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.
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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.
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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.
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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.
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Table 1.1 Strengths and Weaknesses of the Common Legal Forms of Business Organization
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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.
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The Managerial Finance Function: 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.
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The Managerial Finance Function: Relationship to Accounting The firms finance (treasurer) and accounting (controller) functions are closely-related and overlapping. In smaller firms, the financial manager generally performs both functions.
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The Managerial Finance Function: 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.
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Now contrast the differences in performance under the accounting method versus the cash method.
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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.
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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
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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.
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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.
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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.
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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.
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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.
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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.
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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.
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Business Taxation: Average & Marginal Tax Rates A firms marginal tax rate represents the rate at which additional income is taxed. The average tax rate is the firms taxes divided by taxable income.
Example What is the marginal and average tax rate for the previous example? Marginal Tax Rate Average Tax Rate = 34% = $15,450/$80,000 = 19.31%
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