SUNY at Buffalo Managerial Finance Discussion

Reflection statement 1•
Points 25
Write a one (full) page paper, single spaced, 12 pt. font., Calibri or Arial, stating your
thoughts on the assigned topic.
What is Finance?

Please put your name, course description FIN 348, date, and Reflection # at top left hand side
of each reflection statement.
Topic for Reflection statement 1:
Why are the financial statements key resources for a finance officer?
Principles of Managerial Finance
Fifteenth Edition
Chapter 1
The Role of Managerial
Finance
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Learning Goals (1 of 2)
LG 1 Define finance and the managerial finance function.
LG 2 Describe the goal of the firm, and explain why
maximizing the value of the firm is an appropriate goal
for a business.
LG 3 Identify the primary activities of the financial manager.
LG 4 Explain the key principles that financial managers use
when making business decisions.
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Learning Goals (2 of 2)
LG 5 Describe the legal forms of business organization.
LG 6 Describe the nature of the principal–agent relationship
between the owners and managers of a corporation,
and explain how various corporate governance
mechanisms attempt to manage agency problems.
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1.1 Finance and the Firm (1 of 3)
• 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
▪ how they invest their savings
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1.1 Finance and the Firm (2 of 3)
• What Is Finance?
– In a business context, finance involves:
▪ how firms raise money from investors
▪ how firms invest money in an attempt to earn a profit
▪ how firms decide whether to reinvest profits in the business or
distribute them back to investors
– Managerial finance concerns the duties of the financial
manager in a business
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1.1 Finance and the Firm (3 of 3)
• What Is a Firm?
– A firm is a business organization that sells goods or services
– Firms exist because investors want access to risky
investment opportunities
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1.1 Finance and the Firm (1 of 7)
• What Is the Goal of the Firm?
– Maximize Shareholder Wealth
▪ The primary goal of managers should be to maximize the
wealth of the firm’s owners
▪ In most instances this is equivalent to maximizing the stock
price
– Maximize Profit?
▪ Does profit maximization lead to the highest possible share
price?
▪ For at least three reasons, the answer is often no:
– Timing
– Cash Flows
– Risk
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Example 1.1 (1 of 2)
Nick Dukakis, the financial manager of Neptune
Manufacturing, a producer of marine engine components, is
choosing between two investments, Rotor and Valve. The
following table shows the EPS Dukakis expects each
investment to earn over its 3-year life.
Earnings per share (EPS)
Investment
Year 1
Year 2
Year 3
Total for years 1, 2, and 3
Rotor
$1.40
$1.00
$0.40
$2.80
Valve
0.60
1.00
1.40
3.00
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Example 1.1 (2 of 2)
If Dukakis thought he should make decisions to maximize
profits, he would recommend that Neptune invest in Valve
rather than Rotor because it results in higher total earnings
per share over the 3-year period ($3.00 EPS compared with
$2.80 EPS).
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1.1 Finance and the Firm (2 of 7)
• What Is the Goal of the Firm?
– Maximize Stakeholders’ Welfare?
▪ Some suggest a balanced consideration of the welfare of
shareholders and other firm stakeholders
– Stakeholders include employees, suppliers, customers,
and even members of the local community where a firm is
located
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1.1 Finance and the Firm (3 of 7)
• What Is the Goal of the Firm?
– Maximize Stakeholders’ Welfare?
▪ Flaws in neglecting shareholder wealth maximization:
– Maximizing shareholder wealth does not in any way imply
that managers should ignore the interests of everyone
connected to a firm who is not a shareholder
– To maximize shareholder value, managers must
necessarily assess the long-term consequences of their
actions
– The stakeholder perspective is intrinsically difficult to
implement, and advocates of the idea that managers
should consider all stakeholders’ interests along with those
of shareholders do not typically indicate how managers
should carry it out
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1.1 Finance and the Firm (4 of 7)
• What Is the Goal of the Firm?
– Maximize Stakeholders’ Welfare?
▪ Flaws in neglecting shareholder wealth maximization:
– Many people misinterpret the statement that managers
should maximize shareholder wealth as implying that
managers should take any action, including illegal or
unethical actions, that increases the stock price
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1.1 Finance and the Firm (5 of 7)
• The Role of Business Ethics
– Business ethics are the standards of conduct or moral
judgment that apply to persons engaged in commerce
– The goal of such standards is to motivate business and
market participants to adhere to both the letter and the spirit
of laws and regulations concerned with business and
professional practice
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1.1 Finance and the Firm (6 of 7)
• The Role of Business Ethics
– Ethical Guidelines
▪ Is the action arbitrary or capricious? Does it unfairly single out
an individual or group?
▪ Does the action violate the moral 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?
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1.1 Finance and the Firm (7 of 7)
• The Role of Business Ethics
– Ethics and Share Price
▪ An effective ethics program can enhance corporate value by
producing positive benefits
▪ Ethical behavior is for achieving the firm’s goal of owner wealth
maximization
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1.2 Managing the Firm (1 of 7)
• The Managerial Finance Function
– Financial Managers’ Key Decisions
▪ Investment Decisions
▪ Capital Budgeting Decisions
▪ Financing Decisions
– Capital Structure Decisions
• The money that firms raise to finance their activities
– Working Capital Decisions
• Decisions that refer to the management of a firm’s
short-term resources
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Figure 1.1 Financial Activities
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1.2 Managing the Firm (2 of 7)
• The Managerial Finance Function
– Principles That Guide Managers’ Decisions





Time Value of Money
Tradeoff between Return and Risk
Cash Is King
Competitive Financial Markets
Incentives are Important
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1.2 Managing the Firm (3 of 7)
• The Managerial Finance Function
– Principal–Agent Problem
▪ A problem that arises because the owners of a firm and its
managers are not the same people and the agent does not act
in the interest of the principal
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1.2 Managing the Firm (4 of 7)
• The Managerial Finance Function
– Organization of the Finance Function
▪ CEO
– CFO
• Treasurer
• Controller
• Director of Investor Relations
• Director of Internal Audit
• Foreign Exchange Manager
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Figure 1.2 Corporate Organization
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1.2 Managing the Firm (5 of 7)
• The Managerial Finance Function
– Relationship to Economics
▪ Marginal Cost–Benefit Analysis
– Economic principle that states that financial decisions
should be made and actions taken only when the marginal
benefits exceed the marginal costs
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Example 1.2 (1 of 2)
Jamie Teng is a financial manager for Nord Department
Stores, a large chain of upscale stores operating primarily in
the western United States. She is currently trying to decide
whether to replace one of the firm’s computer servers with a
new, more sophisticated one that would both speed
processing and handle a larger volume of transactions. The
new computer server would require a cash outlay of $8,000,
and the old one could be sold to net $2,000. The future
benefits from faster processing would be $10,000 in today’s
dollars. The benefits over a similar period from the old
computer (measured in today’s dollars) would be $3,000.
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Example 1.2 (2 of 2)
Applying marginal cost–benefit analysis, Jamie organizes
the data as follows:
Benefits with new computer
Less: Benefits with old computer
(1) Marginal benefits
Cost of new computer
Less: Proceeds from sale of old computer
$10,000
3,000
$ 7,000
$ 8,000
2,000
(2) Marginal costs
$ 6,000
Net benefit [(1) – (2)]
$ 1,000
Because the marginal benefits of $7,000 exceed the
marginal costs of $6,000, Jamie recommends purchasing
the new computer to replace the old one. The firm will
experience a net benefit of $1,000 as a result of this action.
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1.2 Managing the Firm (6 of 7)
• The Managerial Finance Function
– Relationship to Accounting
▪ Emphasis on Cash Flows
– Accrual Basis
• Recognizes revenue at the time of sale and
recognizes expenses when they are incurred
– Cash Basis
• Recognizes revenues and expenses only with respect
to actual inflows and outflows of cash
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Example 1.3 (1 of 2)
Nassau Corporation, a small yacht dealer, sold one yacht for
$1,000,000 in the calendar year just ended. Nassau
originally purchased the yacht for $800,000. Although the
firm paid in full for the yacht during the year, at year’s end it
has yet to collect the $1,000,000 from the customer. The
accounting view and the financial view of the firm’s
performance during the year are given by the following
income and cash flow statements, respectively.
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Example 1.3 (2 of 2)
Accounting view (accrual basis)
Financial view (cash basis)
Nassau Corporation income
statement for the year ended 12/31
Nassau Corporation cash flow
statement for the year ended 12/31
Sales revenue
Cash inflow
Less: Costs
Net profit
$1,000,000
800,000
$ 200,000
Less: Cash outflow
Net cash flow
$
0
800,000
−$800,000
In an accounting sense, Nassau Corporation is profitable,
but in terms of actual cash flow, it has a problem. Its lack of
cash flow resulted from the uncollected accounts receivable
of $1,000,000. Without adequate cash inflows to meet its
obligations, the firm will not survive, regardless of its level of
profits.
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Personal Finance Example 1.4 (1 of 2)
Individuals rarely use accrual concepts. Rather, they rely mainly
on cash flows to measure their financial outcomes. Generally,
individuals plan, monitor, and assess their financial activities using
cash flows over a given period, typically a month or a year. Ann
Bach projects her cash flows during October 2018 as follows:
Amount
Item
Net pay received
Rent
Car payment
Utilities
Groceries
Clothes
Dining out
Gasoline
Interest income
Misc. expense
Totals
Inflow
$4,400
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blank
blank
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220
_____
$4,620
Outflow
−$1,200
−450
−300
−800
−750
−650
−260
Blank
−425
−$4,835
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Personal Finance Example 1.4 (2 of 2)
Ann subtracts her total outflows of $4,835 from her total
inflows of $4,620 and finds that her net cash flow for October
will be – $215. To cover the $215 shortfall, Ann will have to
either borrow $215 (putting it on a credit card is a form of
borrowing) or withdraw $215 from her savings. Alternatively,
she may decide to reduce her outflows in areas of
discretionary spending such as clothing purchases, dining
out, or those items that make up the $425 of miscellaneous
expense.
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1.2 Managing the Firm (7 of 7)
• The Managerial Finance Function
– Relationship to Accounting
▪ 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 based on
their assessment of the associated returns and risks
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1.3 Organizational Forms, Taxation, and
the Principal–Agent Relationship (1 of 13)
• Legal Forms of Business Organizations
– Sole Proprietorships
▪ Businesses owned by one person and operated for his or her
own profit
– Unlimited Liability
• The condition of a sole proprietorship, giving creditors
the right to make claims against the owner’s personal
assets to recover debts owed by the business
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1.3 Organizational Forms, Taxation, and
the Principal–Agent Relationship (2 of 13)
• Legal Forms of Business Organizations
– Partnerships
▪ Businesses owned by two or more people and operated for
profit
– Articles of Partnership
• The written contract used to formally establish a
business partnership
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1.3 Organizational Forms, Taxation, and
the Principal–Agent Relationship (3 of 13)
• Legal Forms of Business Organizations
– Corporations
▪ Legal business entities with rights and duties similar to those of
individuals but with a legal identity distinct from its owners
▪ Stockholders
– The owners of a corporation, whose ownership, or equity,
takes the form of common stock or, less frequently,
preferred stock
▪ Limited Liability
– A legal provision that limits stockholders’ liability for a
corporation’s debt to the amount they initially invested in
the firm by purchasing stock
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1.3 Organizational Forms, Taxation, and
the Principal–Agent Relationship (4 of 13)
• Legal Forms of Business Organizations
– Corporations
▪ Stock
– A security that represents an ownership interest in a
corporation
▪ Dividends
– Periodic distributions of cash to the stockholders of a firm
▪ Board of Directors
– Group elected by the firm’s stockholders and typically
responsible for approving strategic goals and plans, setting
general policy, guiding corporate affairs, and approving
major expenditures
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1.3 Organizational Forms, Taxation, and
the Principal–Agent Relationship (5 of 13)
• Legal Forms of Business Organizations
– Corporations
▪ President or Chief Executive Officer (CEO)
– Corporate official responsible for managing the firm’s
day-to-day operations and carrying out the policies
established by the board of directors
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Table 1.1 Strengths and Weaknesses of
the Common Legal Forms of Business
Organization (1 of 2)
Strengths
Sole proprietorship
Partnership
Corporation
• Owner receives all
profits (and sustains all
losses)
• Low organizational
costs
• Income included and
taxed on proprietor’s
personal tax return
• Independence
• Secrecy
• Ease of dissolution
• Can raise more funds
than sole
proprietorships
• Borrowing power
enhanced by more
owners
• More available brain
power and managerial
skill
• Income included and
taxed on partner’s
personal tax return
• Owners have limited liability,
which guarantees that they cannot
lose more than they invested
• Can achieve large size via sale of
ownership (stock)
• Ownership (stock) is readily
transferable
• Long life of firm
• Can hire professional managers
• Has better access to financing
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Table 1.1 Strengths and Weaknesses of
the Common Legal Forms of Business
Organization (2 of 2)
Weaknesses
Sole proprietorship
Partnership
Corporation
• Owner has unlimited
liability in that total
wealth can be taken to
satisfy debts
• Limited fund-raising
power tends to inhibit
growth
• Proprietor must be jackof-all-trades
• Difficult to give
employees long-run
career opportunities
• Lacks continuity when
proprietor dies
• Owners have unlimited
liability and may have to
cover debts of other
partners
• Partnership is dissolved
when a partner dies
• Difficult to liquidate or
transfer partnership
• Taxes are generally higher
because corporate income is
taxed, and dividends paid to
owners are also taxed at a
maximum 15% rate
• More expensive to organize than
other business forms
• Subject to greater government
regulation
• Lacks secrecy because
regulations require firms to
disclose financial results
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Matter of Fact (1 of 2)
Number of Businesses and Income Earned by Type of
U.S. Firm
Although sole proprietorships greatly outnumber
partnerships and corporations combined, they generate the
lowest level of income. In total, sole proprietorships
accounted for almost three-quarters of the number of
business establishments in operation, but they earned just
10% of all business income. Corporations, on the other
hand, accounted for just 17% of the number of businesses,
but they earned almost two-thirds of all business income.
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Matter of Fact (2 of 2)
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Sole
proprietorships Partnerships
Number of firms (millions)
25.3
Corporations
3.4
5.8
Percentage of all firms
73%
10%
17%
Percentage of all business
income
10%
26%
64%
Source: Overview of Approaches to Corporate Integration, Joint Committee on
Taxation, United States Congress, May 17, 2016.
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1.3 Organizational Forms, Taxation, and
the Principal–Agent Relationship (6 of 13)
• Business Organizational Forms and Taxation
• Prior to 2018
– Proprietorships and partnerships taxed according to the
same progressive rate structure as individual taxpayers
– Corporations taxed according to an alternative, mostly
progressive rate structure
• Marginal vs. Average Tax Rate
▪ The marginal tax rate represents the rate at which the next
dollar of income is taxed while the average tax rate equals
taxes paid divided by taxable income
▪ The marginal rate does not usually equal the average rate
under a progressive tax rate structure
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1.3 Organizational Forms, Taxation, and
the Principal–Agent Relationship (7 of 13)
• Business Organizational Forms and Taxation
• After 2018 (Tax Cuts and Jobs Act)
– Proprietorships and partnerships still taxed according to a
(revised) progressive rate structure
– Corporations taxed at a flat rate of 21%
– Under a flat tax, the marginal and average tax rates are
equal
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1.3 Organizational Forms, Taxation, and
the Principal–Agent Relationship (8 of 13)
• Legal Forms of Business Organizations
– Business Organizational Forms and Taxation
▪ Double Taxation
– A situation facing corporations in which income from the
business is taxed twice—once at the business level and
once at the individual level when cash is distributed to
shareholders
▪ Ordinary Income versus Capital Gains
– Ordinary income is income earned by a business through
the sale of goods or services while capital gains is income
earned by selling an asset for more than it cost
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Table 1.2 2018 Tax Rate Schedule for Single
Taxpayer (Tax Rates Faced by Pass-Through
Businesses Like Proprietorships and Partnerships)
Tax calculation
Base tax
+
(Marginal rate × amount over
bracket lower limit)
$ 0 to $ 9,525
$
0
+
(10% × amount over $ 0)
9,525 to 38,700
$
953
+
(12% × amount over $ 9,525)
38,700 to 82,500
$
4,454
+
(22% × amount over $ 38,700)
82,500 to 157,500
$ 14,090
+
(24% × amount over $ 82,500)
157,500 to 200,000
$ 32,090
+
(32% × amount over $157,500)
200,000 to 500,000
$ 45,690
+
(35% × amount over $200,000)
$150,690
+
(37% × amount over $500,000)
Taxable income brackets
Over 500,000
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Pre-2018 Corporate Tax Rate Schedule
Tax calculation
Taxable income brackets
$0
Base tax
+
(Marginal rate × amount over
bracket lower limit)
to $ 50,000
$
0
+
(15% × amount over $ 0)
50,000
to
75,000
$
7,500
+
(25% × amount over $ 50,000)
75,000
to 100,000
$
13,750
+
(34% × amount over $ 75,000)
100,000
to 335,000
$
22,250
+
(39% × amount over $ 100,000)
335,000 to 10,000,000
$ 113,900
+
(34% × amount over $335,000)
10,000,000 to 15,000,000
$3,400,000
+
(35% × amount over $10,000,000)
15,000,000 to 18,333,333
$5,150,000
+
(38% × amount over $15,000,000)
Over 18,333,333
$6,416,667
+
(35% × amount over $18,333,333)
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Example 1.5 (1 of 2)
Dan Webster is the sole proprietor of Webster Manufacturing.
This year Webster earned $80,000 before taxes from his
business. Assuming that Dan has no other income, the taxes
he will owe on his business income (based on 2018 tax law)
are as follows:
Total taxes due = (0.10 × $9,525) + [0.12 × ($38,700 − $9,525)]
+ [0.22 × ($80,000 − $38,700)]
= $953 + $3,501 + $9,086
= $13,540
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Example 1.5 (2 of 2)
Notice that Webster’s tax liability has two components. The
first $4,454 in tax, denoted in Table 1.2 as the base tax, is
calculated by multiplying 10% times Webster’s first $9,525 in
income and then multiplying 12% times Webster’s next
$29,175 in income. The sum of those two calculations is the
$4,454 base tax from line 3 in Table 1.2. On top of that,
Webster must pay an additional 22% in taxes on income
above $38,700.
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Figure 1.3 Marginal and Average Tax Rates
at Different Income Levels for a Single
Taxpayer (2018 Tax Rates)
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Pre-2018 Marginal and Average Tax Rates
at Different Income Levels for a Single
Taxpayer
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Example 1.6 (1 of 2)
Peter Strong is a partner in Argaiv Software, and from that
business he earned taxable income of $300,000. Assuming that
this is Peter’s only source of income, from Table 1.2 we can see
that based on Peter’s tax bracket, he faces a marginal tax rate of
35%. How much in tax does Peter owe, and what is his average
tax rate? Table 1.2 shows a base tax of $45,690 for individuals
with income above $200,000 but below $500,000. Here’s where
that base tax comes from:
Base tax = (0.10 × $9,525) + (0.12 × $29,175) + (0.22 × $43,800)
+ (0.24 × $75,000) + (0.32 × $42,500)
= $953 + $3,501 + $9,636 + $18,000 + $13,600
= $45,690
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Example 1.6 (2 of 2)
In other words, based on his first $200,000 in partnership
earnings, Peter owes $45,690 in taxes. In addition to that base
tax, Peter must pay 35% tax on the last $100,000 that he earns,
so his total tax bill is
Total taxes due = $45,690 + (0.35 × $100,000) = $80,690
Given Peter’s total tax bill, we can calculate the average tax rate
by dividing taxes due by taxable income, as follows:
Average tax rate = $80,690 ÷ $300,000 = 0.269 = 26.9%
Again we stress that in many cases the marginal tax rate and the
average tax rate are not equal, and in such cases, managers
should focus on the marginal tax rate when they make decisions
about how to invest the firm’s money.
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Example 1.7
Suppose that Argaiv Software (from Example 1.6) is organized as a
corporation rather than as a partnership, and suppose also that
Argaiv paid $300,000 in dividends to shareholders. For individuals,
the tax code applies a different marginal rate to dividends than to
ordinary income, with the top marginal tax rate on dividends equal
to 23.8%. On the $300,000 in corporate taxable income, Argaiv will
pay taxes of $63,000 (0.21 × $300,000), and its shareholders could
pay as much as $71,400 (0.238 × $300,000) in taxes on the
dividends that they receive. Therefore, the total tax burden faced by
Argaiv and its shareholders is as high as $134,400, compared to the
total tax bill of $80,690 that would be owed if Argaiv were organized
as a partnership as in the previous example. The taxes paid on
Argaiv dividends by its shareholders could be less than shown here
if shareholders are not in the highest individual tax bracket.
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1.3 Organizational Forms, Taxation, and
the Principal–Agent Relationship (9 of 13)
• Legal Forms of Business Organizations
– Business Organizational Forms and Taxation
▪ Ordinary Income
– Income earned by a business through the sale of goods or
services
▪ Capital Gain
– Income earned by selling an asset for more than its cost
– For corporations, ordinary income and capital gains are
treated the same for tax purposes
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1.3 Organizational Forms, Taxation, and
the Principal–Agent Relationship (10 of 13)
• Legal Forms of Business Organizations
– Business Organizational Forms and Taxation
▪ Interest received by corporations is taxed as ordinary income,
while dividends received get a special tax break that moderates
the effect of double taxation
▪ Dividends received by the firm for stock held in other corporations
are usually subject to a 50% exclusion for tax purposes
– The dividend exclusion in effect eliminates half of the
potential tax liability from dividends received by the second
and any subsequent corporations
▪ In calculating their taxes, corporations can deduct operating
expenses, as well as interest expenses they pay to lenders
– The tax deductibility of these expenses reduces their after-tax
cost
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Example 1.8 (1 of 2)
Two corporations, Debt Co. and No-Debt Co., earned $200,000
before interest and taxes this year. During the year, Debt Co. paid
$30,000 in interest. No-Debt Co. had no debt and no interest
expense. How do the after-tax earnings of these firms compare?
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Debt Co.
No-Debt Co.
Earnings before interest and taxes
$200,000
$200,000
30,000
0
$170,000
$200,000
35,700
42,000
$134,300
$158,000
Less: Interest expense
Earnings before taxes
Less: Taxes (21%)
Earnings after taxes
Difference in earnings after taxes
$23,700
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Example 1.8 (2 of 2)
Both firms face a 21% flat tax rate. Debt Co. had $30,000 more
interest expense than No-Debt Co., but Debt Co.’s earnings after
taxes are only $23,700 less than those of No-Debt Co. This
difference is attributable to Debt Co.’s $30,000 interest expense
deduction, which provides a tax savings of $6,300 (the tax bill is
$35,700 for Debt Co. versus $42,000 for No-Debt Co.). The tax
savings can be calculated directly by multiplying the 21% tax rate
by the interest expense (0.21 × $30,000 = $6,300). Similarly, the
$23,700 after-tax interest expense can be calculated directly by
multiplying 1 minus the tax rate by the interest expense [(1 − 0.21)
× $30,000 = $23,700].
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1.3 Organizational Forms, Taxation, and
the Principal–Agent Relationship (11 of 13)
• Legal Forms of Business Organizations
– Other Limited Liability Organizations




Limited partnership (LP)
S corporation (S corp)
Limited liability company (LLC)
Limited liability partnership (LLP)
• Agency Problems and Agency Costs
– Agency Costs
▪ Costs that shareholders bear due to managers’ pursuit of their
own interests
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1.3 Organizational Forms, Taxation, and
the Principal–Agent Relationship (12 of 13)
• Corporate Governance
– The rules, processes, and laws by which companies are
operated, controlled, and regulated
– Internal Corporate Governance Mechanisms
▪ Stock Options
– Securities that allow managers to buy shares of stock at a
fixed price
▪ Restricted Stock
– Shares of stock paid out as part of a compensation
package that do not fully transfer from the company to the
employee until certain conditions are met
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1.3 Organizational Forms, Taxation, and
the Principal–Agent Relationship (13 of 13)
• Corporate Governance
– External Corporate Governance Mechanisms
▪ Individual versus Institutional Investors
– Activist Investors
• Investors who specialize in influencing management
▪ The Threat of Takeover
– Government Regulation
▪ Sarbanes-Oxley Act of 2002
– An act aimed at eliminating corporate disclosure and conflict
of interest problems
– Contains provisions concerning corporate financial
disclosures and the relationships among corporations,
analysts, auditors, attorneys, directors, officers, and
shareholders
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1.4 Developing Skills for Your Career
• Critical Thinking
• Communication and Collaboration
• Financial Computing Skills
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Review of Learning Goals (1 of 8)
• LG 1
– Define finance and the managerial finance function.
▪ Finance is the science and art of how individuals and firms
raise, allocate, and invest money. It affects virtually all aspects
of business
▪ 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
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Review of Learning Goals (2 of 8)
• LG 2
– Describe the goal of the firm, and explain why maximizing
the value of the firm is an appropriate goal for a business.
▪ The goal of the firm is to maximize its value and therefore the
wealth of its shareholders. Maximizing the value of the firm
means running the business in the interest of those who own it,
the shareholders. Because shareholders are paid after other
stakeholders, it is also generally necessary to satisfy the
interests of other stakeholders to enrich shareholders
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Review of Learning Goals (3 of 8)
• LG 3
– Identify the primary activities of the financial manager.
▪ Financial managers are primarily involved in three types of
decisions. Investment decisions relate to how a company
invests its capital to generate wealth for shareholders.
Financing decisions relate to how a company raises the
capital it needs to invest. Working capital decisions refer to the
day-to-day management of a firm’s short-term resources such
as cash, receivables, inventory, and payables
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Review of Learning Goals (4 of 8)
• LG 4
– Explain the key principles that financial managers use when
making business decisions.
▪ The time value of money means that money is more valuable
today than in the future because of the opportunity to earn a
return on money that is on hand now. Because a tradeoff
exists between risk and return, managers have to consider
both factors for any investment they make
▪ Managers should also focus more on cash flow than on
accounting profit. Furthermore, managers need to recognize
that market prices reflect information gathered by many
different investors, so the price of a company’s stock is an
important signal of how the company is doing
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Review of Learning Goals (5 of 8)
• LG 4 (Cont.)
– Explain the key principles that financial managers use when
making business decisions.
▪ Finally, although managers should act in shareholders’
interest, they do not always do so, which requires various
kinds of incentives to be in place so that the interests of
managers and shareholders align to the greatest extent
possible
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Review of Learning Goals (6 of 8)
• LG 5
– Describe the legal forms of business organization.
▪ These are the sole proprietorship, the partnership, and the
corporation. The corporation is dominant in the sense that
most large companies are corporations, and a corporation’s
owners are its stockholders. Stockholders expect to earn a
return by receiving dividends or by realizing gains through
increases in share price
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Review of Learning Goals (7 of 8)
• LG 6
– Describe the nature of the principal–agent relationship
between the owners and managers of a corporation, and
explain how various corporate governance mechanisms
attempt to manage agency problems.
▪ The separation of owners and managers in a corporation
gives rise to the classic principal–agent relationship, in which
shareholders are the principals and managers are the agents.
This arrangement works well when the agent makes decisions
in the principal’s best interest, but it can lead to agency
problems when the interests of the principal and agent differ
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Review of Learning Goals (8 of 8)
• LG 6 (Cont.)
– Describe the nature of the principal–agent relationship
between the owners and managers of a corporation, and
explain how various corporate governance mechanisms
attempt to manage agency problems.
▪ A firm’s corporate governance structure is intended to help
ensure that managers act in the best interests of the firm’s
shareholders and other stakeholders, and it is usually
influenced by both internal and external factors
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Copyright
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Principles of Managerial Finance
Fifteenth Edition
Chapter 2
The Financial Market
Environment
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Learning Goals (1 of 2)
LG 1 Understand the role that financial institutions play in
managerial finance.
LG 2 Understand the role that financial markets play in
managerial finance.
LG 3 Describe the differences between the money market
and the capital market.
LG 4 Understand the major regulations and regulatory
bodies that affect financial institutions and markets.
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Learning Goals (2 of 2)
LG 5 Describe the process of issuing common stock,
including venture capital, going public, and the role of
the investment bank.
LG 6 Understand what is meant by financial markets in
crisis, and describe some of the root causes of the
Great Recession.
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2.1 Financial Institutions (1 of 2)
• 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.
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2.1 Financial Institutions (2 of 2)
• Commercial Banks, Investment Banks, and the Shadow
Banking System
– Commercial Banks
▪ Institutions that provide savers with a secure place to invest their
funds offer loans to individual and business borrowers
– Investment Banks
▪ Assist companies in raising capital advise firms on major
transactions such as mergers or financial restructurings and
engage in trading and market making activities
– Shadow Banking System
▪ A group of institutions that engage in lending activities, much like
traditional banks, but that do not accept deposits and therefore
are not subject to the same regulations as traditional banks
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Matter of Fact
Consolidation in the U.S. Banking Industry
The U.S. banking industry has been going through a long
period of consolidation. According to the Federal Deposit
Insurance Corporation (FDIC), the number of commercial
banks in the United States declined from 14,400 in early
1984 to 4,964 by October 2017, a decline of more than 65%.
The decline is concentrated among small community banks,
which larger institutions have been acquiring at a rapid pace.
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2.2 Financial Markets (1 of 12)
• The Relationship Between Institutions and 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
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2.2 Financial Markets (2 of 12)
• The Relationship Between Institutions and Markets
– 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
– Secondary markets are financial markets in which
preowned securities (those that are not new issues) are
traded
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Figure 2.1 Flow of Funds
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2.2 Financial Markets (3 of 12)
• The Money Market
– A market where investors trade highly liquid securities with
maturities of 1 year or less
– Most money market transactions are made in marketable
securities which are short-term debt instruments, such as:
▪ U.S. Treasury bills issues by the federal government
▪ Commercial paper issued by businesses
▪ Negotiable certificates of deposit issued by financial institutions
– Investors generally consider marketable securities to be
among the least risky investments available.
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2.2 Financial Markets (4 of 12)
• The Money Market
– Eurocurrency Market
▪ International equivalent of the domestic money market
▪ It is a market for short-term bank deposits denominated in U.S.
dollars or other marketable currencies
▪ The Eurocurrency market has grown rapidly mainly because it
is unregulated and because it meets the needs of international
borrowers and lenders
▪ Nearly all Eurodollar deposits are time deposits
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2.2 Financial Markets (5 of 12)
• The Capital Market
– A market that enables suppliers and demanders of longterm funds to make transactions
– Key Securities Traded: Bonds and Stocks
▪ Securities traded in the capital market fall into two broad
categories: debt and equity
▪ Bonds
– Long-term debt instruments used by businesses and
government to raise large sums of money, generally from a
diverse group of lenders
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2.2 Financial Markets (6 of 12)
• The Capital Market
– Key Securities Traded: Bonds and Stocks
▪ Common Stock
– Units of ownership interest or equity in a corporation
▪ Preferred Stock
– A special form of ownership that has features of both a
bond and common stock
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2.2 Financial Markets (7 of 12)
• The Capital Market
– Broker Markets and Dealer Markets
▪ Securities Exchanges
– Organizations that provide the marketplace in which firms
can raise funds through the sale of new securities and in
which purchasers can resell securities
▪ Broker Markets
– Securities exchanges in which the two sides of a
transaction, the buyer and the seller, are brought together
to trade securities
– Trading takes place on centralized trading floors of
national exchanges, such as NYSE Euronext, as well as
regional exchanges
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2.2 Financial Markets (8 of 12)
• The Capital Market
– Broker Markets and Dealer Markets
▪ Dealer Markets
– Markets, like the NASDAQ, in which the buyer and seller
are not brought together directly but instead have their
orders executed by securities dealers that “make markets”
in the given security
– The dealer market has no centralized trading floors
• It is made up of a large number of market makers who
are linked together via a mass-telecommunications
network
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2.2 Financial Markets (9 of 12)
• The Capital Market
– Broker Markets and Dealer Markets
▪ Dealer Markets
– As compensation for executing orders, market makers
make money on the bid/ask spread (ask price – bid price)
• Ask Price: The lowest price a seller is willing to accept
for a security
• Bid Price: The highest price a buyer is willing to pay for
a security
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Example 2.1
Mark instructs his broker to submit a market order to buy
100 shares of Facebook common stock. At the time, the ask
price for Facebook is $138.79, and the bid price is $138.71.
Remember, the ask price is the lowest price offered in the
market to sell Facebook to a potential buyer. Since Mark is
trying to buy Facebook stock, and he wants to buy at the
lowest possible price, he will pay $138.79, plus whatever
commissions his broker charges. If, however, Mark already
owned Facebook stock and wanted to sell it, he would be
looking for the market’s best offer to buy, the bid price. In
that case, Mark would sell his shares for $138.71, less
commissions charged by the broker.
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Personal Finance Example 2.2 (1 of 3)
Assume that the current bid price for Merck & Co. stock is
$63.25 and the ask price is $63.45. Suppose you have an
E*TRADE brokerage account that charges a $6.95
commission for online equity trades. What is the current
bid/ask spread for Merck?
Bid/Ask Spread = Ask Price − Bid Price
(2.1)
Bid/Ask Spread = $63.45 – $63.25 = $0.20
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Personal Finance Example 2.2 (2 of 3)
Inserting the current bid and ask prices into Equation 2.1,
you find that the bid/ask spread for Merck is $0.20. What
would your total transaction costs be if you purchased 100
shares of Merck by submitting a market order via your
E*TRADE account? Assume the trade is sent to a broker
market for execution, and the market maker matches your
order with a 100-share sell order for Merck from another
investor. In this case your order will be executed at the
midpoint of the bid/ask spread ($63.35), so you will pay only
the brokerage commission.
Total Transaction Costs = Brokerage Commission = $6.95
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Personal Finance Example 2.2 (3 of 3)
Now what would your total transaction costs be if you
purchased 100 shares of Merck by submitting a market order
via your E*TRADE account, and it is routed to a dealer
market for execution?
Total Transaction Costs = ( Number of Shares 1/2 the Bid/Ask Spread )
+ Brokerage Commission
= (100 1/2  $0.20 ) + $6.95
= $10 + $6.95 = $16.95
Depending on where your brokerage routes your order, you
find that your total transaction costs are either $6.95 in a
broker market or $16.95 in a dealer market.
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2.2 Financial Markets (10 of 12)
• The Capital Market
– International Capital Markets
▪ Eurobond Market
– The market where corporations and governments typically
issue bonds denominated in dollars and sell them to
investors located outside the United States.
▪ Foreign Bond Market
– A market for bonds issued by a foreign corporation or
government that is denominated in the investor’s home
currency and sold in the investor’s home market
▪ International Equity Market
– Allows corporations to sell blocks of shares to investors in
a number of different countries simultaneously
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2.2 Financial Markets (11 of 12)
• The Role of Capital Markets
– The Efficient-Market Hypothesis
▪ Securities are typically in equilibrium, which means they are
fairly priced and their expected returns equal their required
returns
▪ At any point in time, security prices fully reflect all information
available about the firm and its securities, and these prices
react swiftly to new information
▪ Because stocks are fully and fairly priced, investors need not
waste their time trying to find mispriced (undervalued or
overvalued) securities
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2.2 Financial Markets (12 of 12)
• The Role of Capital Markets
– Behavioral Finance
▪ Argues that stock prices and prices of other securities can
deviate from their true values for extended periods and that
these deviations may lead to predictable patterns in stock
prices
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2.3 Regulation of Financial Markets and
Institutions (1 of 4)
• Regulations Governing Financial Institutions
– Glass-Steagall Act
▪ Prohibited institutions that took deposits from engaging in
activities such as securities underwriting and trading, thereby
effectively separating commercial banks from investment
banks
– Federal Deposit Insurance Corporation (FDIC)
▪ An agency created by the Glass-Steagall Act that provides
insurance for deposits at banks and monitors banks to ensure
their safety and soundness
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2.3 Regulation of Financial Markets and
Institutions (2 of 4)
• Regulations Governing Financial Institutions
– Gramm-Leach-Bliley Act
▪ Allows mergers between commercial banks, investment banks,
and insurance companies and thus permits these institutions to
compete in markets that prior regulations prohibited them from
entering
– Dodd-Frank Wall Street Reform and Consumer Protection
Act
▪ Realigns the duties of several existing agencies and requires
existing and new agencies to report to Congress regularly
▪ Nearly a decade after Dodd-Frank became law, the various
agencies affected or created by the new law were still writing
rules specifying how the new law’s provisions would be
implemented
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2.3 Regulation of Financial Markets and
Institutions (3 of 4)
• Regulations Governing Financial Markets
– 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
– Securities Exchange Act of 1934
▪ Regulates the trading of securities in the secondary market
▪ Created the Securities Exchange Commission
▪ 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
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2.3 Regulation of Financial Markets and
Institutions (4 of 4)
• Regulations Governing Financial Markets
– Securities and Exchange Commission
▪ The primary government agency responsible for enforcing
federal securities laws
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2.4 The Securities Issuing Process (1 of 12)
• Issuing Common Stock
– Private Equity
▪ External equity financing that is raised via a private placement,
typically by private early-stage firms with attractive growth
prospects
▪ Angel Investors (Angels)
– Wealthy individual investors who make their own
investment decisions and are willing to invest in promising
startups in exchange for a portion of the firm’s equity
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2.4 The Securities Issuing Process (2 of 12)
• Issuing Common Stock
– Private Equity
▪ Venture Capitalists (VCs)
– Formal business entities that take in private equity capital
from many individual investors, often institutional investors
such as endowments and pension funds or individuals of
high net worth, and make private equity investment
decisions on their behalf
– Organization and Investment Stages
▪ VC Limited Partnership is the most common structure
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2.4 The Securities Issuing Process (3 of 12)
• Issuing Common Stock
– Deal Structure and Pricing
▪ The deal structure allocates responsibilities and ownership
interests between the existing owners (typically the founders)
and the venture capitalist, and its terms depend on numerous
factors related to the founders; the business structure, stage of
development, and outlook; and other market and timing issues
▪ Venture capitalists will require more equity ownership and pay
less for it the riskier and less developed the business
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Table 2.1 Organization of Venture Capital
Investors
Organization
Description
Small business
investment companies
(SBICs)
Corporations chartered by the federal government that can borrow at
attractive rates from the U.S. Treasury and use the funds to make venture
capital investments in private companies.
Financial VC funds
Subsidiaries of financial institutions, particularly banks, set up to help
young firms grow and, it is hoped, become major customers of the
institution.
Corporate VC funds
Firms, sometimes subsidiaries, established by nonfinancial firms, typically
to gain access to new technologies that the corporation can access to
further its own growth.
VC limited partnerships
Limited partnerships organized by professional VC firms, which serve as
the general partner and organize, invest, and manage the partnership
using the limited partners’ funds; the professional VCs ultimately liquidate
the partnership and distribute the proceeds to all partners.
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2.4 The Securities Issuing Process (4 of 12)
• Issuing Common Stock
– Going Public
▪ Private Placement
– The firm sells new securities directly to an investor or
group of investors
▪ Rights Offering
– The firm sells new shares to existing stockholders
▪ Public Offering
– The firm sells new shares to the general public
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2.4 The Securities Issuing Process (5 of 12)
• Issuing Common Stock
– Going Public
▪ Initial Public Offering (IPO)
– The first public sale of a firm’s stock, typically made by
small, rapidly growing companies that either require
additional capital to continue growing or have met a
milestone for going public that was established in an
earlier agreement to obtain VC funding
▪ Prospectus
– A portion of a security registration statement that describes
the key aspects of the issue, the issuer, and its
management and financial position
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2.4 The Securities Issuing Process (6 of 12)
• Issuing Common Stock
– Going Public
▪ Red Herring
– A preliminary prospectus made available to prospective
investors during the waiting period between the registration
statement’s filing with the SEC and its approval
▪ Quiet Period
– Period during which the law places restrictions on what
company officials may say about the company
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2.4 The Securities Issuing Process (7 of 12)
• Issuing Common Stock
– Going Public
▪ Roadshow
– A series of presentations to potential investors around the
country, providing investors with information about the new
issue
– Sessions help investment banks gauge demand for the
offering and set a preliminary offer price range
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Figure 2.2 Cover of a Preliminary Prospectus
for a Stock Issue
Source: From SEC filing Form S1/A, Copyright © U.S. Securities
and Exchange Commission.
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2.4 The Securities Issuing Process (8 of 12)
• Issuing Common Stock
– The Investment Bank’s Role
▪ Investment Bank
– Financial intermediary that specializes in selling new
security issues and advising firms with regard to major
financial transactions
▪ Underwriting
– The role of the investment bank in bearing the risk of
reselling, at a profit, the securities purchased from an
issuing corporation at an agreed-on price
▪ IPO Offer Price
– The price at which the issuing firm sells its securities
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2.4 The Securities Issuing Process (9 of 12)
• Issuing Common Stock
– The Investment Bank’s Role
▪ Originating Investment Bank
– The investment bank initially hired by the issuing firm, it
brings other investment banks in as partners to form an
underwriting syndicate
▪ Underwriting Syndicate
– A group of other banks formed by the originating
investment bank to share the financial risk associated with
underwriting new securities
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2.4 The Securities Issuing Process (10 of 12)
• Issuing Common Stock
– The Investment Bank’s Role
▪ Tombstone
– The list of underwriting syndicate banks, presented in such
a way to indicate a syndicate member’s level of
involvement, located at the bottom of the IPO prospectus
cover page
▪ Selling Group
– A large number of brokerage firms that join the originating
investment bank(s); each accepts responsibility for selling
a certain portion of a new security issue on a commission
basis
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Figure 2.3 The Selling Process for a Large
Security Issue
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Figure 2.4 Cover of a Final Prospectus for
a Stock Issue
Source: From SEC filing Form
424B4. Copyright © U.S.
Securities and Exchange
Commission.
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2.4 The Securities Issuing Process (11 of 12)
• Issuing Common Stock
– The Investment Bank’s Role
▪ Total Proceeds
– The total amount of proceeds for all shares sold in the IPO
– Total Proceeds = (IPO Offer Price × # of IPO Shares Issued)
▪ Market Price
– The price of the firm’s shares as determined by the
interaction of buyers and sellers in the secondary market
▪ Market Capitalization
– The total market value of a publicly traded firm’s outstanding
stock
– Market Capitalization = (Market Price of Stock × # of Shares
of Stock Outstanding)
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2.4 The Securities Issuing Process (12 of 12)
• Issuing Common Stock
– The Investment Bank’s Role
▪ IPO Market Price
– The final trading price on the first day in the secondary
market
▪ IPO Underpricing
– The percentage change from the final IPO offer price to the
IPO market price, which is the final trading price on the first
day in the secondary market; this is also called the IPO initial
return
– IPO Underpricing = (Market Price − Offer Price) ÷ Offer Price
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Example 2.3 (1 of 2)
With baby boomers retiring and hitting the open roads of
America in droves, the largest U.S. recreational vehicle dealer,
Camping World, decided it was time to go public. Its IPO took
place on October 7, 2016, at which time the company sold
11.4 million shares at an IPO offer price of $22 per share.
Checking prices for Camping World on Yahoo! Finance, you
can find that the IPO market price at the close of secondary
market trading on October 7 was $22.50. With this information
you can calculate the IPO underpricing using Equation 2.4.
IPO Underpricing = ( Market Price – Offer Price )  Offer Price
(2.4)
= ( $22.50 – $22 )  $22 = 0.0227 or 2.27%
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Example 2.3 (2 of 2)
Camping World’s IPO underpricing of 2.27% is considerably
less than the 44% underpricing for Snap Inc. This
demonstrates another interesting fact about IPOs,
specifically, that the degree to which IPOs are underpriced
varies tremendously from one deal to another and one time
to another. Usually, smaller IPOs are underpriced more than
larger ones, but that was not the case here. Camping World
raised $250.8 million in its offering, which is a small fraction
of the $3.4 billion raised in Snap’s IPO.
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2.5 Financial Markets in Crisis (1 of 4)
• Financial Institutions and Real Estate Finance
– Securitization
▪ The process of pooling mortgages or other types of loans and
then selling claims or securities against that pool in the
secondary market
– Mortgage-Backed Securities
▪ Securities that represent claims on the cash flows generated
by a pool of mortgages
▪ A primary risk associated with mortgage-backed securities is
that homeowners may not be able to, or may choose not to,
repay their loans
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2.5 Financial Markets in Crisis (2 of 4)
• Financial Institutions and Real Estate Finance
– Falling Home Prices and Delinquent Mortgages
▪ Rising home prices between 1987 and 2006 kept mortgage
default rates low
▪ Lenders relaxed standards for borrowers and created subprime
mortgages
▪ As housing prices fell from 2006 to 2009, many borrowers had
trouble making payments, but were unable to refinance
▪ As a result, there was a sharp increase in the number of
delinquencies and foreclosures
▪ Subprime Mortgages
– Mortgage loans made to borrowers with lower incomes and
poorer credit histories as compared to “prime” borrowers
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Figure 2.5 House Prices Soar and Then
Crash
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2.5 Financial Markets in Crisis (3 of 4)
• Financial Institutions and Real Estate Finance
– Crisis of Confidence in Banks
▪ With delinquency rates rising, the value of mortgage-backed
securities began to fall and so did the fortunes of financial
institutions that had invested heavily in real estate assets
▪ Only 3 banks failed in 2007, but 25 failed in 2008, 140 failed in
2009, peaking at 157 bank failures in 2010
▪ It was not until 2015 that bank failures fell back into the single
digits
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Figure 2.6 Bank Stocks Plummet During
Financial Crisis
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2.5 Financial Markets in Crisis (4 of 4)
• Spillover Effects and Recovery from the Great Recession
– As banks came under intense financial pressure in 2008,
they tightened their lending standards and dramatically
reduced the quantity of loans they made
– Corporations found that they could no longer raise money in
the money market, or could only do so at extraordinarily
high rates
– As a consequence, businesses began to hoard cash and cut
back on expenditures, and economic activity contracted
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Review of Learning Goals (1 of 10)
• LG 1
– Understand the role that financial institutions play in
managerial finance.
▪ Financial institutions bring net suppliers of funds and net
demanders together to help translate the savings of
individuals, businesses, and governments into loans and other
types of investments
▪ The net suppliers of funds are generally individuals or
households who save more money than they borrow
▪ Businesses and governments are generally net demanders of
funds, meaning they borrow more money than they save
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Review of Learning Goals (2 of 10)
• LG 2
– Understand the role that financial markets play in
managerial finance.
▪ Like financial institutions, financial markets help businesses
raise the external financing they need to fund new investments
for growth
▪ Financial markets provide a forum in which savers and
borrowers can transact business directly
▪ Businesses and governments issue debt and equity securities
directly to the public in the primary market
▪ Subsequent trading of these securities between investors
occurs in the secondary market
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Review of Learning Goals (3 of 10)
• LG 3
– Describe the differences between the money market and the
capital market.
▪ In the money market, savers who want a temporary place to
deposit funds where they can earn interest interact with
borrowers who have a short-term need for funds
▪ Marketable securities, including Treasury bills, commercial
paper, and other instruments, are the main securities traded in
the money market
▪ The Eurocurrency market is the international equivalent of the
domestic money market.
▪ In contrast, the capital market is the forum in which savers and
borrowers interact on a long-term basis
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Review of Learning Goals (4 of 10)
• LG 3 (Cont.)
– Describe the differences between the money market and the
capital market.
▪ Firms issue either debt (bonds) or equity (stock) securities in
the capital market
▪ Once issued, these securities trade on secondary markets that
are either broker markets or dealer markets
▪ An important function of the capital market is to determine the
underlying value of the securities issued by businesses
▪ In an efficient market, the price of a security is an unbiased
estimate of its true value
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Review of Learning Goals (5 of 10)
• LG 4
– Understand the major regulations and regulatory bodies that
affect financial institutions and markets.
▪ The Glass-Steagall Act created the FDIC and imposed a
separation between commercial and investment banks
▪ The act was designed to limit the risks that banks could take
and to protect depositors
▪ More recently, the Gramm-Leach-Bliley Act essentially
repealed the elements of Glass-Steagall pertaining to the
separation of commercial and investment banks.
▪ After the recent financial crisis, much debate has occurred
regarding the proper regulation of large financial institutions
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Review of Learning Goals (6 of 10)
• LG 4 (Cont.)
– Understand the major regulations and regulatory bodies that
affect financial institutions and markets.
▪ The Dodd-Frank Act was passed in 2010 and contained a host
of new regulatory requirements, the effects of which are yet to
be determined
▪ The Securities Act of 1933 and the Securities Exchange Act of
1934 are the major pieces of legislation shaping the regulation
of financial markets
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Review of Learning Goals (7 of 10)
• LG 4 (Cont.)
– Understand the major regulations and regulatory bodies that
affect financial institutions and markets.
▪ The 1933 act focuses on regulating the sale of securities in the
primary market, whereas the 1934 act deals with regulations
governing transactions in the secondary market
▪ The 1934 act also created the Securities and Exchange
Commission, the primary body responsible for enforcing
federal securities laws
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Review of Learning Goals (8 of 10)
• LG 5
– Describe the process of issuing common stock, including
venture capital, going public, and the investment bank.
▪ The initial external financing for business startups with
attractive growth prospects typically comes in the form of
private equity raised via a private equity placement
▪ These investors can be either angel investors or venture
capitalists (VCs). VCs usually invest in both early-stage and
later-stage companies that they hope to take public to cash out
their investments
▪ The first public issue of a firm’s stock is called an initial public
offering (IPO).
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Review of Learning Goals (9 of 10)
• LG 5 (Cont.)
– Describe the process of issuing common stock, including
venture capital, going public, and the investment bank.
▪ The company selects an investment bank to advise it and to
sell the securities
▪ The lead investment bank may form a selling syndicate with
other investment banks
▪ The IPO process includes getting SEC approval, promoting the
offering to investors, and pricing the issue
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Review of Learning Goals (10 of 10)
• LG 6
– Understand what is meant by financial markets in crisis, and
describe some of the root causes of the Great Recession.
▪ The financial crisis was caused by several factors related to
investments in real estate
▪ Financial institutions lowered their standards for lending to
prospective homeowners, and institutions also invested heavily
in mortgage-backed securities
▪ When home prices fell and mortgage delinquencies rose, the
value of the mortgage-backed securities held by banks
plummeted, causing some banks to fail and many others to
restrict the flow of credit to business
▪ That, in turn, contributed to a severe recession in the United
States that became known as the Great Recession
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Copyright
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Principles of Managerial Finance
Fifteenth Edition
Chapter 3
Financial Statements and
Ratio Analysis
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Learning Goals (1 of 2)
LG 1 Review the contents of the stockholders’ report and the
procedures for consolidating international financial
statements.
LG 2 Understand who uses financial ratios and how.
LG 3 Use ratios to analyze a firm’s liquidity and activity.
LG 4 Discuss the relationship between debt and financial
leverage, as well as the ratios used to analyze a firm’s
debt.
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Learning Goals (2 of 2)
LG 5 Use ratios to analyze a firm’s profitability and its market
value.
LG 6 Use a summary of financial ratios and the DuPont
system of analysis to perform a complete ratio
analysis.
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3.1 The Stockholders’ Report (1 of 8)
• General Accepted Accounting Principals (GAAP)
– Authorized by the Financial Accounting Standards Board
(FASB)
• Sarbanes-Oxley Act of 2002
– Established the Public Company Accounting Oversight
Board (PCAOB)
• The Letter to Stockholders
– The first element of the annual stockholders’ report and the
primary communication from management
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3.1 The Stockholders’ Report (2 of 8)
• The Four Key Financial Statements
– Income Statement
▪ Provides a financial summary of the firm’s operating results
during a specified period
▪ Dividends Per Share
– The dollar amount of cash distributed during the period on
behalf of each outstanding share of common stock
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Table 3.1 Bartlett Company Income
Statements ($000) (1 of 2)
For the years ended December 31
blank
Sales revenue
2019
2018
$ 3,074
$ 2,567
2,088
1,711
Less: Cost of goods sold
Gross profits
$
Less: Operating expenses
Selling expense
General and administrative expenses
Other operating expenses
Depreciation expense
Operating profits
$
blank
$
Total operating expense
986
100
856
blank
$
108
194
187
35
35
239
223
$
568
$
553
$
418
$
303
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Table 3.1 Bartlett Company Income
Statements ($000) (2 of 2)
For the years ended December 31
blank
2019
2018
93
91
$ 325
$ 212
94
64
$ 231
$ 148
10
10
$ 221
$ 138
Earnings per share (EPS)a
$ 2.90
$ 1.81
Dividend per share (DPS)b
$ 1.29
$ 0.75
Less: Interest expense
Net profits before taxes
Less: Taxes
Net profits after taxes
Less: Preferred stock dividends
Earnings available for common stockholders
aCalculated
by dividing the earnings available for common stockholders by the number of shares of common stock
outstanding: 76,262 in 2019 and 76,244 in 2018. Earnings per share in 2019: $221,000 ÷ 76,262 = $2.90; in 2018:
$138,000 ÷ 76,244 = $1.81.
bCalculated by dividing the dollar amount of dividends paid to common stockholders by the number of shares of common
stock outstanding. Dividends per share in 2019: $98,000 ÷ 76,262 = $1.29; in 2018: $57,183 ÷ 76,244 = $0.75.
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Personal Finance Example 3.1 (1 of 4)
Jan and Jon Smith, a mid-30s married couple with no
children, prepared a personal income and expense
statement, which is similar to a corporate income statement.
A condensed version of their income and expense statement
follows.
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Personal Finance Example 3.1 (2 of 4)
Jan and Jon Smith’s Income and Expense Statement for the Year
Ended December 31, 2019
Income
BLANK
Salaries
$ 91,500
Interest received
195
Dividends received
120
(1) Total income
Expenses
$ 91,815
blank
Mortgage payments
$ 11,500
Auto loan payments
4,280
Utilities
3,180
Home repairs and maintenance
1,050
Food
8,235
Car expense
5,450
Health care and insurance
3,150
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Personal Finance Example 3.1 (3 of 4)
Jan and Jon Smith’s Income and Expense Statement for the Year
Ended December 31, 2019
Expenses
BLANK
Clothes, shoes, accessories
2,745
Insurance
1,380
Taxes
36,600
Appliance and furniture payments
1,250
Recreation and entertainment
4,575
Tuition and books for Jan
3,830
Personal care and other items
915
(2) Total expenses
$ 88,140
(3) Cash surplus (or deficit) [(1) − (2)]
$ 3,675
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Personal Finance Example 3.1 (4 of 4)
During the year, the Smiths had total income of $91,815 and
total expenses of $88,140, which left them with a cash
surplus of $3,675. They can save and invest the surplus.
Notice that the $3,675 represents just about 4% of the
Smiths’ total income. Most financial advisors would suggest
a much higher savings rate, so Jan and Jon may want to
take a hard look at their budget to see where they can cut
expenses.
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3.1 The Stockholders’ Report (3 of 8)
• The Four Key Financial Statements
– Balance Sheet
▪ Summary statement of the firm’s financial position at a given
point in time
▪ Current Assets
– Short-term assets, expected to be converted into cash
within 1 year
▪ Current Liabilities
– Short-term liabilities, expected to be paid within 1 year
▪ Long-Term Debt
– Debt for which payment is not due in the current year
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3.1 The Stockholders’ Report (4 of 8)
• The Four Key Financial Statements
– Balance Sheet
▪ Paid-in-Capital in Excess of Par
– The amount of proceeds in excess of the par value
received from the original sale of common stock
▪ Statement of Stockholders’ Equity
– Shows all equity account transactions that occurred during
a given year
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Table 3.2 Bartlett Company Balance
Sheets ($000) (1 of 2)
December 31
Assets
Cash
2019
$
363
2018
$
288
Marketable securities
68
51
Accounts receivable
503
365
Inventories
289
300
$ 1,223
$ 1,004
$ 2,072
$ 1,903
1,866
1,693
Furniture and fixtures
358
316
Vehicles
275
314
98
96
$ 4,669
$ 4,322
2,295
2,056
Net fixed assets
$ 2,374
$ 2,266
Total assets
$ 3,597
$ 3,270
Total current assets
Land and buildings
Machinery and equipment
Other (includes financial leases)
Total gross fixed assets (at cost)
Less: Accumulated depreciation
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Table 3.2 Bartlett Company Balance
Sheets ($000) (2 of 2)
December 31
Assets
2019
2018
Liabilities and Stockholders’ Equity
Blank
blank
Accounts payable
$
Notes payable
Accruals
Total current liabilities
$
Long-term debt (includes financial leases)
Total liabilities
Preferred stock: cumulative 5%, $100 par, 2,000 shares authorized and issued
Common stock: $2.50 par, 100,000 shares authorized, shares issued and outstanding in 2019:
382
$
270
79
99
159
114
620
$
483
1,023
967
$ 1,643
$ 1,450
$
$
200
200
191
191
428
417
1,135
1,012
Total stockholders’ equity
$ 1,954
$ 1,820
Total liabilities and stockholders’ equity
$ 3,597
$ 3,270
76,262; in 2018: 76,244
Paid-in capital in excess of par on common stock
Retained earnings
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Personal Finance Example 3.2 (1 of 2)
The following personal balance sheet for Jan and Jon
Smith—the couple introduced earlier, who are married, in
their mid-30s, and have no children—is similar to a corporate
balance sheet.
Jan and Jon Smith’s Balance Sheet: December 31, 2019
Assets
Cash on hand
blank
$
Liabilities and Net Worth
90
Credit card balances
blank
$
665
Checking accounts
575
Utility bills
Savings accounts
760
Medical bills
75
Money market funds
800
Other current liabilities
45
$2,225
Total current liabilities
Total liquid assets
Stocks and bonds
$2,250
Real estate mortgage
265
$
1,050
$120,000
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Personal Finance Example 3.2 (2 of 2)
Assets
blank
Liabilities and Net Worth
blank
Mutual funds
1,500
Auto loans
14,250
Retirement funds, IRA
2,000
Education loan
13,800
5,750
Personal loan
4,000
$180,000
Furniture loan
800
Total investments
Real estate
Cars
$
34,000
Total long-term liabilities
$152,850
$153,900
Household furnishings
3,700
Total liabilities
Jewelry and artwork
1,500
Net worth (N/W)
Total personal property
$219,200
Total assets
$227,175
Total liabilities and net worth
Blank
73,275
$227,175
blank
The Smiths have total assets of $227,175 and total liabilities of $153,900. Personal net worth
(N/W) is a “plug figure”—the difference between total assets and total liabilities—which in the
case of Jan and Jon Smith is $73,275.
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3.1 The Stockholders’ Report (5 of 8)
• The Four Key Financial Statements
– 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
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Table 3.3 Bartlett Company Statement of
Retained Earnings ($000) for the Year
Ended December 31, 2019
Retained earnings balance (January 1, 2019)
Plus: Net profits after taxes (for 2019)
Less: Cash dividends (paid during 2019)
$1,012
231
blank
Preferred stock
10
Common stock
98
Total dividends paid
$ 108
Retained earnings balance (December 31, 2019)
$1,135
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3.1 The Stockholders’ Report (6 of 8)
• The Four Key Financial Statements
– 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
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Table 3.4 Bartlett Company Statement of
Cash Flows ($000) for the Year Ended
December 31, 2019 (1 of 2)
Cash Flow from Operating Activities
Net profits after taxes
Blank
$ 231
Depreciation
239
Increase in accounts receivable
Decrease in inventories
−138a
11
Increase in accounts payable
Increase in accruals
112
45
Cash provided by operating activities
$ 500
Cash Flow from Investment Activities
blank
Increase in gross fixed assets
−347
Change in equity investments in other firms
Cash provided by investment activities
0
−$ 347
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Table 3.4 Bartlett Company Statement of
Cash Flows ($000) for the Year Ended
December 31, 2019 (2 of 2)
Cash Flow from Financing Activities
Decrease in notes payable
−20
Increase in long-term debts
56
Changes in stockholders’ equityb
11
− 108
Dividends paid
a
b
Blank
Cash provided by financing activities
−$ 61
Net increase in cash and marketable securities
$ 92
As is customary, parentheses are used to denote a negative number, which in this case is a cash outflow.
Retained earnings are excluded here because their change is actually reflected in the combination of the “net profits after
taxes” and “dividends paid” entries.
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3.1 The Stockholders’ Report (7 of 8)
• Notes to the Financial Statements
– Explanatory notes keyed to relevant accounts in the
statements; they provide detailed information on the
accounting policies, procedures, calculations, and
transactions underlying entries in the financial statements
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3.1 The Stockholders’ Report (8 of 8)
• Consolidating International Financial Statements
– Financial Accounting Standards Board (FASB) Standard
No. 52
▪ Mandates that U.S.–based companies translate their foreigncurrency-denominated assets and liabilities into U.S. dollars,
for consolidation with the parent company’s financial
statements
– Current Rate (Translation) Method
▪ Technique used by U.S.–based companies to translate their
foreign-currency-denominated assets and liabilities into U.S.
dollars, for consolidation with the parent company’s financial
statements, using the year-end (current) exchange rate
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3.2 Using Financial Ratios (1 of 5)
• Interested Parties
– Shareholders
– Creditors
– Management
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3.2 Using Financial Ratios (2 of 5)
• Types of Ratio Comparisons
– Cross-Sectional Analysis
▪ Comparison of different firms’ financial ratios at the same point
in time; involves comparing the firm’s ratios with those of other
firms in its industry or with industry averages
– Benchmarking
▪ A type of cross-sectional analysis in which the firm’s ratio
values are compared with those of a key competitor or with a
group of competitors that it wishes to emulate
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Table 3.5 Financial Ratios for Select Firms
and Their Industry Average Values (1 of 2)
blank
Inventory
turnover
Average
collection
period
(days)
Total
asset
turnover
Debt
ratio
Net
profit
margin
Return on Return on
total
common
assets
equity
Current
ratio
Quick
ratio
Apple
1.4
1.3
61.6
49.6
0.7
0.6
21.2%
14.2%
Hewlett-
1.0
0.7
8.8
31.1
1.7
0.7
5.2
Computers
1.5
0.6
21.0
57.0
0.8
0.4
Home Depot
1.3
0.4
4.3
5.3
1.6
Lowe’s
1.3
0.2
3.7
0.0
2.8
0.8
3.7
0.8
0.2
11.5
Price to
earnings
ratio
35.6%
16.9
8.6
16.4
10.7
15.6
11.9
32.3
16.0
0.5
4.0
6.5
13.7
22.7
1.4
0.4
3.7
5.4
9.3
20.6
5.3
1.6
0.3
4.0
6.5
13.7
26.2
5.8
3.2
0.8
1.9
6.0
30.0
13.6
Packard
Building
materials
Kroger
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Table 3.5 Financial Ratios for Select Firms
and Their Industry Average Values (2 of 2)
Current
ratio
Quick
ratio
Inventory
turnover
Average
collection
period
(days)
1.5
1.1
19.9
5.6
2.5
0.5
3.2
8.0
15.7
18.0
1.3
0.7
11.1
7.5
2.4
0.6
2.1
3.1
9.8
20.8
Target
0.9
0.3
5.9
3.9
1.8
0.7
3.8
7.1
24.4
10.7
Walmart
0.9
0.3
9.0
3.7
2.4
0.6
3.5
8.4
20.3
16.3
1.7
0.6
4.1
3.7
2.3
0.5
1.5
4.9
10.8
37.1
blank
Whole Foods
Total
asset
turnover
Debt
ratio
Net
profit
margin
Return on Return on
total
common
assets
equity
Price to
earnings
ratio
Market
Grocery
stores
Merchandis
e stores
The data used to calculate these ratios are drawn from the Compustat North American database.
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Example 3.3 (1 of 3)
In early 2019, Mary Boyle, the chief financial analyst at Caldwell
Manufacturing, a producer of heat exchangers, gathered data on the
firm’s financial performance during 2018, the year just ended. She
calculated a variety of ratios and obtained industry averages. She
was especially interested in inventory turnover, which reflects the
speed with which the firm moves its inventory from raw materials
through production into finished goods and to the customer as a
completed sale. Generally, analysts like to see higher values of this
ratio because they indicate a quicker turnover of inventory and more
efficient inventory management. Caldwell Manufacturing’s inventory
turnover for 2018 and the industry average inventory turnover were
as follows:
blank
Caldwell Manufacturing
Industry average
Inventory Turnover, 2018
14.8
9.7
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Example 3.3 (2 of 3)
Initially, Mary believed these data showed that the firm had
managed its inventory much better than the average firm in
the industry. The turnover was nearly 53% faster than the
industry average. On reflection, however, she realized that a
very high inventory turnover could be a sign that the firm is
not holding enough inventories. The consequence of low
inventory could be excessive stockouts (insufficient inventory
to meet customer needs). Discussions with people in the
manufacturing and marketing departments did, in fact,
uncover such a problem.
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Example 3.3 (3 of 3)
Inventories of raw materials during the year were extremely
low, resulting in numerous production delays that hindered
the firm’s ability to meet demand and resulted in disgruntled
customers and lost sales. A ratio that initially appeared to
reflect extremely efficient inventory management was
actually the symptom of a major problem.
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3.2 Using Financial Ratios (3 of 5)
• Types of Ratio Comparisons
– Time-Series Analysis
▪ Evaluation of the firm’s financial performance over time using
financial ratio analysis
– Combined Analysis
▪ Combines cross-sectional and time-series analyses
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Figure 3.1 Combined Analysis
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3.2 Using Financial Ratios (4 of 5)
• Cautions About Using Ratio Analysis
– Ratios that reveal large deviations from the norm merely
indicate the possibility of a problem
– A single ratio does not generally provide sufficient
information from which to judge the overall performance of
the firm
– The ratios being compared should be calculated using
financial statements dated at the same point in time during
the year
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3.2 Using Financial Ratios (5 of 5)
• Cautions About Using Ratio Analysis
– It is preferable to use audited financial statements
– The financial data being compared should have been
developed in the same way
– Results can be distorted by inflation
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Table 3.6 Whole Foods Market Inc.
Balance Sheets for 2016 and 2015
($ millions)
Assets
Cash
2016
2015
Liabilities and Equity
2016
2015
Accounts payable
$307
$295
Other current liabilities
1,034
957
$1,341
$1,252
$ 852
$ 519
Accounts receivable
242
218
Inventory
517
500
Other current assets
364
307
Long-term debt
1,776
720
$1,975
$1,544
Total liabilities
$3,117
$1,972
3,442
3,163
Common stock
907
1,780
924
1,034
Retained earnings
2,317
1,989
Total fixed assets
$4,366
$4,197
Total equity
$3,224
$3,769
Total assets
$6,341
$5,741
Total liabilities plus equity
$6,341
$5,741
Total current assets
Property, plant, and
Total current liabilities
equipment (net)
Other long-term assets
Note: The company had 318.3 million and 348.9 million shares outstanding in 2016 and 2015,
respectively.
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Table 3.7 Whole Foods Market Inc. Income
Statements for 2016 and 2015 ($ millions)
blank
2016
2015
Sales
$ 15,724
$ 15,389
10,313
9,973
$ 5,411
$ 5,416
4,477
4,472
77
83
Less: Cost of goods sold
Gross profit
Less: Selling, general, and administrative expenses
Other operating expenses
Operating profit (EBIT)
$
857
$
861
Less: Interest expense
41
0
Plus: Other income
11
17
Pre-tax income
$
Less: Taxes
827
$
320
878
342
Net income
$
507
$
536
Dividends paid
$
177
$
186
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3.3 Liquidity Ratios (1 of 2)
• Liquidity
– A firm’s ability to satisfy its short-term obligations as they
come due
• Current Ratio = Current Assets ÷ Current Liabilities
– A measure of liquidity calculated by dividing the firm’s
current assets by its current liabilities
Copyright © 2019, 2015, 2012 Pearson Education, Inc. All Rights Reserved.
Matter of Fact (1 of 2)
Determinants of Liquidity Needs
Glance back at the first column of data in Table 3.5, which
shows the current ratio for a variety of companies and
industries. Notice that the industry with the highest current
ratio (i.e., most liquidity) is building materials, an industry
notoriously sensitive to business cycle swings. The current
ratio for that industry is 2.8, indicating that the typical firm in
that business has almost 3 times as much in current assets
as in current liabilities.
Copyright © 2019, 2015, 2012 Pearson Education, Inc. All Rights Reserved.
Matter of Fact (2 of 2)
Two of the largest competitors in that industry, Home Depot
and Lowe’s, operate with a current ratio of 1.3, less than half
the industry average. Does this ratio mean that these firms
have a liquidity problem? Not necessarily. Large enterprises
generally have well-established relationships with banks that
can provide lines of credit and other short-term loan products
in the event that the firm needs liquidity. Smaller firms may
not have the same access to credit and therefore tend to
operate with more liquidity.
Copyright © 2019, 2015, 2012 Pearson Education, Inc. All Rights Reserved.
Personal Finance Example 3.4 (1 of 3)
Individuals, like corporations, can use financial ratios to
analyze and monitor their performance. Typically, personal
finance ratios are calculated using the personal income and
expense statement and personal balance sheet for the
period of concern. Here we use these statements, presented
in the preceding personal finance examples, to demonstrate
calculation of Jan and Jon Smith’s liquidity ratio for calendar
year 2019.
Copyright © 2019, 2015, 2012 Pearson Education, Inc. All Rights Reserved.
Personal Finance Example 3.4 (2 of 3)
The personal liquidity ratio is calculated by dividing total
liquid assets by total current debt. It indicates the percentage
of annual debt obligations that an individual can meet using
current liquid assets. The Smiths’ total liquid assets were
$2,225. Their total current debts are $18,080 (total current
liabilities of $1,050 + mortgage payments of $11,500 + auto
loan payments of $4,280 + appliance and furniture payments
of $1,250). Substituting these values into the ratio formula,
we get
Total liquid assets $2, 225
Liquidity ratio =
=
= 0.123, or 12.3%
Total current debts $18,880
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Personal Finance Example 3.4 (3 of 3)
The ratio indicates that the Smiths can cover only about 12%
of their existing 1-year debt obligations with their current
liquid assets. Clearly, the Smiths plan to meet these debt
obligations from their income, but this ratio suggests that
their liquid funds do not provide a large cushion. As one of
their goals, they should probably build up a larger fund of
liquid assets to meet unexpected expenses.
Copyright © 2019, 2015, 2012 Pearson Education, Inc. All Rights Reserved.
3.3 Liquidity Ratios (2 of 2)
• Quick (Acid-Test) Ratio = (Current Assets − Current
Liabilities) ÷ Current Liabilities
– A measure of liquidity calculated by dividing the firm’s
current assets less inventory by its current liabilities
Copyright © 2019, 2015, 2012 Pearson Education, Inc. All Rights Reserved.
Matter of Fact (1 of 2)
The Importance of Inventories
Turn again to Table 3.5 and examine the columns listing
current and quick ratios for different firms and industries.
Notice that Apple has a current ratio of 1.4, almost identical
to current ratios for Home Depot and Lowe’s, which are both
1.3. The quick ratios for Home Depot and Lowe’s are much
lower than their current ratios, but for Apple that is not true—
that firm’s current and quick ratios are nearly equal.
Copyright © 2019, 2015, 2012 Pearson Education, Inc. All Rights Reserved.
Matter of Fact (2 of 2)
Why? First, Apple relies primarily on contract manufacturers
to make its products, so it holds little or no inventory while its
devices are being made. Second, the popularity of Apple’s
products means that inventory does not sit on retail store
shelves very long. In contrast, all it takes is a trip to your
local Home Depot or Lowe’s store to see that the business
model in this industry requires a massive investment in
inventory, which implies that the quick ratio will be much less
than the current ratio for building materials firms.
Copyright © 2019, 2015, 2012 Pearson Education, Inc. All Rights Reserved.
3.4 Activity Ratios (1 of 3)
• Activity Ratios
– Measure the speed with which various accounts are
converted into sales or cash, or inflows or outflows
• Inventory Turnover = Cost of Goods Sold ÷ Inventory
– Measures the activity, or liquidity, of a firm’s inventory
▪ Average Age of Inventory = Inventory Turnover ÷ 365
– Average number of days’ sales in inventory
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3.4 Activity Ratios (2 of 3)
• Average Collection Period = Accounts Receivable ÷ Average
Sales Per Day
or
Accounts Receivable ÷ (Annual Sales ÷ 365)
– The average amount of time needed to collect accounts
receivable
Copyright © 2019, 2015, 2012 Pearson Education, Inc. All Rights Reserved.
Matter of Fact (1 of 2)
Who Gets Credit?
Notice in Table 3.5 the vast differences across industries in
the average collection periods. Companies in the building
materials, grocery, and merchandise store industries collect
in just a few days, whereas firms in the computer industry
take a month or two to collect on their sales. This difference
exists primarily because these industries serve very different
customers.
Copyright © 2019, 2015, 2012 Pearson Education, Inc. All Rights Reserved.
Matter of Fact (2 of 2)
Grocery and retail stores serve individuals who pay cash or
use credit cards (which, to the store, are essentially the
same as cash). Computer manufacturers sell to retail chains,
businesses, and other large organizations that negotiate
agreements allowing them to pay well after the sale is made.
Copyright © 2019, 2015, 2012 Pearson Education, Inc. All Rights Reserved.
3.4 Activity Ratios (3 of 3)
• Average Payment Period = Accounts Payable ÷ Average
Purchases Per Day
or
Accounts Payable ÷ (Annual Purchases ÷ 365)
– The average amount of time needed to pay accounts
payable
• Total Asset Turnover = Sales ÷ Total Assets
– Indicates the efficiency with which the firm uses its assets to
generate sales
Copyright © 2019, 2015, 2012 Pearson Education, Inc. All Rights Reserved.
Matter of Fact (1 of 2)
Sell It Fast
Observe in Table 3.5 that the grocery business has more
rapid total asset turnover than any other industry. That
makes sense because inventory is among the most valuable
asset held by these firms, and grocery stores must sell
baked goods, dairy products, and produce quickly or throw
such items away when they spoil.
Copyright © 2019, 2015, 2012 Pearson Education, Inc. All Rights Reserved.
Matter of Fact (2 of 2)
It’s true that some items in a grocery store have a shelf life
longer than anyone really wants to know (think Twinkies), but
on average a grocery store has to replace its entire inventory
in just a few days or weeks, and that practice contributes to
the rapid turnover of the firm’s total assets.
Copyright © 2019, 2015, 2012 Pearson Education, Inc. All Rights Reserved.
3.5 Debt Ratios (1 of 3)
• Financial Leverage
– The magnification of risk and return through the use of fixedcost financing, such as debt and preferred stock
• Degree of Indebtedness
– Ratios that measure the amount of debt relative to other
significant balance sheet amounts
Copyright © 2019, 2015, 2012 Pearson Education, Inc. All Rights Reserved.
Example 3.5 (1 of 2)
Patty Akers is incorporating her new business. After much
analysis, she determines that an initial investment of
$50,000—$20,000 in current assets and $30,000 in fixed
assets—is necessary. These funds can be obtained in one of
two ways. The first is the no-debt plan, under which she
would invest the full $50,000 without borrowing. The other
alternative, the debt plan, involves investing $25,000 and
borrowing the balance of $25,000 at 6% annual interest.
Copyright © 2019, 2015, 2012 Pearson Education, Inc. All Rights Reserved.
Example 3.5 (2 of 2)
Patty expects $30,000 in sales, $18,000 in operating
expenses, and a 21% tax rate. Projected balance sheets and
income statements associated with the two plans appear
below in Table 3.8. The no-debt plan results in after-tax
profits of $9,480, which represent a 19% rate of return on
Patty’s $50,000 investment. The debt plan results in $8,295
of after-tax profits, which represent a 33.2% rate of return on
Patty’s investment of $25,000. The debt plan provides Patty
with a higher rate of return, but also has a greater risk
because the annual $1,500 of interest must be paid whether
Patty’s business is profitable or not.
Copyright © 2019, 2015, 2012 Pearson Education, Inc. All Rights Reserved.
Table 3.8 Financial Statements Associated
with Patty’s Alternatives
Copyright © 2019, 2015, 2012 Pearson Education, Inc. All Rights Reserved.
3.5 Debt Ratios (2 of 3)
• Debt Ratio = Total Liabilities ÷ Total Assets
– Measures the proportion of total assets financed by the
firm’s creditors
• Debt-to-Equity Ratio = Total Liabilities ÷ Common Stock
Equity
– Measures the relative proportion of total liabilities and
common stock equity used to finance the firm’s total assets
• Times Interest Earned Ratio = Earnings Before Interest
and Taxes ÷ Interest
– Measures the firm’s ability to make contractual interest
payments; sometimes called the interest coverage ratio
Copyright © 2019, 2015, 2012 Pearson Education, Inc. All Rights Reserved.
3.5 Debt Ratios (3 of 3)
• Fixed Payment Coverage Ratio …

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