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Chapter 1 & 2

• The Role of Environment and Financial Market

Environment

1-1

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1-2

Learning Goals

1. Define finance, its major areas and opportunitiesavailable in this field, and the leal forms of businessorani!ation.

". Describe the manaerial finance function and itsrelationship to economics and accountin.

#. $dentif% the primar% activities of the financialmanaer.

&. E'plain the oal of the firm, corporate overnance,the role of ethics, and the aenc% issue.

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1-3

Learning Goals (cont.)

(. )nderstand financial institutions and markets,

and the role the% pla% in manaerial finance.

*. Discuss business ta'es and their importance in

financial decisions.

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1-4

What is Finance?

• Finance can be defined as the art and science of

manain mone%.

• Finance is concerned +ith the process,

institutions, markets, and instruments involved

in the transfer of mone% amon individuals,

businesses, and overnments.

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1-5

Major Areas & Opportunities in Finance

Financial !er"ices

• Financial Services deals +ith manaement of

mone% for individuals, business and overnment

and includes the desin and advice and financial products.

• Career opportunities include bankin, personal

financial plannin, investments, real estate, andinsurance.

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Major Areas & Opportunities in Finance

Managerial Finance

• Managerial finance is concerned +ith the duties of the

financial manaer in the business firm.

• The financial manager includes

- Developin financial plan and budet

- E'tend credit to customers

- Evaluate proposed lare e'penditures

- Raise mone% to fund firms operations

• The% are also more involved in developin corporate

strate% and improvin the firms competitive position.

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Legal For#s o$ %usiness

Organiation

• / sole proprietorship is a business o+ned b% one

person and operated for his or her o+n profit.

•/ partnership is a business o+ned b% t+o or more people and operated for profit.

• / corporation is an entit% created b% la+. 0orporations

have the leal po+ers of an individual in that it can sue

and be sued, make and be part% to contracts, andacuire propert% in its o+n name.

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'roprietorships

•/dvantaes - Ease of formation - 2ubject to fe+ reulations

- 3o corporate income ta'es•Disadvantaes

- Difficult to raise capital - )nlimited liabilit% - 4imited life

1-9

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'artnership

• /dvantaes

- /ble to raise more fundin from sole proprietorship

- $ncome ta' on personal ta' return

- More brain po+er and manaerial skills

• Disadvantaes

- 5+ner have unlimited liabilit%

- Ma% have to cover partners debt - 6artnership dissolves upon partnership dies

- Difficult to liuidate and transfer o+nership

1-10

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Corporation

•/dvantaes - )nlimited life - Eas% transfer of o+nership

- 4imited liabilit% - Ease of raisin capital - Emplo% professional manaers - /ble to obtain better financin

•Disadvantaes - More reulations - Ta'ed at corporate rate7 hiher - 0ost of set7up and report filin

1-11

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ale 1.1 !trengths an* Wea+nesses o$ theCo##on Legal For#s o$ %usiness Organiation

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Matter o$ Fact

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1-15

he Managerial Finance Function

• The si!e and importance of the manaerial finance

function depends on the si!e of the firm.

• $n small companies, the finance function ma% be performed b% the compan% president or accountin

department.

• /s the business e'pands, finance t%picall% evolves intoa separate department linked to the president as +as

previousl% described in Fiure 1.1.

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1-16


,elationship to -cono#ics

• The field of finance is actuall% an outro+th ofeconomics.

• $n fact, finance is sometimes referred to asfinancial economics.

• Financial manaers must understand theeconomic frame+ork +ithin +hich the% operatein order to react or anticipate to chanes inconditions.

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1-17


,elationship to -cono#ics (cont.)

• The primar% economic principal used b%

financial manaers is marginal cost-benefit

analysis +hich sa%s that financial decisionsshould be implemented onl% +hen added

benefits e'ceed added costs.

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1-18


,elationship to Accounting

• The firms finance 8treasurer9 and accountin

8controller9 functions are closel%7related and

overlappin.

• $n smaller firms, the financial manaer enerall%

performs both functions.

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1-19


,elationship to Accounting (cont.)

• 5ne major difference in perspective and

emphasis bet+een finance and accountin is that

accountants enerall% use the accrual method+hile in finance, the focus is on cash flows.

• The sinificance of this difference can be

illustrated usin the follo+in simple e'ample.

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1-20

Sales $100,000 (1 yach s!l", 100# sill uc!llece"%

&!ss $ 80,000 (all 'ai" i ull u"er su''lier er)s%



• The 3assau 0orporation e'perienced the follo+in

activit% last %ear

• 3o+ contrast the differences in performance under the

accountin method versus the cash method.

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1-21

*+& ST/T+T S/

/&&/ &/S

Sales $100,000 $ 0

ess &!ss (80,000% (80,000%

+e r!i(!ss% $ 20,000 $(80,000%



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1-22



• Finance and accountin also differ +ith respect todecision-making.

• :hile accountin is primaril% concerned +ith the

presentation of financial data, the financial manaer is primaril% concerned +ith analyzing and interpreting this information for decision7makin purposes.

• The financial manaer uses this data as a vital tool for

makin decisions about the financial aspects of thefirm.

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1-23

Figure 1.2 Financial Acti"ities

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1-24

Goal o$ the Fir# Mai#ie 'ro$it???

• 6rofit ma'imi!ation fails to account for differences in the level

of cash flo+s 8as opposed to profits9, the timin of these cash

flo+s, and the risk of these cash flo+s.

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1-25

!hare 'rice / Future 0i"i*en*s

,euire* ,eturn

leel i)ig! cash l!:s

ris; ! cashl!:s

Goal o$ the Fir#

Mai#ie !harehol*er Wealth

• :h%;

•

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1-26

Goal o$ the Fir#

Mai#ie !harehol*er Wealth (cont.)

• The process of shareholder +ealth ma'imi!ation

can be described usin the follo+in flo+ chart

Figure 1. 2hare 6rice Ma'imi!ation

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1-27

Goal o$ the Fir#

What Aout Other !ta+ehol*ers?

• 2takeholders include all roups of individuals +hohave a direct economic link to the firm includinemplo%ees, customers, suppliers, creditors, o+ners, and

others +ho have a direct economic link to the firm.

• The =2takeholder >ie+= prescribes that the firm make aconscious effort to avoid actions that could bedetrimental to the +ealth position of its stakeholders.

• 2uch a vie+ is considered to be =sociall% responsible.=

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1-28

3n*i"i*ual "ersus 3nstitutional 3n"estors

• $ndividual investors are investors +ho purchase relativel% small

uantities of shares in order to earn a return on idle funds, build

a source of retirement income, or provide financial securit%.

• $nstitutional investors are investment professionals +ho are paid

to manae other peoples mone%.

• The% hold and trade lare uantities of securities for individuals,

businesses, and overnments and tend to have a much reaterimpact on corporate overnance.

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1-29

he ,ole o$ -thics -thics 0e$ine*

• !thics is the standards of conduct or moral

judment?have become an overridin issue in

both our societ% and the financial communit%• Ethical violations attract +idespread publicit%

• 3eative publicit% often leads to neative

impacts on a firm

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4iolations o$ -thics

• E'ample

- 0reative /ccountin

- Earnins Manaement

- Misleadin Financial Forecast

- $nsider Tradin

- Fraud

- E'cessive E'ecutive 0ompensation

-

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1-31

Corporate Go"ernance

• 0orporate Aovernance refers to the rules, processes and

la+s b% +hich companies operated, controlled and

reulated.

• $t defines the rihts and responsibilities of ke% corporate

participants such as shareholders, the board of directors,

officers and manaers, and other stakeholders.

• The structure of corporate overnance +as previousl%

described in Fiure 1.1.

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Go"ernance an* Agenc5

Go"ern#ent ,egulation

• Aovernment reulation enerall% shapes the corporate

overnance of all firms.

• Durin the recent decade, corporate overnance has

received increased attention due to several hih7profile

corporate scandals involvin abuse of corporate po+er

and, in some cases, alleed criminal activit% b%

corporate officers.

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!aranes an* Ole5 Act

• /n act aim at eliminatin corporate disclosure

and conflict of interest problems.

• 0ontain provision about corporate financialdisclosure and relationship amon the

corporations, anal%st, auditors, attorne%s,

directors, officers, and shareholders

1-33

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Go"ern#ent ,egulation

• The 2arbanes75'le% /ct of "BB"• established an oversiht board to monitor the accountin industr%C

• tihtened audit reulations and controlsC

• touhened penalties aainst e'ecutives +ho commit corporate fraudC

• strenthened accountin disclosure reuirements and ethical uidelines forcorporate officersC

• established corporate board structure and membership uidelinesC

• established uidelines +ith reard to anal%st conflicts of interestC

• mandated instant disclosure of stock sales b% corporate e'ecutivesC

• increased securities reulation authorit% and budets for auditors andinvestiators.

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he Agenc5 3ssue

• / principal-agent relationship is an arranement in

+hich an aent acts on the behalf of a principal. For

e'ample, shareholders of a compan% 8principals9 elect

manaement 8aents9 to act on their behalf.• "gency problems arise +hen manaers place personal

oals ahead of the oals of shareholders.

•2hareholder incurs aenc% cost +hen manaers make poor decisions and have to be monitored to ensure the

best investment decision is made

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he Agenc5 3ssue

Manage#ent Co#pensation 'lans

• $n addition to the roles pla%ed b% corporate boards,

institutional investors, and overnment reulations,

corporate overnance can be strenthened b% ensurin

that manaers interests are alined +ith those ofshareholders.

• / common approach is to structure manaement

compensation to correspond +ith firm performance.

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he Agenc5 3ssue

Manage#ent Co#pensation 'lans

• #ncentive plans are manaement compensation plans

that tie manaement compensation to share priceC one

e'ample involves the rantin of stock options.

• $erformance plans tie manaement compensation to

measures such as E62 or ro+th in E62. 6erformance

shares andor cash bonuses are used as compensation

under these plans.

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Matter o$ Fact6Fores.co#

C-O 'er$or#ance "s. 'a5

$

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he Agenc5 3ssue he hreat o$

a+eo"er

• :hen a firms internal corporate overnance structure

is unable to keep aenc% problems in check, it is likel%

that rival manaers +ill tr% to ain control of the firm.

• The threat of takeover b% another firm, +hich believes

it can enhance the troubled firms value b% restructurin

its manaement, operations, and financin, can provide

a stron source of e'ternal corporate overnance.

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1-40

Financial 3nstitutions & Mar+ets

• Firms that reuire funds from e'ternal sources

can obtain them in three +a%s

- throuh a bank or other financial institution

- throuh financial markets

- throuh private placements

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1-41


Financial 3nstitutions

• Financial institutions are intermediaries that channel

the savins of individuals, businesses, and overnments

into loans or investments.

• The ke% suppliers and demanders of funds are

individuals, businesses, and governments.

• $n eneral, individuals are net suppliers of funds, +hile

businesses and overnments are net demanders of

funds.

Fi i l 3 tit ti & M + t

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2-42


Financial 3nstitutions

• Financial institutions are intermediaries that channel

the savins of individuals, businesses, and overnments

into loans or investments.

• The ke% suppliers and demanders of funds are

individuals, businesses, and overnments.

• $n eneral, individuals are net suppliers of funds, +hile

businesses and overnments are net demanders offunds.

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2-43

Co##ercial %an+s7 3n"est#ent %an+s7 an*

the !ha*o8 %an+ing !5ste#

• Commercial banks are institutions that provide savers

+ith a secure place to invest their funds and that offer

loans to individual and business borro+ers.

• #nvestment banks are institutions that assist companies

in raisin capital, advise firms on major transactions

such as merers or financial restructurins, and enae

in tradin and market makin activities.

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2-44

Co##ercial %an+s7 3n"est#ent %an+s7 an*

the !ha*o8 %an+ing !5ste# (cont.)

• The %lass-Steagall "ct +as an act of 0onress in 1##that created the federal deposit insurance proram andseparated the activities of commercial and investment

banks. - Repealed in the late 1Bs.

• The shadow banking system describes a roup ofinstitutions that enae in lendin activities, much like

traditional banks, but these institutions do not acceptdeposits and are therefore not subject to the samereulations as traditional banks.

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2-45

Matter o$ Fact

0onsolidation in the ).2.

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2-46


Financial Mar+ets

• Financial markets are forums in +hich suppliers of fundsand demanders of funds can transact business directl%.

• Transactions in short term marketable securities take place

in the mone% market +hile transactions in lon7termsecurities take place in the capital market.

• / private placement involves the sale of a ne+ securit%directl% to an investor or roup of investors.

• Most firms, ho+ever, raise mone% throuh a public offering of securities, +hich is the sale of either bonds or stocks tothe eneral public.


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1-47


Financial Mar+ets

• Financial markets provide a forum in +hich suppliers

of funds and demanders of funds can transact business

directl%.

• The t+o ke% financial markets are the money market

and the capital market.

• Transactions in short term marketable securities take

place in the mone% market +hile transactions in lon7

term securities take place in the capital market.


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Financial Mar+ets (cont.)

• The primary market is the financial market in +hich

securities are initiall% issuedC the onl% market in +hich

the issuer is directl% involved in the transaction.

• 2econdary markets are financial markets in +hich

preo+ned securities 8those that are not ne+ issues9 are

traded.

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1-49

Figure 1.4 Flo8 o$ Fun*s

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2-50

he Mone5 Mar+et

• The money market is created b% a financial relationship

bet+een suppliers and demanders of short7term funds.

• Most mone% market transactions are made in marketable

securities +hich are short7term debt instruments, such as).2. Treasur% bills, commercial paper, and neotiable

certificates of deposit issued b% overnment, business, and

financial institutions, respectivel%.

• $nvestors enerall% consider marketable securities to be

amon the least risk% investments available.

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Mala5sian Mone5 Mar+et

• 3$D or &egotiable #nstrument of 'eposit $n

denomination more than RM1BB@.

• (epurchase "greement or Repo $ssued b% banks for

duration from 1 da% to 1 %ear.

• MT< or Malaysian )reasury *ills are short7term

securities issued b% the Aovernment of Mala%sia to raise

short7term funds for AovernmentHs +orkin capital.

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2-52

he Mone5 Mar+et (cont.)

• The international euivalent of the domestic 8).2.9

mone% market is the !urocurrency market.

• The Eurocurrenc% market is a market for short7term

bank deposits denominated in ).2. dollars or other

marketable currencies.

• The Eurocurrenc% market has ro+n rapidl% mainl%

because it is unreulated and because it meets the needsof international borro+ers and lenders.

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2-53

he Capital Mar+et

• The capital market is a market that enables suppliers anddemanders of lon7term funds to make transactions.

• The ke% capital market securities are bonds 8lon7term debt9

and both common and preferred stock 8euit%, or o+nership9. - *onds are lon7term debt instruments used b% businesses andovernment to raise lare sums of mone%, enerall% from a diverseroup of lenders.

- Common stock are units of o+nership interest or euit% in a

corporation. - $referred stock is a special form of o+nership that has features of

both a bond and common stock.

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Mala5sian Capital Mar+et

•

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2-55

%ro+er Mar+ets an*

0ealer Mar+ets

*roker markets are securities e'chanes on +hich the

t+o sides of a transaction, the bu%er and seller, are

brouht toether to trade securities.

- Tradin takes place on centrali!ed tradin floors.

- E'amples include 3J2E Eurone't, /merican 2tock

E'chane

%ro+er Mar+ets an*

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2-56

%ro+er Mar+ets an*

0ealer Mar+ets (cont.)

'ealer markets are markets in +hich the bu%er and seller are

not brouht toether directl% but instead have their orders

e'ecuted b% securities dealers that Kmake marketsL in the iven

securit%. - / market +here dealers are assined for specific securities. The

dealers create liuid markets b% purchasin and sellin aainst

personal inventor%.

- The 3asda market is one e'ample

/s compensation for e'ecutin orders, market makers make

mone% on the spread 8bid price - ask price9.

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2-57

Matter o$ Fact

3J2E Eurone't is the :orlds 4arest 2tock E'chane

- /ccordin to the :orld Federation of E'chanes, 3J2E

Eurone't is the larest stock market in the +orld, as measured

b% the total market value of securities listed on that market. - 3J2E Eurone't has listed securities +orth more than 11.

trillion in the ).2. and ". trillion in Europe.

- 3e't larest is the 4ondon 2tock E'chane +ith securities

valued at N1.I trillion, +hich is euivalent to ". trillioniven the e'chane rate bet+een pounds and dollars prevailin

at the end of "BB.

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2-58

3nternational Capital Mar+ets

• / !urobond is an international bond that is denominated in acurrenc% not native to the countr% +here it is issued. $t can becateorised accordin to the currenc% in +hich it is issued. 4ondonis one of the centers of the Eurobond market, but Eurobonds ma% be

traded throuhout the +orld 7 for e'ample in 2inapore or Tok%o.• $n the !urobond market, corporations and overnments

t%picall% issue bonds denominated in dollars or %ens and sellthem to investors located outside the home countr%

• The foreign bond market is a market for bonds issued b% a forein

corporation or overnment that is denominated in the investorshome currenc% and sold in the investors home market.

http://en.wikipedia.org/wiki/Bond_(finance)http://en.wikipedia.org/wiki/Currencyhttp://en.wikipedia.org/wiki/Singaporehttp://en.wikipedia.org/wiki/Tokyohttp://en.wikipedia.org/wiki/Tokyohttp://en.wikipedia.org/wiki/Singaporehttp://en.wikipedia.org/wiki/Currencyhttp://en.wikipedia.org/wiki/Bond_(finance)

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he ,ole o$ Capital Mar+ets

• From a firms perspective, the role of capital markets is to be a

liuid market +here firms can interact +ith investors in order to

obtain valuable e'ternal financin resources.

• From investors perspectives, the role of capital markets is to bean efficient market that allocates funds to their most productive

uses.

• /n efficient market allocates funds to their most productive

uses as a result of competition amon +ealth7ma'imi!ininvestors and determines and publici!es prices that are believed

to be close to their true value.


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(cont.)

• /dvocates of behavioral finance, an emerin field that blends ideas from finance and ps%cholo%, arue that stock prices and prices of other securities can deviate from theirtrue values for e'tended periods.

• These people point to episodes such as the hue run up andsubseuent collapse of the prices of $nternet stocks in the late1Bs, or the failure of markets to accuratel% assess the riskof mortae7backed securities in the more recent financial

crisis, as e'amples of the principle that stock pricessometimes can be +ildl% inaccurate measures of value.

he Financial Crisis Financial

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2-61

he Financial Crisis Financial

3nstitutions an* ,eal -state Finance

• Securitization is the process of poolin mortaes orother t%pes of loans and then sellin claims or securitiesaainst that pool in a secondar% market.

• Mortgage-backed securities represent claims on the cashflo+s enerated b% a pool of mortaes and can be

purchased b% individual investors, pension funds, mutualfunds, or virtuall% an% other investor.

• / primar% risk associated +ith mortae7back securities isthat homeo+ners ma% not be able to, or ma% choose notto, repa% their loans.

he Financial Crisis Falling :o#e 'rices

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2-62

he Financial Crisis Falling :o#e 'rices

an* 0elinuent Mortgages (Figure 2.2)

he Financial Crisis Crisis o$

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2-63

he Financial Crisis Crisis o$

Con$i*ence in %an+s (Figure 2.;)

he Financial Crisis !pillo"er -$$ects

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2-64

he Financial Crisis !pillo"er -$$ects

an* the Great ,ecession

• /s banks came under intense financial pressure in "BB,

the% tihtened their lendin standards and dramaticall%

reduced the uantit% of loans the% made.

• 0orporations found that the% could no loner raise mone%in the mone% market, or could onl% do so at

e'traordinaril% hih rates.

• /s a conseuence, businesses bean to hoard cash and

cut back on e'penditures, and economic activit%

contracted.

,egulation o$ Financial 3nstitutions an* Mar+ets

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,egulations Go"erning Financial 3nstitutions

• The Alass72teaall /ct 81##9 established the Federal 'eposit

#nsurance Corporation +F'#C, +hich provides insurance for

deposits at banks and monitors banks to ensure their safet% and

soundness.

• The Alass72teaall /ct also prohibited institutions that took

deposits from enain in activities such as securities

under+ritin and tradin, thereb% effectivel% separatin

commercial banks from investment banks.


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,egulations Go"erning Financial 3nstitutions

• The %ramm-each-*liley "ct +1, allo+s business combinations

8e.. merers9 bet+een commercial banks, investment banks, and

insurance companies, and thus permits these institutions to compete

in markets that prior reulations prohibited them from enterin.

• 2ome leaders have arued that 0onress should reenact Alass7

2teaall, +hich +ould effectivel% mandate the breakup of lare

financial conlomerates.

• 5thers have proposed the implementation of ne+ reulations,

particularl% on the lare financial institutions that received the mostassistance from the overnment durin the financial crisis.


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,egulations Go"erning Financial Mar+ets

• The Securities "ct of 1 reulates the sale of securities to the public via the primar% market. - Reuires sellers of ne+ securities to provide e'tensive disclosures to the

potential bu%ers of those securities.

• The Securities !/change "ct of 10 reulates the tradin ofsecurities such as stocks and bonds in the secondar% market. - 0reated the Securities !/change Commission, +hich is the primar%

overnment aenc% responsible for enforcin federal securities la+s.

- Reuires onoin disclosure b% companies +hose securities trade in

secondar% markets 8e.., 1B7O, 1B7@9. - $mposes limits on the e'tent to +hich KinsidersL can trade in their firms

securities.

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%usiness aes

•

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%usiness aation Or*inar5 3nco#e

Table 1.4 Corporate a ,ate !che*ule

%usiness aation

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%usiness aation (a 0e*uctiilit5)

0et "ersus -uit5 Financing (cont.)


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• /s the e'ample sho+s, the use of debt financin can

increase cash flo+ and E62, and decrease ta'es paid.

• The ta' deductibilit% of interest and other certain

e'penses reduces their actual 8after7ta'9 cost to the

profitable firm.

• $t is the non7deductibilit% of dividends paid that results

in double ta'ation under the corporate form oforani!ation.


0et "ersus -uit5 Financing (cont.)

% i ti C it l G i

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%usiness aation Capital Gains

• / capital gain results +hen a firm sells an asset such as

a stock held as an investment for more than its initial

purchase price.

• The difference bet+een the sales price and the purchase

price is called a capital ain.

• For corporations, capital ains are added to ordinar%

income and ta'ed like ordinar% income at the firms

marinal ta' rate.

01 - Chapter 1 2

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