faculty of commerce financial management course

Faculty of CommerceFaculty of Commerce

Financial Management Course Financial Management Course

Chapter 1Chapter 1

The Role and EnvironmentThe Role and Environmentof Managerial Financeof Managerial Finance

Learning GoalsLearning Goals

1. Define finance, its major areas and 1. Define finance, its major areas and opportunities available in this field, and the legal opportunities available in this field, and the legal forms of business organization.forms of business organization.2. Describe the managerial finance function and 2. Describe the managerial finance function and its relationship to economics and accounting.its relationship to economics and accounting.3. Identify the primary activities of the financial 3. Identify the primary activities of the financial manager.manager.4. Explain the goal of the firm, corporate 4. Explain the goal of the firm, corporate governance, the role of ethics, and the agency governance, the role of ethics, and the agency issue.issue.

Learning Goals (cont.)Learning Goals (cont.)

5. Understand financial institutions and5. Understand financial institutions and

markets, and the role they play in markets, and the role they play in managerial finance.managerial finance.

6. Discuss business taxes and their 6. Discuss business taxes and their importance in financial decisions.importance in financial decisions.

What is Finance?What is Finance?

Finance can be defined as the art andFinance can be defined as the art and

science of managing money.science of managing money.

Finance is concerned with the process,Finance is concerned with the process,

institutions, markets, and instrumentsinstitutions, markets, and instruments

involved in the transfer of money amonginvolved in the transfer of money among

individuals, businesses, and governments.individuals, businesses, and governments.

Major Areas & Opportunities inMajor Areas & Opportunities inFinance: Financial ServicesFinance: Financial Services

Financial Services Financial Services is the area of financeis the area of finance

concerned with the design and delivery ofconcerned with the design and delivery of

advice and financial products toadvice and financial products to

individuals, businesses, and government.individuals, businesses, and government.

• • Career opportunities Career opportunities include banking,include banking,

personal financial planning, investments,personal financial planning, investments,

real estate, and insurance.real estate, and insurance.

Major Areas & Opportunities inMajor Areas & Opportunities inFinance: Managerial FinanceFinance: Managerial Finance

Managerial finance Managerial finance is concerned with the duties is concerned with the duties of the financial manager in the business firm.of the financial manager in the business firm.

• • The The financial manager financial manager actively manages theactively manages thefinancial affairs of any type of business, whetherfinancial affairs of any type of business, whetherprivate or public, large or small, profit-seeking orprivate or public, large or small, profit-seeking ornot-for-profit.not-for-profit.• • They are also more involved in developingThey are also more involved in developingcorporate strategy and improving the firm’scorporate strategy and improving the firm’scompetitive position.competitive position.

Major Areas & Opportunities inMajor Areas & Opportunities inFinance: Managerial Finance (cont.)Finance: Managerial Finance (cont.)

Increasing globalization has complicatedIncreasing globalization has complicated

the financial management function by requiring the financial management function by requiring them to be proficient in managing cash flows in them to be proficient in managing cash flows in different currencies and protecting against the different currencies and protecting against the risks inherent in international transactions (more risks inherent in international transactions (more investment, sales, purchases and fund raisinginvestment, sales, purchases and fund raising

• • Changing economic and regulatoryChanging economic and regulatory

conditions also complicate the financialconditions also complicate the financial

management function.management function.

Legal Forms of Business Legal Forms of Business OrganizationOrganization

Sole ProprietorshipSole Proprietorship

PartnershipPartnership

CorporationCorporation


Strength:Strength:

- Owner receives all profits (and sustain all Owner receives all profits (and sustain all loses)loses)

- Low organizational costsLow organizational costs

- Income included and taxed on proprietor’s Income included and taxed on proprietor’s personal tax returnpersonal tax return

- Independence – SecrecyIndependence – Secrecy

- Ease of dissolutionEase of dissolution


Weaknesses:Weaknesses:

- Owner has unlimited liability (wealth can Owner has unlimited liability (wealth can be taken)be taken)

- Limited fund-raisingLimited fund-raising

- Difficult to give employees long-run career Difficult to give employees long-run career opportunitiesopportunities

- Lacks of continuity when proprietor passes Lacks of continuity when proprietor passes awayaway


Strength:Strength:

- Can raise more funds than sole prop.Can raise more funds than sole prop.

- Borrowing power enhanced by more Borrowing power enhanced by more ownersowners

- Brain power and managerial skillsBrain power and managerial skills

- Income included and tax on partner’s Income included and tax on partner’s personal tax returnpersonal tax return



- Owners have unlimited liability (may have Owners have unlimited liability (may have to cover other partners’ debts)to cover other partners’ debts)

- Partnership is dissolved when a partner Partnership is dissolved when a partner diesdies

- Difficult to liquidate or transfer partnershipDifficult to liquidate or transfer partnership


Strength:Strength:- Owners have limited liability (invested lost)Owners have limited liability (invested lost)- can achieve large size thru’ sale of can achieve large size thru’ sale of

ownership (stock) which is transferableownership (stock) which is transferable- Long life of firmLong life of firm- Can hire professional managers Can hire professional managers - Better access to financingBetter access to financing- Offer attractive retirement plansOffer attractive retirement plans



- Taxes higher (both corporate income Taxes higher (both corporate income dividends paid to owners are taxed)dividends paid to owners are taxed)

- More expensiveMore expensive

- Subject to greater government regulationSubject to greater government regulation

- Lacks secrecy, because stock-holders Lacks secrecy, because stock-holders must receive financial reportsmust receive financial reports

Corporate OrganisationCorporate Organisation

Look at Page 7 in the text book (Figure Look at Page 7 in the text book (Figure 1.1)1.1)

Other limited liability organisationsOther limited liability organisations

Look at Page 8 in the text book (Table 1.2)Look at Page 8 in the text book (Table 1.2)

Why study Managerial Finance?Why study Managerial Finance?

Understanding of concepts, techniques, Understanding of concepts, techniques, and practices will fully acquaint you with and practices will fully acquaint you with the financial manager’s activities and the financial manager’s activities and decisionsdecisions

People in all areas of responsibility need a People in all areas of responsibility need a basic understanding as well to get their basic understanding as well to get their duties done (justify labor requirements, duties done (justify labor requirements, negotiate operating budgets….)negotiate operating budgets….)

Managerial Finance FunctionManagerial Finance Function

People in all areas within the firm must People in all areas within the firm must interact with finance personnel and interact with finance personnel and proceduresprocedures

Example: to consider a new product, F.M. Example: to consider a new product, F.M. needs to obtain sales forecasts, pricing needs to obtain sales forecasts, pricing guidelines, advertising and promotion guidelines, advertising and promotion budget estimates from marketing budget estimates from marketing personnel…personnel…

The Managerial Finance FunctionThe Managerial Finance Function

• • The size and importance of the managerialThe size and importance of the managerialfinance function depends on the size of the firm.finance function depends on the size of the firm.• • In small companies, the finance function mayIn small companies, the finance function maybe performed by the company president orbe performed by the company president oraccounting department.accounting department.• • As the business expands, finance typicallyAs the business expands, finance typicallyevolves into a separate department linked to theevolves into a separate department linked to thepresident as was previously described in Figure president as was previously described in Figure

1.11.1

The Managerial Finance Function:The Managerial Finance Function:Relationship to EconomicsRelationship to Economics

• • The field of finance is actually an outgrowth The field of finance is actually an outgrowth of economics.of economics.

• • In fact, finance is sometimes referred to asIn fact, finance is sometimes referred to as

financial economics.financial economics.

• • F.Ms must understand the economic F.Ms must understand the economic framework within which they operate in framework within which they operate in order to react or anticipate to changes in order to react or anticipate to changes in conditionsconditions

The Managerial Finance Function:The Managerial Finance Function:Relationship to Economics (cont.)Relationship to Economics (cont.)

• • The primary economic principal used byThe primary economic principal used by

financial managers is financial managers is marginal cost-benefitmarginal cost-benefit

analysis analysis which says that financialwhich says that financial

decisions should be implemented onlydecisions should be implemented only

when added benefits exceed added costs.when added benefits exceed added costs.

- Give an example, buying new computer (speed - Give an example, buying new computer (speed processing & volume of transactions)processing & volume of transactions)

The Managerial Finance Function:The Managerial Finance Function:Relationship to Economics (cont.)Relationship to Economics (cont.)

Benefits with new PCBenefits with new PC $100,000$100,000

Less: benefits with old PCLess: benefits with old PC $ 35,000$ 35,000

(1) Marginal (added) benefits(1) Marginal (added) benefits $65,000$65,000

Cash of new PCCash of new PC $ 80,000$ 80,000

Less: proceeds from sale of old PCLess: proceeds from sale of old PC $ 28,000$ 28,000

(2) Marginal (added) costs(2) Marginal (added) costs $52,000$52,000

Net Profit {(1) – (2)}Net Profit {(1) – (2)} $13,000$13,000

The Managerial Finance Function:The Managerial Finance Function:Relationship to AccountingRelationship to Accounting

• • The firm’s finance (treasurer) andThe firm’s finance (treasurer) and

accounting (controller) functions areaccounting (controller) functions are

closely-related and overlapping.closely-related and overlapping.

• • In smaller firms, the financial managerIn smaller firms, the financial manager

generally performs both functions.generally performs both functions.

The Managerial Finance Function:The Managerial Finance Function:Relationship to Accounting (cont.)Relationship to Accounting (cont.)

• • One major difference in perspective and One major difference in perspective and emphasis between finance and accounting emphasis between finance and accounting is that accountants generally use the is that accountants generally use the accrual method while in finance, the focus accrual method while in finance, the focus is on is on cash flows (intake & outgo of cash flows (intake & outgo of cash)cash)

• • The significance of this difference can be The significance of this difference can be illustrated using the following simple illustrated using the following simple example.example.


The Nassau Corporation experienced the The Nassau Corporation experienced the following activity last year:following activity last year:

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

CostsCosts $ 80,000 $ 80,000 (all paid in full under supplier terms)(all paid in full under supplier terms)

Now contrast the difference in Now contrast the difference in performance under the accounting method performance under the accounting method versus the cash methodversus the cash method


INCOME STATEMENT SUMMARYINCOME STATEMENT SUMMARY

AccrualAccrual CashCash

SalesSales $100,000$100,000 $0$0

Less: costsLess: costs ($80,000)($80,000) ($80,000)($80,000)

Net Profit/(loss)Net Profit/(loss) $20,000$20,000 $(80,000)$(80,000)


In accounting terms, the Nassau corporation is In accounting terms, the Nassau corporation is profitable, but in the terms of actual cash flow, it profitable, but in the terms of actual cash flow, it is a financial failure.is a financial failure.Accrual accounting data do not fully describe the Accrual accounting data do not fully describe the position of a firm.position of a firm.F.M. must look beyond financial statementsF.M. must look beyond financial statementsF.M. should be able to avoid insolvency and F.M. should be able to avoid insolvency and achieve the firm’s financial goals.achieve the firm’s financial goals.Regardless of its profit or loss, a firm must have Regardless of its profit or loss, a firm must have a sufficient flow of cash to meet its obligations a sufficient flow of cash to meet its obligations as they come dueas they come due


• • Finance and accounting also differ with respect to Finance and accounting also differ with respect to decision-makingdecision-making..

• • While accounting is primarily concerned with the While accounting is primarily concerned with the presentation of financial data, the financial presentation of financial data, the financial manager is primarily concerned with manager is primarily concerned with analyzing analyzing and interpreting and interpreting this information for decision-this information for decision-making purposes.making purposes.

• • The financial manager uses this data as a vital The financial manager uses this data as a vital tool for making decisions about the financial tool for making decisions about the financial aspects of the firm.aspects of the firm.

Primary Activities ofPrimary Activities ofthe Financial Managerthe Financial Manager

Ongoing involvement in financial analysis Ongoing involvement in financial analysis and planningand planningMaking investment decisions: Making investment decisions: This This determines both the mix and the type of determines both the mix and the type of assets held by a firm (debit side of B.S.)assets held by a firm (debit side of B.S.)Making financing decisions:Making financing decisions: This This determines both the mix and the type of determines both the mix and the type of financing used by the firm (credit side of financing used by the firm (credit side of B.S.) – Figure 1.2, P. 13B.S.) – Figure 1.2, P. 13

Goal of the Firm: Maximize Goal of the Firm: Maximize Profit???Profit???

Corporations measure profits in terms of Earnings Per Share (EPS) Corporations measure profits in terms of Earnings Per Share (EPS) which is calculated by dividing the period’s total earnings available which is calculated by dividing the period’s total earnings available for the firm’s common stockholders by the No. of shares of common for the firm’s common stockholders by the No. of shares of common stock outstanding.stock outstanding.

Q?: Is profit maximization is a reasonable goal???Q?: Is profit maximization is a reasonable goal???

Which investment is preferred (marine engine components)Which investment is preferred (marine engine components)

Earnings per share (EPS) Earnings per share (EPS) InvestmentInvestment Year 1Year 1 Year 2Year 2 Year 3Year 3 Total (years 1-3)Total (years 1-3) RotorRotor $1.40$1.40 $1$1 $0.40$0.40 $2.80$2.80ValveValve $0.60$0.60 $1$1 $1.40$1.40 $3.00$3.00

Profit maximization fails to account for differences in the level of Profit maximization fails to account for differences in the level of cash flows (as opposed to profits), the timing of these cash flows, cash flows (as opposed to profits), the timing of these cash flows, and the risk of these cash flows. and the risk of these cash flows.


Valve is preferred !!! However, because of:Valve is preferred !!! However, because of:

1)1) Timing: Rotor is preferred (1Timing: Rotor is preferred (1stst year earns) year earns)

2)2) Cash flows available for stockholders: profits Cash flows available for stockholders: profits do not necessarily result in cash flows do not necessarily result in cash flows available to stockholders. Higher EPS does not available to stockholders. Higher EPS does not mean higher stock price.mean higher stock price.Only when earnings increases are Only when earnings increases are accompanied by increase future cash flows accompanied by increase future cash flows would a higher stock price be expected.would a higher stock price be expected.


3) Risk: Trade-off exists between return (cash flow) and 3) Risk: Trade-off exists between return (cash flow) and risk.risk.

- - Stockholders are risk-averse, i.e. want to avoid risk!Stockholders are risk-averse, i.e. want to avoid risk!- Return and Risk are the key determinants of share price, Return and Risk are the key determinants of share price,

which represents the wealth of owners in a firmwhich represents the wealth of owners in a firm- When risk is involved, stockholders expect to earn higher When risk is involved, stockholders expect to earn higher

rates of return on investments (visa-versa)rates of return on investments (visa-versa)

**Conclusion: as profit max. does not achieve the **Conclusion: as profit max. does not achieve the objectives of firm’s owners, it should be the primary goal objectives of firm’s owners, it should be the primary goal of the financial managerof the financial manager

Goal of the Firm:Goal of the Firm:Maximize Shareholder Wealth!!!Maximize Shareholder Wealth!!!

• • Why?Why?. F.Ms. should accept only actions that are . F.Ms. should accept only actions that are

expected to increase share price.expected to increase share price.• • Because maximizing shareholder wealth Because maximizing shareholder wealth

properly considers cash flows, the timing properly considers cash flows, the timing of these cash flows, and the risk of these of these cash flows, and the risk of these cash flows.cash flows.

• • This can be illustrated using the following This can be illustrated using the following simple stock valuation equation:simple stock valuation equation:


Share Price = Future Dividend/Required Share Price = Future Dividend/Required ReturnReturn

Future dividend considers level & timing of Future dividend considers level & timing of cash flowscash flows

Required return considers risk of cash Required return considers risk of cash flowsflows


The process of shareholder wealthThe process of shareholder wealth

maximization can be described using themaximization can be described using the

following flow chart:following flow chart:

Figure 1.3 – P. 15Figure 1.3 – P. 15

Goal of the Firm:Goal of the Firm:What About Other Stakeholders?What About Other Stakeholders?

• • Stakeholders include all groups of individuals who haveStakeholders include all groups of individuals who havea direct economic link to the firm including employees,a direct economic link to the firm including employees,customers, suppliers, creditors, owners, and others whocustomers, suppliers, creditors, owners, and others whohave a direct economic link to the firm.have a direct economic link to the firm.

• • The "Stakeholder View" prescribes that the firm make aThe "Stakeholder View" prescribes that the firm make aconscious effort to avoid actions that could beconscious effort to avoid actions that could bedetrimental to the wealth position of its stakeholders.detrimental to the wealth position of its stakeholders.

• • Such a view is considered to be "socially responsible.“ No Such a view is considered to be "socially responsible.“ No conflict with stakeholders & maintain positive relationshipconflict with stakeholders & maintain positive relationship

Corporate GovernanceCorporate Governance

Corporate Governance is the system used toCorporate Governance is the system used to

direct and control a corporation.direct and control a corporation.

• • It defines the rights and responsibilities of keyIt defines the rights and responsibilities of key

corporate participants such as shareholders, thecorporate participants such as shareholders, the

board of directors, officers and managers, andboard of directors, officers and managers, and

other stakeholders.other stakeholders.

• • The structure of corporate governance wasThe structure of corporate governance was

previously described in Figure 1.1.previously described in Figure 1.1.

Individual versus Institutional Individual versus Institutional InvestorsInvestors

• • Individual investors are investors who purchaseIndividual investors are investors who purchaserelatively small quantities of shares in order to earn arelatively small quantities of shares in order to earn areturn on idle funds, build a source of retirement income,return on idle funds, build a source of retirement income,or provide financial security.or provide financial security.• • Institutional investors are investment professionals whoInstitutional investors are investment professionals whoare paid to manage other people’s money.are paid to manage other people’s money.• • They hold and trade large quantities of securities forThey hold and trade large quantities of securities forindividuals, businesses, and governments and tend toindividuals, businesses, and governments and tend tohave a much greater impact on corporate governance.have a much greater impact on corporate governance.

The Sarbanes-Oxley Act of 2002The Sarbanes-Oxley Act of 2002

• • The Sarbanes-Oxley Act of 2002 (commonly called SOX) The Sarbanes-Oxley Act of 2002 (commonly called SOX) eliminated many disclosure and conflict of interest eliminated many disclosure and conflict of interest problems that surfaced during the early 2000s.problems that surfaced during the early 2000s.

• • SOX:SOX:– – established an oversight board to monitor the accounting established an oversight board to monitor the accounting

industry;industry;– – tightened audit regulations and controls;tightened audit regulations and controls;– – toughened penalties against executives who committoughened penalties against executives who commitcorporate fraud;corporate fraud;– – strengthened accounting disclosure requirements;strengthened accounting disclosure requirements;– – established corporate board structure guidelines.established corporate board structure guidelines.

The Role of Ethics: Ethics DefinedThe Role of Ethics: Ethics Defined

Ethics is the standards of conduct or moral Ethics is the standards of conduct or moral judgment—have become an overriding judgment—have become an overriding issue in both our society and the financial issue in both our society and the financial communitycommunity

• • Ethical violations attract widespread Ethical violations attract widespread publicitypublicity

• • Negative publicity often leads to negative Negative publicity often leads to negative impacts on a firmimpacts on a firm

The Role of Ethics: Considering The Role of Ethics: Considering EthicsEthics

• • Robert A. Cooke, a noted ethicist, suggests that the Robert A. Cooke, a noted ethicist, suggests that the following questions be used to assess the ethical viability following questions be used to assess the ethical viability of a proposed action:of a proposed action:– – Does the action unfairly single out an individual or Does the action unfairly single out an individual or group?group?– – Does the action affect the morals, or legal rights of Does the action affect the morals, or legal rights of any individual or group?any individual or group?– – Does the action conform to accepted moral standards?Does the action conform to accepted moral standards?– – Are there alternative courses of action that are less Are there alternative courses of action that are less likely to cause actual or potential harm?likely to cause actual or potential harm?

The Role of Ethics:The Role of Ethics:Considering Ethics (cont.)Considering Ethics (cont.)

• • Cooke suggests that the impact of a proposed decision Cooke suggests that the impact of a proposed decision should be evaluated from a number of perspectives:should be evaluated from a number of perspectives:– – Are the rights of any stakeholder being violated?Are the rights of any stakeholder being violated?– – Does the firm have any overriding duties to any Does the firm have any overriding duties to any stakeholder?stakeholder?– – Will the decision benefit any stakeholder to the Will the decision benefit any stakeholder to the detriment of another stakeholder?detriment of another stakeholder?– – If there is a detriment to any stakeholder, how should it If there is a detriment to any stakeholder, how should it be remedied, if at all?be remedied, if at all?– – What is the relationship between stockholders and What is the relationship between stockholders and stakeholders?stakeholders?

The Role of Ethics:The Role of Ethics:Ethics & Share PriceEthics & Share Price

• • Ethics programs seek to:Ethics programs seek to:– – reduce litigation and judgment costsreduce litigation and judgment costs– – maintain a positive corporate imagemaintain a positive corporate image– – build shareholder confidencebuild shareholder confidence– – gain the loyalty and respect of all stakeholdersgain the loyalty and respect of all stakeholders

• • The expected result of such programs isThe expected result of such programs isto positively affect the firm's share price.to positively affect the firm's share price.** Therefore, ethical behaviour is viewed as ** Therefore, ethical behaviour is viewed as

necessary for achieving the firm’s goal of owner necessary for achieving the firm’s goal of owner wealth maximizationwealth maximization

The Agency Issue:The Agency Issue:The Agency ProblemThe Agency Problem

• • Whenever a manager (Agent) owns less than Whenever a manager (Agent) owns less than 100% of the firm’s equity, a potential 100% of the firm’s equity, a potential agency agency problem problem exists (conflict between owners or exists (conflict between owners or corporate goals & personal goals)corporate goals & personal goals)

• • In theory, managers would agree with In theory, managers would agree with shareholder wealth maximization.shareholder wealth maximization.

• • However, managers are also concerned with However, managers are also concerned with their personal wealth, job security, fringe their personal wealth, job security, fringe benefits, and lifestyle. They take moderate risk benefits, and lifestyle. They take moderate risk decisions (reluctant & unwilling to jeopardise)decisions (reluctant & unwilling to jeopardise)

• • This would cause managers to act in ways that This would cause managers to act in ways that do not always benefit the firm shareholders.do not always benefit the firm shareholders.

The Agency Issue:The Agency Issue:Resolving the ProblemResolving the Problem

2 Factors serve to minimize agency problems:2 Factors serve to minimize agency problems:

1• 1• Market Forces Market Forces such as major shareholders such as such as major shareholders such as a) a) institutional investorsinstitutional investors (insurance comp. pension funds) (insurance comp. pension funds) exert pressure on management to perform well, exercise exert pressure on management to perform well, exercise voting rights to respond positively to their concerns) and voting rights to respond positively to their concerns) and b) the threat of a hostile takeoverb) the threat of a hostile takeover act to keep managers act to keep managers in check and motivated to act in the best interests of in check and motivated to act in the best interests of firmsfirms

2• 2• Agency Costs Agency Costs are the costs borne by stockholders to are the costs borne by stockholders to maintain a corporate governance structuremaintain a corporate governance structure that that minimizes agency problems and contributes to the minimizes agency problems and contributes to the maximization of shareholder wealth.maximization of shareholder wealth.

The Agency Issue:The Agency Issue:Resolving the Problem (cont.)Resolving the Problem (cont.)

• • Examples would include bonding orExamples would include bonding ormonitoring management behaviour, andmonitoring management behaviour, andstructuring management compensation tostructuring management compensation tomake shareholders interests their own.make shareholders interests their own.

** 2 key types of compensation plans:** 2 key types of compensation plans:

1• A 1• A stock option stock option is an incentive plan allowingis an incentive plan allowingmanagers to purchase stock at the marketmanagers to purchase stock at the marketprice set at the time of the grant.price set at the time of the grant.

The Agency Issue:The Agency Issue:Resolving the Problem (cont.)Resolving the Problem (cont.)

• • Performance plans Performance plans tie managementtie managementcompensation to measures such as EPScompensation to measures such as EPSgrowth; performance shares and/or cashgrowth; performance shares and/or cashbonuses are used as compensation underbonuses are used as compensation underthese plans.these plans.• • Recent studies have failed to find a strongRecent studies have failed to find a strongrelationship between CEO compensationrelationship between CEO compensationand share price.and share price.* Also, much of evidence suggests that share price * Also, much of evidence suggests that share price

max. is the primary goal of most firmsmax. is the primary goal of most firms

Financial Institutions & MarketsFinancial Institutions & Markets

• • Firms that require funds from externalFirms that require funds from external

sources can obtain them in three ways:sources can obtain them in three ways:

– – through a bank or other financial institutionthrough a bank or other financial institution

– – through financial marketsthrough financial markets

– – through private placementsthrough private placements

Financial Institutions & Markets:Financial Institutions & Markets:Financial InstitutionsFinancial Institutions

• • Financial institutions are Financial institutions are intermediaries intermediaries thatthatchannel the savings of individuals, businesses,channel the savings of individuals, businesses,and governments into loans or investments.and governments into loans or investments.

• • The key suppliers and demanders of funds areThe key suppliers and demanders of funds areindividualsindividuals, , businessesbusinesses, and , and governmentsgovernments..

• • In general, individuals are In general, individuals are net suppliers net suppliers ofoffunds (they save more money than they borrow), funds (they save more money than they borrow), while businesses and governments arewhile businesses and governments arenet demanders net demanders of funds (they borrow more of funds (they borrow more money than they save).money than they save).

Financial Institutions & Markets:Financial Institutions & Markets:Financial MarketsFinancial Markets

• • Financial markets Financial markets provide a forum in which provide a forum in which suppliers of funds and demanders of funds can suppliers of funds and demanders of funds can transact business directly.transact business directly.

• • The two key financial markets are the The two key financial markets are the money money market market and the and the capital marketcapital market..

• • Transactions in short term marketable securities Transactions in short term marketable securities take place in the money market while take place in the money market while transactions in long-term securities take place in transactions in long-term securities take place in the capital market.the capital market.

Financial Institutions & Markets:Financial Institutions & Markets:Financial Markets (cont.)Financial Markets (cont.)

• • Whether subsequently traded in the money orWhether subsequently traded in the money or capital market, securities are first issued throughcapital market, securities are first issued through

the the primary marketprimary market..• • The primary market is the only market in which aThe primary market is the only market in which a

corporation or government is directly involved incorporation or government is directly involved inand receives the proceeds from the transaction.and receives the proceeds from the transaction.

• • Once issued, securities then trade on the Once issued, securities then trade on the secondary markets secondary markets such as the New York such as the New York

Stock Exchange or NASDAQ.Stock Exchange or NASDAQ.

Financial Institutions & Markets:Financial Institutions & Markets:Financial Markets (cont.)Financial Markets (cont.)

Money raising can be done either thru’ :Money raising can be done either thru’ :

1- Private Placements: it involves the sale of 1- Private Placements: it involves the sale of a new security issue (such as bonds, a new security issue (such as bonds, preferred stock…etc)preferred stock…etc)

2- Public Offering (of securities): which is the 2- Public Offering (of securities): which is the non-exclusive sale of either bonds or stock non-exclusive sale of either bonds or stock to the general public to the general public

Relationship between Institutions & Relationship between Institutions & Markets – Market MoneyMarkets – Market Money

. . The The money market money market exists as a result of the exists as a result of the interaction between the suppliers and interaction between the suppliers and demanders of short-term funds (those having a demanders of short-term funds (those having a maturity of a year or less).maturity of a year or less).

. Most money market transactions are made in. Most money market transactions are made inmarketable securities marketable securities which are short-termwhich are short-termdebt instruments such as T-bills and commercial debt instruments such as T-bills and commercial paper.paper.

• • Money market transactions can be executedMoney market transactions can be executeddirectly or through an intermediary.directly or through an intermediary.

The Money Market (cont.)The Money Market (cont.)

• • The international equivalent of the domestic (U.S.) money The international equivalent of the domestic (U.S.) money market is the market is the Eurocurrency marketEurocurrency market..

• • The Eurocurrency market is a market for short-term bank The Eurocurrency market is a market for short-term bank deposits denominated in U.S. dollars or other marketable deposits denominated in U.S. dollars or other marketable currencies.currencies.

• • The Eurocurrency market has grown rapidly mainly The Eurocurrency market has grown rapidly mainly because it is unregulated and because it meets the because it is unregulated and because it meets the needs of international borrowers and lenders.needs of international borrowers and lenders.

The Capital MarketThe Capital Market

• • The The capital market capital market is a market that enables suppliersis a market that enables suppliersand demanders of long-term funds to make transactions.and demanders of long-term funds to make transactions.• • The key capital market securities are The key capital market securities are bonds bonds (long-term(long-termdebt) and both debt) and both common and preferred stock common and preferred stock (equity).(equity).• • Bonds are long-term debt instruments used byBonds are long-term debt instruments used bybusinesses and government to raise large sums ofbusinesses and government to raise large sums ofmoney or capital.money or capital.• • Common stock are units of ownership interest or equityCommon stock are units of ownership interest or equityin a corporation.in a corporation.

In today's financial markets, the distinction between In today's financial markets, the distinction between stocks and and shares has has been somewhat blurred. Generally, these words are used interchangeably been somewhat blurred. Generally, these words are used interchangeably to refer to the pieces of paper that denote ownership in a particular to refer to the pieces of paper that denote ownership in a particular company, called company, called stock certificates. However, the difference between the two . However, the difference between the two words comes from the context in which they are used.words comes from the context in which they are used. For example, "stock" is a general term used to describe the ownership For example, "stock" is a general term used to describe the ownership certificates of any company, in general, and "shares" refers to certificates of any company, in general, and "shares" refers to a the ownership certificates of a particular company. So, if investors say a the ownership certificates of a particular company. So, if investors say they own stocks, they are generally referring to their overall ownership in they own stocks, they are generally referring to their overall ownership in one or more companies. Technically, if someone says that they own shares one or more companies. Technically, if someone says that they own shares - the question then becomes - shares in what company?- the question then becomes - shares in what company?

Bottom line, stocks and shares are the same thing. The minor distinction Bottom line, stocks and shares are the same thing. The minor distinction between stocks and shares is usually overlooked, and it has more to do with between stocks and shares is usually overlooked, and it has more to do with syntax than financial or legal accuracy. syntax than financial or legal accuracy.

Major Securities Exchanges:Major Securities Exchanges:Organized ExchangesOrganized Exchanges

• • Organized securities exchanges are Organized securities exchanges are tangibletangible

secondary markets where outstanding securitiessecondary markets where outstanding securities

are bought and sold.are bought and sold.

• • They account for about 46% of the total dollarThey account for about 46% of the total dollar

volume of domestic shares traded.volume of domestic shares traded.

• • Only the largest and most profitable companiesOnly the largest and most profitable companies

meet the requirements necessary to be meet the requirements necessary to be listedlisted

on the New York Stock Exchange.on the New York Stock Exchange.

Major Securities Exchanges:Major Securities Exchanges:Organized Exchanges (cont.)Organized Exchanges (cont.)

• • Only those that own a seat on the exchange can make Only those that own a seat on the exchange can make transactions on the Floor (there are currently 1,366 transactions on the Floor (there are currently 1,366 seats).seats).

• • Trading is conducted through an Trading is conducted through an auction auction process where process where specialists specialists “make a market” in selected securities.“make a market” in selected securities.

• • As compensation for executing orders, specialists make As compensation for executing orders, specialists make money on the money on the spread (dealers to make profit)spread (dealers to make profit)(bid price: highest price offered by dealers to buy a (bid price: highest price offered by dealers to buy a security) –security) –

(ask price: lowest price dealer is welling to sell a (ask price: lowest price dealer is welling to sell a security).security).

Major Securities Exchanges:Major Securities Exchanges:Over-the-Counter ExchangeOver-the-Counter Exchange

• • The The over-the-counter (OTC) over-the-counter (OTC) market is anmarket is anintangible intangible market for securities transactions.market for securities transactions.

• • Unlike organized exchanges, the OTC is both aUnlike organized exchanges, the OTC is both aprimary primary market and a market and a secondary secondary market.market.

• • The OTC is a The OTC is a computer-based computer-based market wheremarket wheredealers dealers make a market in selected securitiesmake a market in selected securitiesand are linked to buyers and sellers through theand are linked to buyers and sellers through theNASDAQ NASDAQ System (National Association of System (National Association of Securities Dealers Automated Quotation)Securities Dealers Automated Quotation)

• • Dealers also make money on the “spread.”Dealers also make money on the “spread.”

Major Securities Exchanges:Major Securities Exchanges:International Capital MarketsInternational Capital Markets

• • In the In the Eurobond marketEurobond market, corporations and, corporations andgovernments typically issue bonds denominatedgovernments typically issue bonds denominatedin dollars and sell them to investors locatedin dollars and sell them to investors locatedoutside the United States.outside the United States.

• • The The foreign bond market foreign bond market is a market foris a market forforeign bonds, which are bonds issued by aforeign bonds, which are bonds issued by aforeign corporation or government that isforeign corporation or government that isdenominated in the investor’s home currencydenominated in the investor’s home currencyand sold in the investor’s home market.and sold in the investor’s home market.

Major Securities Exchanges:Major Securities Exchanges:Inter. Capital Markets (cont.)Inter. Capital Markets (cont.)

• • Finally, the Finally, the international equity marketinternational equity market

allows corporations to sell blocks ofallows corporations to sell blocks of

shares to investors in a number ofshares to investors in a number of

different countries simultaneously.different countries simultaneously.

• • This market enables corporations to raiseThis market enables corporations to raise

far larger amounts of capital than theyfar larger amounts of capital than they

could raise in any single national market.could raise in any single national market.

The Role of Securities ExchangesThe Role of Securities Exchanges

Efficient markets allocate funds to their Efficient markets allocate funds to their needed financingneeded financing

Draw the Demand and Supply for Draw the Demand and Supply for securities of a firm (favourable discovery securities of a firm (favourable discovery for oil)for oil)

Business TaxesBusiness Taxes

• • Both individuals and businesses must pay taxesBoth individuals and businesses must pay taxeson income.on income.

• • The income of sole proprietorships and partnerships isThe income of sole proprietorships and partnerships istaxed as the income of the individual owners, whereastaxed as the income of the individual owners, whereascorporate income is subject to corporate taxes.corporate income is subject to corporate taxes.

• • Both individuals and businesses can earn Both individuals and businesses can earn two types oftwo types ofincomeincome——ordinary income ordinary income and and capital gains incomecapital gains income..

• • Under current law, tax treatment of ordinary income andUnder current law, tax treatment of ordinary income andcapital gains income change frequently due frequentlycapital gains income change frequently due frequentlychanging tax laws.changing tax laws.

Business Taxes: Ordinary IncomeBusiness Taxes: Ordinary Income

• • Ordinary income is earned through the sale of a Ordinary income is earned through the sale of a firm’s goods or services and is taxed at the rates firm’s goods or services and is taxed at the rates depicted in Table 1.4 in page 30.depicted in Table 1.4 in page 30.

ExampleExampleCalculate federal income taxes due if taxable Calculate federal income taxes due if taxable income is $80,000.income is $80,000.Tax = .15 ($50,000) + .25 ($25,000) + .34 Tax = .15 ($50,000) + .25 ($25,000) + .34 ($80,000 - $75,000)($80,000 - $75,000)Tax = $15,450Tax = $15,450

Business Taxation:Business Taxation:Average & Marginal Tax RatesAverage & Marginal Tax Rates

A firm’s A firm’s marginal tax rate marginal tax rate represents therepresents therate at which additional income is taxed.rate at which additional income is taxed.

• • The The average tax rate average tax rate is the firm’s taxesis the firm’s taxesdivided by taxable income.divided by taxable income.

ExampleExampleWhat is the marginal and average tax rate for What is the marginal and average tax rate for the previous example?the previous example?Marginal Tax Rate = 34%Marginal Tax Rate = 34%Average Tax Rate = $15,450/$80,000 = 19.31%Average Tax Rate = $15,450/$80,000 = 19.31%

Business Taxation:Business Taxation:Tax on Interest & Dividend IncomeTax on Interest & Dividend Income

• • For corporations only, 70% of all dividendFor corporations only, 70% of all dividend

income received from an investment in the stockincome received from an investment in the stock

of another corporation in which the firm has lessof another corporation in which the firm has less

than 20% ownership is excluded from taxation.than 20% ownership is excluded from taxation.

• • This exclusion is provided to avoid This exclusion is provided to avoid tripletriple

taxation for corporations.taxation for corporations.

• • Unlike dividend income, all Unlike dividend income, all interest incomeinterest income

received is fully taxed.received is fully taxed.

Business Taxation:Business Taxation:Debt versus Equity FinancingDebt versus Equity Financing

• • In calculating taxes, corporations may deduct operating In calculating taxes, corporations may deduct operating expenses and interest expense but not dividends paid.expenses and interest expense but not dividends paid.

• • This creates a built-in tax advantage for using debt This creates a built-in tax advantage for using debt financing as the following example will demonstrate.financing as the following example will demonstrate.Example (look at it in page 32)Example (look at it in page 32)Two companies, Debt Co. and No Debt Co., bothTwo companies, Debt Co. and No Debt Co., bothexpect in the coming year to have EBIT of $200,000.expect in the coming year to have EBIT of $200,000.During the year, Debt Co. will have to pay $30,000 inDuring the year, Debt Co. will have to pay $30,000 ininterest expenses. No Debt Co. has no debt and willinterest expenses. No Debt Co. has no debt and willpay not interest expenses.pay not interest expenses.

Business Taxation:Business Taxation:Debt versus Equity Financ. (cont.)Debt versus Equity Financ. (cont.)

• • As the example shows, the use of debt As the example shows, the use of debt financing can increase cash flow and EPS, financing can increase cash flow and EPS, and decrease taxes paid.and decrease taxes paid.

• • The tax deductibility of interest and other The tax deductibility of interest and other certain expenses reduces their actual certain expenses reduces their actual (after-tax) cost to the profitable firm.(after-tax) cost to the profitable firm.

• • It is the non-deductibility of dividends paidIt is the non-deductibility of dividends paidthat results in double taxation under thethat results in double taxation under thecorporate form of organization.corporate form of organization.

Business Taxation: Capital GainsBusiness Taxation: Capital Gains

• • A A capital gain capital gain results when a firm sells an assetresults when a firm sells an asset

such as a stock held as an investment for moresuch as a stock held as an investment for more

than its initial purchase price.than its initial purchase price.

• • The difference between the sales price and theThe difference between the sales price and the

purchase price is called a capital gain.purchase price is called a capital gain.

• • For corporations, capital gains are added toFor corporations, capital gains are added to

ordinary income and taxed like ordinary incomeordinary income and taxed like ordinary income

at the firm’s marginal tax rate.at the firm’s marginal tax rate.

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