Transcript Financial Economics (ENE38E)

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 Market
Fund 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 Market
Is 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 Market
Key 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 Sheet
Balances 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 Sheet
As 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 Statement
Revenue
-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 Flow
Analyses 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 - 2
You 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?