Dr. Mariusz Dyba Institute of Economic Sciences mariusz_dybal@prawo.uni.wroc.

pl Economic analysis of the firm The role and environment of finance (lecture 1)
(Based upon: Lawrance J. Gitman, Principles of managerial finance, Pearson/Addison Wesley, 2006)

Scheme of the Lecture 1. Learning goals; 2. Finance and business; 3. The finance function; 4. Goal of the firm; 5. Financial institutions and markets 6. Business taxes; 7. Case study. ----------------------------------------------------------------------------------1. Learning Goals i. Define finance, its major areas and opportunities available in this field, and the legal forms of business organization. ii. Describe the managerial finance function and its relationship to economics and accounting. iii. Identify the primary activities of the financial manager. iv. Explain the goal of the firm, corporate governance, the role of ethics, and the agency issue. ----------------------------------------------------------------------------------------1.Learning Goals (cont.) v. Understand financial institutions and markets, and the role they play in managerial finance. vi. Discuss business taxes and their importance in financial decisions. ------------------------------------------------------------------------------------2. Finance and business 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. --------------------------------------------------------------------2. Finance and business 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. ---------------------------------------------------------2. Finance and business 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 firms competitive position. ------------------------------------------------------2. Finance and business Legal Forms of Business Organization

-----------------------------------------------------------------2. Finance and business Corporate Organization

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2. Finance and business Other Limited Liability Organizations

-------------------------------------------2. Finance and business Career Opportunities

----------------------------------3. The 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 company president or accounting department. As the business expands, finance typically evolves into a separate department linked to the president as was previously described in Figure 1.1. -----------------------------------------3. The Finance Function: Relationship to Economics

Financial managers must understand the economic framework within which they operate in order to react or anticipate to changes in conditions. ---------------------------------------------------3. The 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. ----------------------------------------------------------------------------3. The Finance Function: Relationship to Economics (cont.) Example of marginal cost-benefit analysis: Jamie Teng is a financial manager for Nord Department Stores, a large chain of upscale department stores operating primarily in western United States. She is currently trying to decide whether to replace one of the firms online computers with a new, more sophisticated one that would both speed processing and handle a larger volume of transactions. The new computer would require a cash outlay of $80,000, and the old computer could be sold to net $28,000. The total benefits from the new computer (measured in todays $) would be $100,000. The benefits over the similar time period from the old computer (measured in todays $) would be $35,000. Applying marginal costbenefit analysis, Jamie organizes the data as follows Benefits with new computer $100,000 Less: Benefits with old computer $ 35,000 (1) Marginal (added) benefits $ 65,000 Cost of new computer $ 80,000 Less: Proceeds from sale of old computer $ 28,000 (2) Marginal (added) costs $ 52,000 Net benefit [(1)-(2)] $ 13,000 Because the marginal (added) benefits of $65,000 exceed the marginal (added) costs of $52,000, Jamie recommends that the firm purchase the new computer to replace the old one. The firm will experience a net benefit of $13,000 as a result of this action. ----------------------------------------------------------------------------------------------3. The 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. ---------------------------------------------------------------------------------3. The 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. ----------------------------------------------------------------------------------3. The Finance Function: Relationship to Accounting (cont.) The Nassau Corporation experienced the following activity last year: Sales Costs $100,000 (1 yacht sold, 100% still uncollected) $ 80,000 (all paid in full under supplier terms)

Now contrast the differences in performance under the accounting method versus the cash method. ----------------------------------------------------------------------------------------------3. The Finance Function: Relationship to Accounting (cont.)

INCOME STATEMENT SUMMARY ACCRUAL CASH Sales $100,000 $ 0 Less: Costs (80,000) (80,000) Net Profit/(Loss) $ 20,000 $(80,000) ---------------------------------------------------------------3. The Finance Function: Relationship to Accounting (cont.) Finance and accounting also differ with respect to decision-making. While accounting is primarily concerned with the presentation of financial data, the financial manager is primarily concerned with analyzing and interpreting this information for decision-making purposes. The financial manager uses this data as a vital tool for making decisions about the financial aspects of the firm. ---------------------------------------------------3. The Finance Function: Primary Activities of the Financial Manager

-------------------------------------------4. Goal of the Firm: Maximize Profit???

Which Investment is Preferred?

Earnings per share (EPS) Investment Rotor Valve

Year 1 $ $ 1.40 $ 0.60 $

Year 2 1.00 $ 1.00 $

Year 3 0.40 $ 1.40 $

Total (years 1-3) 2.80 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. -------------------------------------------4. 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 stock valuation equation:

level & timing of cash flows

Share Price = Future Dividends Required Return

risk of cash flows

--------------------------------------------------------4. Goal of the Firm: Maximize Shareholder Wealth!!! (cont.) The process of shareholder wealth maximization can be described using the following flow chart:

---------------------------------------------4. Goal of the Firm: What About Other Stakeholders? Stakeholders include all groups of individuals who have a direct economic link to the firm including employees, customers, suppliers, creditors, owners, and others who have a direct economic link to the firm. The "Stakeholder View" prescribes that the firm make a conscious effort to avoid actions that could be detrimental to the wealth position of its stakeholders. Such a view is considered to be "socially responsible." --------------------------------------------4. Goal of the Firm: 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. ---------------------------------------------4. Goal of the Firm: Individual versus Institutional Investors Individual investors are investors who purchase relatively small quantities of shares in order to earn a return on idle funds, build a source of retirement income, or provide financial security. Institutional investors are investment professionals who are paid to manage other peoples money. They hold and trade large quantities of securities for individuals, businesses, and governments and tend to have a much greater impact on corporate governance. ----------------------------------------------4. Goal of the Firm: The Role of Ethics: Ethics Defined Ethics is the standards of conduct or moral judgmenthave 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 -------------------------------------------------4. Goal of the Firm: The Role of Ethics: Considering Ethics Robert A. Cooke, a noted ethicist, suggests that the following questions be used to assess the ethical viability of a proposed action: Does the action unfairly single out an individual or group? Does the action affect the morals, or legal rights of any individual or group? Does the action conform to accepted moral standards? Are there alternative courses of action that are less likely to cause actual or potential harm? ---------------------------------------------------------4. Goal of the Firm: 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. -------------------------------------------------------4. Goal of the Firm: The Agency Issue: The Agency Problem Whenever a manager owns less than 100% of the firms 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. ---------------------------------------4. Goal of the Firm: 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. -----------------------------------------------------4. Goal of the Firm: 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. -----------------------------------------------------------4. Goal of the Firm: 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. ----------------------------------------------------------------5. Financial Institutions & Markets Firms that require funds from external sources can obtain them in three ways: through a bank or other financial institution through financial markets through private placements --------------------------------------------------------------5. Financial Institutions & Markets: Financial Institutions

Financial institutions are intermediaries that channel the savings of individuals, businesses, and governments into loans or investments. The key suppliers and demanders of funds are individuals, businesses, and governments. In general, individuals are net suppliers of funds, while businesses and governments are net demanders of funds. ----------------------------------------------5. Financial Institutions & Markets: Financial Markets Financial markets provide a forum in which suppliers of funds and demanders of funds can transact business directly. The two key financial markets are the money market and the capital market. Transactions in short term marketable securities take place in the money market while transactions in longterm securities take place in the capital market. -------------------------------------------5. Financial Institutions & Markets: Financial Markets (cont.) Whether subsequently traded in the money or capital market, securities are first issued through the primary market. The primary market is the only one in which a corporation or government is directly involved in and receives the proceeds from the transaction. Once issued, securities then trade on the secondary markets such as the New York Stock Exchange or NASDAQ. -----------------------------------------------5. Financial Institutions & Markets: The Relationship between Financial Institutions and Financial Markets

----------------------------------5. Financial Institutions & Markets: The Money Market The money market exists as a result of the interaction between the suppliers and demanders of short-term funds (those having a maturity of a year or less). Most money market transactions are made in marketable securities which are short-term debt instruments such as T-bills and commercial paper. Money market transactions can be executed directly or through an intermediary. ----------------------------------------------------------------------5. Financial Institutions & Markets:

The Capital Market The capital market is a market that enables suppliers and demanders of long-term funds to make transactions. The key capital market securities are bonds (long-term debt) and both common and preferred stock (equity). Bonds are long-term debt instruments used by businesses and government to raise large sums of money or capital. Common stock are units of ownership interest or equity in a corporation. --------------------------------------------------------------------5. Financial Institutions & Markets: The Role of Securities Exchanges

--------------------------------6. 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 incomeordinary income and capital gains income. Under current law, tax treatment of ordinary income and capital gains income change frequently due frequently changing tax laws. --------------------------------------------------------------------------6. Business Taxes: Ordinary Income

Ordinary income is earned through the sale of a firms 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

----------------------------------------------------------6. Business Taxes: Ordinary Income (cont.)

-----------------------------------------6. Business Taxes: 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 = 34% Average Tax Rate = $15,450/$80,000 = 19.31%

-----------------------------------------6. 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 firms marginal tax rate. -----------------------------------------------------------------7. Case study no. 1 Ken Allen, capital budgeting analyst for Bally Gears, Inc., has been asked to evaluate a proposal. The manager of the automotive division belives that replacing the robotics used on the heavy truck gear line will produce total benefits of $560,000 (in todays $) over the next 5 years. The existing robotics would produce benefits of $400,000 (also in todays $) over the same time period. An initial cash investment of $220,000 would be required to install the new equipment. The manager estimates that the existing robotics can be sold for $70,000. Show how Ken will apply marginal cost-benefit analysis techniques to determine the following: 1. The marginal (added) benefits of the proposed new robotics. 2. The marginal (added) cost of the proposed new robotics. 3. The net benefit of the proposed new robotics. 4. What should Ken Allen recommend that the company do? Why? 5. What factors besides the costs and benefits should be considered before the final decision is made? -------------------------------------------------------------------------Thank You ;)

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