copyright © 2012 pearson prentice hall. all rights reserved. chapter 1 the role of managerial...

Copyright © 2012 Pearson Prentice Hall. All rights reserved.

Chapter 1

The Role of Managerial

Finance

COURSE DESCRIPTION

Business Finance is an examination of the principles, theory and techniques of

modern corporate financial management. Topics such as risk, return, valuation of

securities and projects, long-term financing and the financial environment are

explored.

COURSE MATERIALS

Textbooks

– Gitman, Lawrence J., Chad J. Zutter, (2012) Principles of Managerial Finance (13th ed.) Addison-Wesley, Reading MA.

– MyFinance Lab add-in

Supplemental Materials

– Notes and homework documents are accessed from MYTMC.

Computing / Software

– It is assumed that all students have a basic understanding of the use of Excel spreadsheet.

– There is an Excel spreadsheet to download from the Handout section of MYTMC.

– All individual homework and exams are completed via MyFinance LAB

EVALUATION CRITERIA / GRADING POLICY

(70 - 100%) = Pass

(69 % or less)= F

If you have a documented physical or learning disability for which you require special accommodations, please see;

Coordinator for Academic Student Support Services, Administration Building Rm.3325,

(513) 344-3521This includes students who have had accommodations from TMC in the past.

GRADE COMPOSITION (TRADITIONAL)

Quizzes 50%

Homework 50%

Grades are based on the total number of

correct points achieved out of the total possible.

The above percentages represent an approximate distribution of the grading.

© 2012 Pearson Prentice Hall. All rights reserved. 1-6

Career Opportunities in Finance: Managerial Finance

• Managerial finance is concerned with the duties of the financial manager working in a business.

• Financial managers administer the financial affairs of all types of businesses—private and public, large and small, profit-seeking and not-for-profit.

• They perform such varied tasks as developing a financial plan or budget, extending credit to customers, evaluating proposed large expenditures, and raising money to fund the firm’s operations.

• Very involved with strategic planning and implementation


Managerial Finance (cont.)

• The recent global financial crisis and subsequent responses by governmental regulators, increased global competition, and rapid technological change also increase the importance and complexity of the financial manager’s duties.

• Increasing globalization has increased demand for financial experts who can manage cash flows in different currencies and protect against the risks that naturally arise from international transactions.


Legal Forms of Business Organization

• A sole proprietorship is a business owned by one person and operated for his or her own profit.

• A partnership is a business owned by two or more people and operated for profit.

• A corporation is an entity created by law. Corporations have the legal powers of an individual in that it can sue and be sued, make and be party to contracts, and acquire property in its own name.

• Finance theories and techniques apply to all.

What is the Goal of the firm?

• Is there a benchmark that serves as an appropriate measure of whether an action should proceed or not?

• Maximize profit

• Minimize expenses

• Maximize marketing share

• Maximize share price

• Maximize stakeholder wealth



Goal of the Firm: Maximize Shareholder Wealth

Decision rule for managers: only take actions that are expected to increase the share price.


Share Price = Future Dividends

Required Return

level & timing of cash flows

risk of cash flows

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 is primarily what the owners want

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


Goal of the Firm: What About Stakeholders?

• Stakeholders are groups such as employees, customers, suppliers, creditors, owners, and others who have a direct economic link to the firm.

• A firm with a stakeholder focus consciously avoids actions that would prove detrimental to stakeholders. The goal is not to maximize stakeholder well-being but to preserve it.

• Such a view is considered to be "socially responsible."


The Role of Business Ethics

• Business ethics are the standards of conduct or moral judgment that apply to persons engaged in commerce.

• Violations of these standards in finance involve a variety of actions: “creative accounting,” earnings management, misleading financial forecasts, insider trading, fraud, excessive executive compensation, options backdating, bribery, and kickbacks.

• Negative publicity often leads to negative impacts on a firm


The Role of Business Ethics: Ethics and 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.

Is there a place in business for the “Golden Rule”??


Managerial Finance Function: Relationship to Economics

• Financial managers must understand the economic framework and be alert to the consequences of varying levels of economic activity and changes in economic policy.

• They must also be able to use economic theories as guidelines for efficient business operation.

• Marginal cost–benefit analysis is the economic principle that states that financial decisions should be made and actions taken only when the added benefits exceed the added costs


Managerial Finance Function: Relationship to Accounting

• The firm’s finance and accounting activities are closely-related and generally overlap.

• In small firms accountants often carry out the finance function, and in large firms financial analysts often help compile accounting information.

• 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.


Managerial Finance Function: Relationship to Accounting (cont.)

Finance and accounting also differ with respect to decision-making:

– Accountants devote most of their attention to the collection and presentation of financial data.

– Financial managers evaluate the accounting statements, develop additional data, and make decisions on the basis of their assessment of the associated returns and risks.


Governance and Agency: Corporate Governance

• Corporate governance refers to the rules, processes, and laws by which companies are operated, controlled, and regulated.

• It defines the rights and responsibilities of the corporate participants such as the shareholders, board of directors, officers and managers, and other stakeholders, as well as the rules and procedures for making corporate decisions.


Governance and Agency: Government Regulation

The Sarbanes-Oxley Act of 2002: • established an oversight board to monitor the accounting industry;

• tightened audit regulations and controls;

• toughened penalties against executives who commit corporate fraud;

• strengthened accounting disclosure requirements and ethical guidelines for corporate officers;

• established corporate board structure and membership guidelines;

• established guidelines with regard to analyst conflicts of interest;

• mandated instant disclosure of stock sales by corporate executives;

• increased securities regulation authority and budgets for auditors and investigators.


Governance and Agency: The Agency Issue

• A principal-agent relationship is an arrangement in which an agent acts on the behalf of a principal. For example, shareholders of a company (principals) elect management (agents) to act on their behalf.

• Agency problems arise when managers place personal goals ahead of the goals of shareholders.

• Agency costs arise from agency problems that are borne by shareholders and represent a loss of shareholder wealth.


The Agency Issue: The Agency Problem

Whenever a manager owns less than 100% of the firm’s 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 might not always benefit the firm shareholders.


The Agency Issue: Management Compensation Plans

• Incentive plans are management compensation plans that tie management compensation to share price; one example involves the granting of stock options.

• Performance plans tie management compensation to measures such as EPS or growth in EPS. Performance shares and/or cash bonuses are used as compensation under these plans.


Options

• Option is the right to buy a stock at a certain price within a certain period of time.– Creates another place for people to acquire

company stock.

You have an option to buy a share of stock at $50. The current price is $35.

Where would you buy?

You have an option to buy a share of stock at $50. After several years of good management the price has risen to $65.

Where would you buy?


Matter of Fact—Forbes.com CEO Performance vs. Pay


The Agency Issue: The Threat of Takeover

• When a firm’s internal corporate governance structure is unable to keep agency problems in check, it is likely that rival managers will try to gain control of the firm.

• The threat of takeover by another firm, which believes it can enhance the troubled firm’s value by restructuring its management, operations, and financing, can provide a strong source of external corporate governance.

Chapter 2 Financial Market Environment



Commercial Banks, Investment Banks,

and the Shadow Banking System

• The Glass-Steagall Act was an act of Congress in 1933 that created the federal deposit insurance program and separated the activities of commercial and investment banks.– Repealed in the late 1990s.

• The shadow banking system describes a group of institutions that engage in lending activities, much like traditional banks, but these institutions do not accept deposits and are therefore not subject to the same regulations as traditional banks.


Financial Institutions & Markets: Financial Markets

• Financial markets are forums in which suppliers of funds and demanders of funds can transact business directly.

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

• A private placement involves the sale of a new security directly to an investor or group of investors.

• Most firms, however, raise money through a public offering of securities, which is the sale of either bonds or stocks to the general public.


Financial Institutions & Markets: Financial Markets (cont.)

• The primary market is the financial market in which securities are initially issued; the only market in which the issuer is directly involved in the transaction.

• IPO

• Seasoned Shares

• Only time issuer gets funds from investors

• Secondary markets are financial markets in which pre-owned securities (those that are not new issues) are traded.


Markets

• The money market is created by a financial relationship between suppliers and demanders of short-term funds.

• marketable securities

• among the least risky investments available.

• The capital market is a market that enables suppliers and demanders of long-term funds to make transactions.

• The key securities are bonds and both common and preferred stock.


Broker Markets and Dealer Markets

Broker markets are securities exchanges on which the two sides of a transaction, the buyer and seller, are brought together to trade securities.

– Trading takes place on centralized trading floors.

– NYSE

Dealer markets are markets in which the buyer and seller are brought together indirectly via computers

– no centralized trading floors.

– The Nasdaq market is one example

–OTC


The Role of Capital Markets

• From a firm’s perspective, the role of capital markets is to be a liquid market where firms can interact with investors in order to obtain valuable external financing resources.

• From investors’ perspectives, the role of capital markets is to be an efficient market that allocates funds to their most productive uses.

• An efficient market allocates funds to their most productive uses as a result of competition among wealth-maximizing investors and determines and publicizes prices that are believed to be close to their true value.

Exchanges

• NYSE

• http://www.youtube.com/watch?v=TPUDPhpCecA&feature=player_detailpage

• CBOE

• http://www.youtube.com/watch?v=_UXomMnQKT4&feature=player_detailpage



Regulation of Financial Institutions and Markets:

Regulations Governing Financial Markets

• The Securities Act of 1933 regulates the sale of securities to the public via the primary market.

– Requires sellers of new securities to provide extensive disclosures to the potential buyers of those securities.

• The Securities Exchange Act of 1934 regulates the trading of securities such as stocks and bonds in the secondary market.

– Created the Securities Exchange Commission, which is the primary government agency responsible for enforcing federal securities laws.

– Requires ongoing disclosure by companies whose securities trade in secondary markets (e.g., 10-Q, 10-K).

– Imposes limits on the extent to which “insiders” can trade in their firm’s securities.


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.


Table 2.1 Corporate Tax Rate Schedule


Calculate corporate taxes

Taxable income = 78,000

13,750 + .34 * 3,000 = 14,770

Average tax rate = 14,770 / 78,000 = 18.9%

Marginal tax rate = 34%

Taxable income = 17,000,000

5,150,000 + .38 * 2,000,000 = 5,910,000

Average tax rate = 5,910,000 / 17,000,000 = 34.7%

Marginal tax rate = 38%

Chapter 3 Statements and Ratios



The Stockholders’ Report

• Generally accepted accounting principles (GAAP) are the practice and procedure guidelines used to prepare and maintain financial records and reports;

• The Sarbanes-Oxley Act of 2002, passed to eliminate the many disclosure and conflict of interest problems of corporations

• More Countries Adopt International Financial Reporting Standards

– International Financial Reporting Standards (IFRS) are established by the International Accounting Standards Board (IASB).


The Four Key Financial Statements: The Income Statement

• The income statement provides a financial summary of a company’s operating results during a specified period.

• Although they are prepared quarterly for reporting purposes, they are generally computed monthly by management and quarterly for tax purposes.


Table 3.1 Bartlett Company Income Statements ($000)

Concentrate on control issue•Gross profit – control expenses of production•Operating profit – control of the expenses of “running” the company•Net income – remaining profits after all expenses paid


The Four Key Financial Statements: The Balance Sheet

• The balance sheet presents a summary of a firm’s financial position at a given point in time.

• The statement balances the firm’s assets (what it owns) against its financing, which can be either debt (what it owes) or equity (what was provided by owners).


Table 3.2a Bartlett Company Balance Sheets ($000)

Represents the assets that management has purchased and uses to achieve it’s mission and goals.


Table 3.2b Bartlett Company Balance Sheets ($000)

Represents how management gets the $$ to purchase the assets of the firm.


The Four Key Financial Statements: Statement of Retained Earnings

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


The Four Key Financial Statements: Statement of Cash Flows

• The statement of cash flows provides a summary of the firm’s operating, investment, and financing cash flows and reconciles them with changes in its cash and marketable securities during the period.

• This statement not only provides insight into a company’s investment, financing and operating activities, but also ties together the income statement and previous and current balance sheets.


Table 3.4 Bartlett Company Statement of

Cash Flows ($000) for the Year Ended

December 31, 2012

The cash flow statement illustrates the primary decisions that managers make.•Managers make decisions on how to run the business (operations)•Managers decide what kinds of assets to buy (investment)•Managers decide where to get the $$ to run the business (financing)


Using Financial Ratios: Cautions about Using Ratio Analysis

1. Ratios that reveal large deviations from the norm merely indicate the possibility of a problem.

2. A single ratio does not generally provide sufficient information from which to judge the overall performance of the firm.

3. The ratios being compared should be calculated using financial statements dated at the same point in time during the year.

4. It is preferable to use audited financial statements.

5. The financial data being compared should have been developed in the same way.

6. Results can be distorted by inflation.


Table 3.5 Financial Ratios for Select Firms

and Their Industry Median Values


Molson Coors (TAP)

Financial Statement Analysis

2002 2003 2004 2005 2006

$3,776 $4,000 $4,305 $5,506 $5,844

$2,415 $2,587 $2,741 $3,307 $3,481

$1,361 $1,413 $1,564 $2,199 $2,363

$1,063 $1,106 $1,216 $1,777 $1,782

$298 $307 $348 $422 $581

-$70 -$81 -$72 -$131 -$143

$28 $27 $32 $4 $34

$256 $253 $308 $295 $472

-$94 -$79 -$95 -$50 -$82

$162 $174 $213 $245 $390

Extraordinary $122 -$137 -$77 $21 -$273

Net Income $40 $311 $290 $224 $663

Fully Diluted EPS $4.420 $4.770 $5.190 $1.690 $4.170

Dividends per Share $0.820 $0.820 $0.820 $1.280 $1.280

$56.850 $52.900 $72.220 $65.230 $75.880

Year

Net Sales

Cost of Goods Sold

EBT (Earn Before Taxes)

Taxes (neg)

NI from Recurring Op

Gross Profit

Other Op Expenses

EBIT (Op Income)

Interest Exp (neg)

Stock Price (end of yr)

Interest Income


2002 2003 2004 2005 2006

$59 $19 $123 $39 $182

$704 $656 $832 $828 $828

$184 $209 $234 $314 $319

$106 $194 $79 $287 $129

$1,053 $1,078 $1,268 $1,468 $1,458

$1,380 $1,450 $1,445 $2,305 $2,421

$1,256 $1,348 $1,471 $7,294 $7,363

$608 $568 $473 $732 $361

$4,297 $4,444 $4,657 $11,799 $11,603

$334 354 326 371 419

$813 $779 $850 $1,865 $1,381

$1,147 $1,133 $1,176 $2,236 $1,800

$2,168 $2,044 $1,843 $4,154 $3,939

$3,315 $3,177 $3,019 $6,390 $5,739

$1,086 $1,231 $1,398 $1,422 $1,673

-$104 $36 $240 $3,987 $4,191

$4,297 $4,444 $4,657 $11,799 $11,603

36.566 36.596 37.909 80.036 86.656

Year

Account Receivable

Cash & Mkt Sec.

Inventory

Misc CA

Net Fixed Assets

Total Current Assets

Intangibles

Total Assets

Other Non-Current Assets

Retained Earnings

Total Liabilities and Equity

Outstanding Shares

Common Stock

Accounts Payable

Other CL

Total Current Liabilities

Notes Payable (LT)

Total Debt

LT Debt


2002 2003 2004 2005 2006

$244 $528 $499 $422 $833

$230 $242 $267 $414 $441

-$1,570 -$214 -$67 -$312 -$294

$1,291 -$357 -$335 -$188 -$401

-$35 -$43 $97 -$78 $138Net Change in Cash

Net Cash from Financing

Net Cash from Investing

Net Cash from Op Activities

Derpreciation

Year


Malt Beverage Industry

2002 2003 2004 2005 2006

1.60 1.20 1.50 1.30 1.40

0.70 0.60 0.90 0.60 0.70

23.00 17.00 21.00 23.00 22.00

32.00 41.00 39.00 42.00 40.00

28.00 29.00 28.00 29.00 31.00

2.20 3.00 1.60 2.40 2.10

1.50 1.40 1.10 1.50 1.40

200.00% 230.00% 180.00% 140.00% 140.00%

56.40% 63.00% 57.40% 57.50% 66.50%

160.00% 210.00% 180.00% 130.00% 160.00%

3.300 1.900 2.200 2.900 3.800

2.29 2.70 2.35 2.35 2.99

38.40% 36.70% 40.30% 37.30% 36.90%

6.20% 4.20% 5.10% 5.60% 7.10%

5.90% 4.80% 3.10% 5.90% 7.40%

9.30% 5.88% 5.61% 8.40% 9.94%

22.40% 18.10% 8.60% 19.50% 24.20%

4.10% 2.60% 3.10% 3.80% 6.00%EBT / Sales

Current Ratio (CR)

Quick Ratio (QR)

Asset Management

Days Sales Outstand DSO

Days Carry Inv DCI

Days Payable Outstand DPO

Liquidity

Year

Fixed Asset Turnover FAT

Total Asset Turnover TAT

Leverage Ratios

LTD / NW (DE)

TD / TA (DR)

FA / NW

Times Int Earned (TIE)

Profitability Ratios

Financial Leverage (FLM)

Gross Profit (GPM)

Operating Profit (OPM)

EBT / TA ("ROA")

BEP

EBT / Tang. NW ("ROE")


sLiabilitie Current

Assets CurrentCR

Liquidity ratios

Measures the ability of the firm to pay current obligations

Use both if inventory is a large portion of the company’s current assets

sLiabilitie Current

InventoryAssets CurrentQR


Matter of Fact

The importance of inventories:– From Table 3.5:

– All three firms have current ratios of 1.3. However, the quick ratios for Home Depot and Lowes are dramatically lower than their current ratios, but for Dell the two ratios are nearly the same. Why?

Company Current ratio Quick ratio

Dell 1.3 1.2

Home Depot 1.3 0.4

Lowes 1.3 0.2


Liquidity Ratios

0.400

0.600

0.800

1.000

1.200

1.400

1.600

1.800

2002 2003 2004 2005 2006

TAP Current ratio

Industry Current Ratio

TAP Quick Ratio

Industry Quick Ratio


365/Sold Goods of Cost

Payable AccountsdingtanOuts Payables DaysDPO

365/Sold Goods of Cost

InventoryInventoryCarry DaysDCI

INVCGS

IT =

365/Sales

Receivable AccountsgOutstandin Sales DaysDSO

R/Asales

turnover R/A =

Asset mgt ratios (Activity)

Average number of days inventory on the shelf

Average number of days for customers to pay for their accounts

Average number of days it takes us to pay our accounts


20.000

25.000

30.000

35.000

40.000

45.000

50.000

2002 2003 2004 2005 2006

TAP Days Carry Inventory

Industry Days Carry Inventory


0.000

10.000

20.000

30.000

40.000

50.000

60.000

70.000

80.000

2002 2003 2004 2005 2006

TAP Days Sales Outstanding

Industry Days Sales Outstanding


Leverage ratios

Degree of indebtedness (how much)– cannot say whether good or bad– Mgt chooses a level of debt– NW = common equity = Total Assets – Total Liabilities

Ability to pay interestFinancial leverage - use of other peoples

money to make a higher return


Assets Total

Debt TotalRatio Debt

Interest

Taxes and Interest Before EarningsEarned Interest Times

leverage ratios


40.000%

45.000%

50.000%

55.000%

60.000%

65.000%

70.000%

75.000%

80.000%

85.000%

90.000%

2002 2003 2004 2005 2006

TAP Debt Ratio

Industry Debt Ratio


0.000

1.000

2.000

3.000

4.000

5.000

6.000

2002 2003 2004 2005 2006

TAP Times Interest Earned

Industry Times Interest Earned Ratio


Sales

Operations Recurring from Income NetMargin Profit Net

Sales

ofitPr GrossinargM ofitPrGross

Sales

Taxes and Interest Before EarningsMargin Profit Operating

Sales

Taxes Before EarningsSales/Taxes Before Earnings

Profitability ratios


0.000%

5.000%

10.000%

15.000%

20.000%

25.000%

30.000%

35.000%

40.000%

45.000%

2002 2003 2004 2005 2006

TAP Gross Profit Margin

Industry GPM

TAP Operating Profit MArgin

Industry OPM


0.000%

2.000%

4.000%

6.000%

8.000%

10.000%

12.000%

2002 2003 2004 2005 2006

TAP Operating Profit MArgin

Industry OPM

TAP EBT / Sales

Industry EBT / Sales


Profitability ratios

Shares gOutstandin #

rsShareholde to AvailableIncome NetEPS

AssetsTotal

rsShareholde to AvailableIncome Net Assetson turnRe

AssetsTotal

Taxes and Interest Before EarningsPower Earning Basic


0.000%

5.000%

10.000%

15.000%

20.000%

25.000%

2002 2003 2004 2005 2006

TAP Basic Earning Power

Industry Basic Earning Power


shares #

equity pfdTLTA

shares #

CEshr. per ValueBook

BPSprice mkt

book to mkt

EPS

price MktEarnings icePr

Market Based Ratios


DuPont System of Analysis

• The DuPont system of analysis is used to dissect the firm’s financial statements and to assess its financial condition.

• It merges the income statement and balance sheet into two summary measures of profitability.

• The Modified DuPont Formula relates the firm’s ROA to its ROE using the financial leverage multiplier (FLM), which is the ratio of total assets to common stock equity:

• ROA and ROE as shown in the series of equations on the following slide.


DuPont System of Analysis

• The DuPont system first brings together the net profit margin, which measures the firm’s profitability on sales, with its total asset turnover, which indicates how efficiently the firm has used its assets to generate sales.

ROA = Net profit margin Total asset turnover

• Substituting the appropriate formulas into the equation and simplifying results in the formula given earlier,

How does a firm create returns for owners?


$$$$AND / OR

Borrow money!!


2002 2003 2004 2005 2006

6.780% 6.325% 7.154% 5.358% 8.077%

0.879 1.111 1.082 2.143 1.985

5.958% 7.027% 7.739% 11.481% 16.036%

4.376 3.507 2.843 2.181 1.979

26.069% 24.647% 22.004% 25.045% 31.730%

2002 2003 2004 2005 2006

5.900% 4.800% 3.100% 5.900% 7.400%

1.500 1.400 1.100 1.500 1.400

8.850% 6.720% 3.410% 8.850% 10.360%

2.294 2.703 2.347 2.353 2.985

20.298% 18.162% 8.005% 20.824% 30.925%

EBT / Sales

TAT

ROA

FLM

Approx EOE

Company

Company

EBT / Sales

TAT

ROA

FLM

Approx EOE

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