Introduction to Financial Management1

1 Notes based on Essentials of Managerial Finance 1st Ed and Principles of Managerial Finance 13thEd.
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1.1. What is Finance?
Finance can be defined as the science and art of managing money.
• At the personal level, finance is concerned with individuals’ decisions about how
much of their earnings they spend, how much they save, and how they invest
their savings.

• In a business context, finance involves the same types of decisions: how firms
raise money from investors, how firms invest money in an attempt to earn a
profit, and how they decide whether to reinvest profits in the business or
distribute them back to investors.

• Finance consists of three interrelated areas:

▪ Money and capital markets
▪ Investments
▪ Financial management

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1.2. Forms of Business Organisations
There are three basic legal forms of business organizations
• Sole proprietorship
▪ Owned and operated by one individual.
▪ Receives all the profits.
▪ Has unlimited liability.

• Partnership
▪ An association of two or more individuals entering into a business relationship for the
purpose of profit making
▪ Has unlimited liability

• Corporation
▪ Separate legal entity distinct from both its owners and its managers
▪ Has limited liability
▪ Transferability of ownership
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 ▪ Ease of raising greater amounts of capital
▪ Subject to more legal requirements
▪ Double taxation (dividend and corporate taxation)

1.3. Financial Management and other Disciplines

• Economic factors such as economic downturns, fluctuating interest rates,
inflation and disinflation have substantially increased the role and importance of
the financial management function.

• The finance manager is responsible for the firm’s financial activities, which
includes financial planning, undertaking capital expenditure, managing inflows
and outflows and advising management on investment related matters.

• Finance is closely related to the field of economics, at both the micro and maro
level.

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• Finance is closely related to accounting with two basic differences - In finance the
emphasis is on cash flows while accountants use the accrual basis of accounting,
where revenues are recognized when earned and expenses when incurred.
Income Statement summary for the year 2013
Accrual Cash
Basis Basis
Sales $200,000 $100,000
Less: Cost of goods sold 120,000 120,000
Gross Profit 80,000 (20,000)
Less: Cash operating 60,000 60,000
expenses
Net Profit / (Loss) 20,000 (80,000)

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 • The accountant mainly focuses on the collection and presentation of financial
data. The financial manager focuses on financial analysis, planning and decision
making, using the information from the accountant and other sources.

1.4. The Goals of the Finance Manager/Firm

• The objectives of the financial manager must be in harmony with those of the
owners.

• Profit Maximisation - The finance manager must always choose alternatives with
the highest rates of return i.e. actions which are expected to make a substantial
contribution to the firm’s overall profits

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• Example - Reno who is the financial manager for Angostura Rum Company must
choose between four alternative Assets: 1, 2, 3, and 4. Each asset costs $70,000
and is expected to provide earnings over a 3-year period as described below.

Yearly and Total Earnings for Assets 1 through 4

Asset Year 1 Year 2 Year 3 Total

Earnings Earnings Earnings Earnings
1 $42,000 $30,000 $12,000 $84,000
2 18,000 30,000 42,000 90,000
3 6,000 40,000 38,000 84,000
4 12,000 24,000 24,000 60,000

• The financial manager would choose Asset 2 because this asset earns the highest
total earnings ($90,000).

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• EPS is commonly used by corporations to measure profits

Total Earnings Availablefor Common Stockholders

• EPS = Total Shares Outstanding

• Example – A financial manager has to make a choice between two investments

Earnings Per Share (EPS)

Investment Year 1 Year 2 Year 3 Total for
EPS EPS EPS 3 years
Raul $3 $2 $0.90 $5.90
Koshina $0 $0.05 $6.05 $6.10

• Investing in Koshina would be preferred given the profit maximization goal

because it results in higher total EPS over the 3-year period ($6.10 vs. $5.90).
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• Drawbacks:
▪ Timing is important—the receipt of funds sooner rather than later is
preferred.
▪ Profits do not necessarily result in cash flows available to stockholders.
▪ Profit maximization fails to account for risk.

• Wealth Maximisation - Actions that are expected to increase the share price.

• Share prices can be treated as a proxy for shareholders’ wealth.

• Assuming that investors are rational, thus they will usually invest in firms that
have a history of healthy dividend payments. Therefore, a firm which maintains
high dividends is likely to attract more shareholders and create a buying pressure
for the shares.

• Future dividends are a reflection of the level and timing of cash flows.
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• A rational investor will not want to invest in a firm that it is perceived to be risky
unless compensation is received for this extra risk.

• A lower share price signals greater risk, while a high share price signals lower
risk.

• The higher the risk involved, the greater the required return (compensation).

Future Dividends
• Share Price =
Required Return

• Corporate Governance - The systems implemented to direct and control a

corporation. It defines the rights and responsibilities of key corporate agents,
decision making procedures, and the way in which the firm will set, achieve and
monitor its objectives.

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• For example, the United States of America enacted the Sarbanes-Oxley Act of
2002, in an attempt to curb corporate disclosure and conflict of interest
problems.

• Sound corporate governance policies enhance openness, transparency and

accountability.

• The Agency Issue (Principal Agent Problem) - A potential conflict of interest when
managers place personal goals ahead of corporate goals.

• Shareholders of a company (principals) elect management (agents) to act on

their behalf.

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

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• In addition to the roles played by corporate boards, institutional investors, and
government regulations, corporate governance can be strengthened by ensuring
that managers’ interests are aligned with those of shareholders.

• A common approach is to structure management compensation to correspond

with firm performance.

• 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.

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• 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.

• Business Ethics - 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.

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 • Negative publicity often leads to negative impacts on a firm.

• Ethics programs promote ethical behavior on a daily basis. They seek to:
▪ reduce litigation and judgment costs
▪ maintain a positive corporate image
▪ build shareholder confidence
▪ gain the loyalty and respect of all stakeholders

• Such programs are likely to positively affect the firm’s competitiveness and share
price.

1.5. Financial Institutions and Markets

• Firms in general must source funding for growth and development.

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• Financial Institutions - institutional arrangements that accept savings from
individuals, businesses and governments and channel these savings in the form
of loans and investment. These include commercial banks, savings bank, credit
unions, insurance companies, mutual funds and pension funds.

• Financial Markets - These markets link the suppliers and demanders of funds
directly. There are two types:

▪ Money Market - Transactions involving short-term (one year or less) debt

instruments and marketable securities such as Treasury Bills, Commercial
Paper, Certificates of Deposit and Eurocurrencies.

▪ Capital Market - Trading long-term (more than one year) securities such as
stocks and bonds (key securities of the capital market).

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• Private placement - A firm can sell new securities directly to an exclusive investor
or group of investors. Alternatively, bonds or stock are offered to the general
public in the form of a public offering, known formally as the Initial Public
Offering (IPO).

• Major security exchanges - Part of secondary market. It includes both organised

exchanges and over-the-counter exchanges.

• Organized exchanges are tangible organisations that act as secondary markets

while over-the-counter exchanges are intangible markets for the purchase and
sale of securities.

• Sometimes, securities trade both on organised exchanges and the over-the-

counter markets. This is known as dual listing. These exchanges provide:

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 ▪ A continuous liquid market
▪ An efficient market that allocates funds to the most productive uses
▪ A forum for the forces of supply and demand to determine prices
▪ Assistance for firms requiring new financing.

• Investment Banker:
▪ Aids in acquiring long-term financing.
▪ Provides financial advice.
▪ Plays an important role in the issuance of new securities by purchasing them
and later re-selling them to the general public.
▪ Bears no risk whenever securities are sold through private placement. But
bears the risk of any price changes whenever these securities are offered to
the public.

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1.6. Business Taxes

• Taxation is an investment in the future growth and development of a country.

• The income earned by businesses can be classified as: ordinary income, which is
income earned through the sale of goods and services, dividends and interest
income; and capital gains income resulting from the sale of an asset above its
original purchase price.

• Example of capital gains income tax – Assume a business acquires a car for
$60000 and sells it for $70000. If the tax rate is 40% then the tax to be paid is
40% of $70000 - $60000, that is, $4000.

• The following Corporate Tax Schedule shows the rate at which ordinary income is
taxed:

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 Corporate Tax Schedule

Tax Calculation
Range of Taxable Income
Base tax + (Marginal rate * Amount over Base
Bracket)
$0- $50,000 $ 0 + (15% * amount over $0)

$50,000–$75,000 $ 7,500 + (25% * amount over $50,000)

$75,000- $100,000 $ 13,750 + (34% * amount over $75,000)

$100,000 - $335,000 $ 22,250 + (39% * amount over $100,000)

$335,000 - $10,000,000 $ 113,900 + (34% * amount over $335,000)

$10,000,000 - $15,000,000 $ 3,400,000 + (35% * amount over $10,000,000)

$15,000,000 - $18,333,333 $ 5,150,000 + (38% * amount over $15,000,000)

> $18,333,333 $ 6,416,667 + (35% * amount over $18,333,333)

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• Example - Weber Manufacturing Inc. has before-tax earnings of $250,000.
Tax = $22,250 + [0.39  ($250,000 – $100,000)]
Tax = $22,250 + (0.39  $150,000)
Tax = $22,250 + $58,500 = $80,750
• A firm’s marginal tax rate represents the rate at which additional income is
taxed.

• The average tax rate is the firm’s taxes divided by taxable income.

• Example - What are Webster Manufacturing’s marginal and average tax rates?
Marginal Tax Rate = 39%
Average Tax Rate = $80,750/$250,000 = 32.3%

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• For corporations only, 70% of all dividend income received from an investment in
the stock of another corporation in which the firm has less than 20% ownership
is excluded from taxation.

• This exclusion moderates the effect of double taxation, which occurs when after-
tax corporate earnings are distributed as cash dividends to stockholders, who
then must pay personal taxes on the dividend amount.

• Unlike dividend income, all interest income received is fully taxed.

• Example - Shadera Company provides the following information:

▪ Pretax earnings from operations $500,000 for the current year.
▪ Interest income received on bonds held in GG corporation $40,000.
▪ Dividend income received from Meena’s Corporation $40,000. Note that
Shadera Company is eligible for a 70% dividend exclusion.
▪ Tax rate 40%.
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Required:
1. Tax on operating earnings = 500,000 x 40% = $200,000

2. Find the after-tax amount from the interest income and dividend income:

Interest Income Dividend Income

Before tax amount $40,000 $40,000

Less: applicable 0 $28,000
exclusion
Taxable amount $40,000 $12,000
Less: Tax (40%) $16,000 $ 4,800
After tax amount $24,000 $35,200*
* $35,200 comprises of the exclusion amount of $28,000 plus the after-tax amount of $7,200.

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3. The after-tax amount of dividends received was $35,200 which exceeds the after-
tax amount of interest, $24,000, because of the 70% corporate dividend exclusion.
Hence, stock investments are more attractive to bond investments.

4. Total tax liability:

Taxes on operating earnings $200,000
+ Taxes on interest income 16,000
+ Taxes on dividend income 4,800
Total tax liability $220,800

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