) into loans and investment, provided to businesses and governments (both are net demanders of funds)

Financial MarketIs divided in

• Money market (short-term securities)

• Capital market (long-term securities)

• Primary market

• Secondary market

Financial Institutions actively participate in the financial market as both suppliers and demanders of funds (banks, investment companies, brokerage firms, pension funds, insurance companies..)

Capital MarketKey securities: Bonds, Stocks

Organizations that provide the marketplace in which firms can raise funds, and investors can resell securities, are securities exchanges

Two types of securities exchanges:

• Organized securities exchanges (NYSE, AMEX)

• The over-the-counter exchange (OTC)

The role of SE is to create liquid markets in which firms can obtain needed financing

Taxes

Types of income: • Ordinary income (earned through the sale of goods and services)

• Capital Gains (difference between the sale price and the purchase price, are added to ordinary income)

Tax-deductible Expenses • Operating expenses

• Interest expenses

Taxes

Average tax rate = Taxes / Taxable income

Marginal tax rate represents the rate at which additional income is taxed. It is given by the Corporate Tax Rate Schedule

Tax calculation:Taxes = Base tax + Marginal rate*Amount over base bracket

Range of taxable income is derived from the Corporate Tax Rate Schedule

Financial Statements

The Income Statement (financial summary of the firm‘s operating result during a specified period) The Balance Sheet (summary statement of the firm‘s financial position at a given point in time) The Statement of Cash Flows (summary of the cash flows over a specified period)The Statement of Retained Earnings (abbreviated form of the statement of stockholders´ equity)

The Balance SheetBalances the firm‘s assets against its financing (debt or equity)

Short-term x Long-term assets and liabilities:

Shotr-term (current assets and liabilities) – they are expected to be converted into cash or paid within 1 year or less.

Long-term (fixed assets, equity, long term debt) – they are expected to remain on the firm‘s books for more than 1 year.

The Balance SheetAs is customary, the assets are listed from the most liquid (cash) down to the least liquid.

Assets

Current assets Fixed assets

Liabilities and Equity

Current liabilities Long term debt / liabilities

Equity

The Income Statement

Provides a financial summary of the firm‘s operating result during a specified period.

Most common are income statements covering a 1-year period ending December 31. Monthly statements are prepared for use by management. Quarterly statements must be made available to the stockholders of publicly owned corporations.

The Income StatementRevenue

-Cost of goods sold

= Gross profit -Operating expenses

= Operating profit (EBIT) -Financial cost

= Net profit before taxes (EBT) -Taxes

= Net profit after taxes (EAT)

The Statement of Cash FlowAnalyses the firm’s ability to generate cash and cash equivalents

Statement of CF shows: • Where did the cash come from? • What was it used for? • What was the change in the cash balance?

Operating, Investing and Financing activities

Sources vs. Usage of funds

The Statement of Retained Earnings

• reconciles the net income earned during a given year, and any dividends paid, with change in retained earnings between the start and the end of that year

Retained earnings balance (beginning of the year)

+ EAT

- Dividends paid

= Retained earnings balance (end of the year)

Exercise 1 - 2You are a treasurer at AIMCO, who develops technology for video conferencing

•Manager of a division asks you to authorize a capital expenditure of $10,000

•The funds are for a project on which $2,5 million had been spent over the past years

•He admits though that the technology concept developed has been surpassed

•Use marginal cost-benefit analysis

Exercise 1 – 2 Solution

• Sunk costs – ignored by marginal benefit analysis = $2,5m are irrelevant

• Will the $10,000 additional investment generate a revenue exceeding $10,000?

- Compare to other possible projects

- Competitors, industry, new technology

Exercise 1 - 3• The end of the year party

• The treasurer’s staff contends that the firm is running low on cash and might have trouble paying its bills.

• The controller’s staff disagrees as the firm continues to be very profitable.

• Who is right? Can both sides be right?

Exercise 1 – 3 Solution

• Cash Flow vs. Accrued Profits

• Expenses have shorter due date than expected revenues

• Short term financing is needed to meet debt obligations before the revenue arrives

• Cash crunch, company experience, employee morale

Problem 1 - 2

Marginal cost benefit analysis

• Benefits from new robotics $560,000

• Benefits from old robotics $400,000

• Cost of new equipment $220,000

• Sale of old equipment $70,000

• Calculate marginal benefits, costs, net benefit.

• What do you recommend that the company do? Why?

• What other factors should you consider?

Problem 1 – 2 Solution

Marginal benefits = 560,000 - 400,000 = 160,000

Marginal cost = 220,000 - 70,000 = 150,000

Net benefits = MB - MC = 10,000

Net benefits are positive = recommend replacement

Other factors affecting expected return - timing, cash flow and risk

Problem 1 – 3

Accrual income versus cash flow

• Value of books shipped $760,000

• Collected in cash $690,000

• Cost of books $300,000

• Using accrual accounting show the firm’s net profit

• Using cash accounting show the firm’s net cash flow

• Which of the statements is more useful to the financial manager and why?

Problem 1 – 3 Solution

• Net profit = Sales - Cost of goods sold = 760,000 - 300,000 = 460,000

• Net cash flow = Cash receipts - Cost of goods sold = 690,000 - 300,000 = 390,000

• Cash flow statement is more useful to financial manager

Problem 1 - 5

Corporate Taxes

• EBIT = $92,500

• $75,000 to $100,000

– Base tax 13,750 + 34% * amount over $75,000

• Calculate firm’s tax liability.

• How much are after tax earnings?

• What was the firm’s average tax rate?

• What was the firm’s marginal tax rate?

Problem 1 – 5 Solution

Total taxes due

= 13,750+[0.34*(92,500-75,000)] =

= 13,750+5,950 = 19,700

After tax earnings: 92,500 - 19,700 = 72,800

Average tax rate: 19,700 / 92,500 = 21,3%

Marginal tax rate: 34%

Problem 1 - 9

Problem 1 - 9

(a) EBIT $40,000

Less: Interest expense 10,000

Earnings before taxes $30,000

Less: Taxes (40%) 12,000

Earnings after taxes* $18,000

* This is also earnings available to common stockholders.

(b) EBIT $40,000

Less: Taxes (40%) 16,000

Earnings after taxes $24,000

Less: Preferred dividends 10,000

Earnings available for common stockholders $14,000

Problem 1 - 11

Problem 1 – 11 Solution

Problems 2-2, 2-3, 2-4, 2-5

See book or PDF(moodle)

Thank You for Your attention

Questions?