Principles of Managerial Finance, Brief 8th Edition PDF

Principles of Managerial Finance, Brief Eighth Edition Chapter 1 The Role of Managerial Finance Copyright © 2019, 2015, 2012 Pearson Education, Inc. All Ri...

Principles of Managerial Finance, Brief Eighth Edition Chapter 1 The Role of Managerial Finance Copyright © 2019, 2015, 2012 Pearson Education, Inc. All Rights Reserved. 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. Copyright © 2019, 2015, 2012 Pearson Education, Inc. All Rights Reserved. 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. Copyright © 2019, 2015, 2012 Pearson Education, Inc. All Rights Reserved. 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 Copyright © 2019, 2015, 2012 Pearson Education, Inc. All Rights Reserved. 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 Copyright © 2019, 2015, 2012 Pearson Education, Inc. All Rights Reserved. 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 Copyright © 2019, 2015, 2012 Pearson Education, Inc. All Rights Reserved. Matter of Fact (1 of 2) Firms Accelerate Dividends So That Shareholders Save on Taxes One way that firms can maximize the wealth of shareholders is by thinking carefully about the taxes their shareholders must pay on dividends. Tax cuts enacted by Congress in 2003 lowered the tax rate on most dividends received by shareholders to a modest 15%. However, the legislation contained a provision by which the tax cuts would expire in 2013 unless Congress specifically acted to renew them. Copyright © 2019, 2015, 2012 Pearson Education, Inc. All Rights Reserved. Matter of Fact (2 of 2) With a political compromise to renew the tax cuts looking unlikely in the 2012 election year, many firms announced plans to accelerate dividend payments they had planned to make in early 2013 to late 2012. The Washington Post Company, for example, announced that on December 27, 2012, it would pay out the entire $9.80 per share dividend that it had planned to distribute in 2013. What was the stock market’s reaction to that announcement? Washington Post shares rose $5. By accelerating their dividend payments, companies such as Washington Post, Expedia, Inc., and luxury goods producer Coach, Inc., were increasing the wealth of their shareholders by helping them save taxes. Copyright © 2019, 2015, 2012 Pearson Education, Inc. All Rights Reserved. 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 Copyright © 2019, 2015, 2012 Pearson Education, Inc. All Rights Reserved. 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 Copyright © 2019, 2015, 2012 Pearson Education, Inc. All Rights Reserved. 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). Copyright © 2019, 2015, 2012 Pearson Education, Inc. All Rights Reserved. 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 Copyright © 2019, 2015, 2012 Pearson Education, Inc. All Rights Reserved. 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 Copyright © 2019, 2015, 2012 Pearson Education, Inc. All Rights Reserved. 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 Copyright © 2019, 2015, 2012 Pearson Education, Inc. All Rights Reserved. 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 Copyright © 2019, 2015, 2012 Pearson Education, Inc. All Rights Reserved. 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? Sarbanes-Oxley Act of 2002 Copyright © 2019, 2015, 2012 Pearson Education, Inc. All Rights Reserved. 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 Copyright © 2019, 2015, 2012 Pearson Education, Inc. All Rights Reserved. 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 Copyright © 2019, 2015, 2012 Pearson Education, Inc. All Rights Reserved. Figure 1.1 Financial Activities Copyright © 2019, 2015, 2012 Pearson Education, Inc. All Rights Reserved. 1.2 Managing the Firm (2 of 7) The Managerial Finance Function – Principles That Guide Managers’ Decisions  Time Value of Money – Having money today is better than having it later because firms and individuals can invest the money and earn a return on that money  Tradeoff between Return and Risk – Investors who want to earn higher returns must be willing to accept greater risk  Cash Is King – Firms need to generate positive cash flow in order to pay investors, suppliers, etc.  Competitive Financial Markets – Firms must convince investors that their investment ideas will generate competitive rates of return, and financial markets provide signals to firms  Incentives Are Important Copyright © 2019, 2015, 2012 Pearson Education, Inc. All Rights Reserved. 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 Copyright © 2019, 2015, 2012 Pearson Education, Inc. All Rights Reserved. 1.2 Managing the Firm (4 of 7) The Managerial Finance Function – Organization of the Finance Function  CEO – CFO Treasurer Controller Director of Risk Management Director of Investor Relations Director of Internal Audit Foreign Exchange Manager Copyright © 2019, 2015, 2012 Pearson Education, Inc. All Rights Reserved. Figure 1.2 Corporate Organization Copyright © 2019, 2015, 2012 Pearson Education, Inc. All Rights Reserved. 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 Copyright © 2019, 2015, 2012 Pearson Education, Inc. All Rights Reserved. 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. Copyright © 2019, 2015, 2012 Pearson Education, Inc. All Rights Reserved. Example 1.2 (2 of 2) Applying marginal cost–benefit analysis, Jamie organizes the data as follows: Benefits with new computer $10,000 Less: Benefits with old computer 3,000 (1) Marginal benefits $ 7,000 Cost of new computer $ 8,000 Less: Proceeds from sale of old computer 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. Copyright © 2019, 2015, 2012 Pearson Education, Inc. All Rights Reserved. 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 Copyright © 2019, 2015, 2012 Pearson Education, Inc. All Rights Reserved. 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. Copyright © 2019, 2015, 2012 Pearson Education, Inc. All Rights Reserved. Example 1.3 (2 of 2) Accounting view (accrual basis) Financial view (cash basis) Nassau Corporation income Nassau Corporation cash flow statement for the year ended 12/31 statement for the year ended 12/31 Sales revenue $1,000,000 Cash inflow $0 Less: Costs 800,000 Less: Cash outflow 800,000 Net profit $ 200,000 Net cash flow −$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. Copyright © 2019, 2015, 2012 Pearson Education, Inc. All Rights Reserved. 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 Inflow Outflow Net pay received $4,400 Rent blank −$1,200 Car payment Blank −450 Utilities blank −300 Groceries Blank −800 Clothes Blank −750 Dining out Blank −650 Gasoline Blank −260 Interest income 220 Blank Misc. expense Blank −425 Totals $4,620 −$4,835 Copyright © 2019, 2015, 2012 Pearson Education, Inc. All Rights Reserved. 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. Copyright © 2019, 2015, 2012 Pearson Education, Inc. All Rights Reserved. 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 Copyright © 2019, 2015, 2012 Pearson Education, Inc. All Rights Reserved. 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 Copyright © 2019, 2015, 2012 Pearson Education, Inc. All Rights Reserved. 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 – Unlimited Liability Each partner is legally liable for all debt of the partnership. Owners may have to cover debts of other partners. Copyright © 2019, 2015, 2012 Pearson Education, Inc. All Rights Reserved. 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 Copyright © 2019, 2015, 2012 Pearson Education, Inc. All Rights Reserved. 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 Copyright © 2019, 2015, 2012 Pearson Education, Inc. All Rights Reserved. 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 Copyright © 2019, 2015, 2012 Pearson Education, Inc. All Rights Reserved.  Table 1.1 Strengths and Weaknesses of the Common Legal Forms of Business Organization (1 of 2) blank Sole proprietorship Partnership Corporation Strengths Owner receives all Can raise more funds Owners have limited liability, profits (and sustains all than sole which guarantees that they cannot losses) proprietorships lose more than they invested Low organizational Borrowing power Can achieve large size via sale of costs enhanced by more ownership (stock) Income included and owners Ownership (stock) is readily taxed on proprietor’s More available brain transferable personal tax return power and managerial Long life of firm Independence skill Can hire professional managers Secrecy Income included and Has better access to financing Ease of dissolution taxed on partner’s personal tax return Copyright © 2019, 2015, 2012 Pearson Education, Inc. All Rights Reserved.  Table 1.1 Strengths and Weaknesses of the Common Legal Forms of Business Organization (2 of 2) blank Sole proprietorship Partnership Corporation Weaknesses Owner has unlimited Owners have unlimited Taxes are generally higher liability in that total liability and may have to because corporate income is wealth can be taken to cover debts of other taxed, and dividends paid to satisfy debts partners owners are also taxed at a Limited fund-raising Partnership is dissolved maximum 15% rate power tends to inhibit when a partner dies More expensive to organize than growth Difficult to liquidate or other business forms Proprietor must be jack- transfer partnership Subject to greater government of-all-trades regulation Difficult to give Lacks secrecy because employees long-run regulations require firms to career opportunities disclose financial results Lacks continuity when proprietor dies Copyright © 2019, 2015, 2012 Pearson Education, Inc. All Rights Reserved. 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. Copyright © 2019, 2015, 2012 Pearson Education, Inc. All Rights Reserved. Matter of Fact (2 of 2) blank Sole proprietorships Partnerships Corporations Number of firms (millions) 25.3 3.4 5.8 Percentage of all firms 73% 10% 17% Percentage of all business 10% 26% 64% income Source: Overview of Approaches to Corporate Integration, Joint Committee on Taxation, United States Congress, May 17, 2016. Copyright © 2019, 2015, 2012 Pearson Education, Inc. All Rights Reserved. 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 Copyright © 2019, 2015, 2012 Pearson Education, Inc. All Rights Reserved. 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 2017) – 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 Copyright © 2019, 2015, 2012 Pearson Education, Inc. All Rights Reserved. 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 Copyright © 2019, 2015, 2012 Pearson Education, Inc. All Rights Reserved. Table 1.2 2018 Tax Rate Schedule for Single Taxpayer (Tax Rates Faced by Pass-Through Businesses Like Proprietorships and Partnerships) Tax calculation (Marginal rate × amount over Taxable income brackets Base tax + 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) Over 500,000 $150,690 + (37% × amount over $500,000) Copyright © 2019, 2015, 2012 Pearson Education, Inc. All Rights Reserved. Pre-2018 Corporate Tax Rate Schedule Tax calculation (Marginal rate × amount over Taxable income brackets Base tax + bracket lower limit) $ 0 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) Copyright © 2019, 2015, 2012 Pearson Education, Inc. All Rights Reserved. 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 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 Copyright © 2019, 2015, 2012 Pearson Education, Inc. All Rights Reserved. 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. Copyright © 2019, 2015, 2012 Pearson Education, Inc. All Rights Reserved. Figure 1.3 Marginal and Average Tax Rates at Different Income Levels for a Single Taxpayer (2018 Tax Rates) Copyright © 2019, 2015, 2012 Pearson Education, Inc. All Rights Reserved. Pre-2018 Marginal and Average Tax Rates at Different Income Levels for a Single Taxpayer Copyright © 2019, 2015, 2012 Pearson Education, Inc. All Rights Reserved. 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 Copyright © 2019, 2015, 2012 Pearson Education, Inc. All Rights Reserved. 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. Copyright © 2019, 2015, 2012 Pearson Education, Inc. All Rights Reserved. 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. Copyright © 2019, 2015, 2012 Pearson Education, Inc. All Rights Reserved. 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 Copyright © 2019, 2015, 2012 Pearson Education, Inc. All Rights Reserved. 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 Copyright © 2019, 2015, 2012 Pearson Education, Inc. All Rights Reserved. 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? blank Debt Co. No-Debt Co. Earnings before interest and taxes $200,000 $200,000 Less: Interest expense 30,000 0 Earnings before taxes $170,000 $200,000 Less: Taxes (21%) 35,700 42,000 Earnings after taxes $134,300 $158,000 Difference in earnings after taxes $23,700 Copyright © 2019, 2015, 2012 Pearson Education, Inc. All Rights Reserved. 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]. Copyright © 2019, 2015, 2012 Pearson Education, Inc. All Rights Reserved. 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) Principal-Agency Problems and Agency Costs – Agency Costs  Costs that shareholders bear due to managers’ pursuit of their own interests Copyright © 2019, 2015, 2012 Pearson Education, Inc. All Rights Reserved. 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 Copyright © 2019, 2015, 2012 Pearson Education, Inc. All Rights Reserved. Matter of Fact (1 of 3) CEO Pay Around the World Both the amount that CEOs receive in compensation and the form their compensation takes vary greatly around the world. A 2016 report noted that median pay for CEOs in the United States was $14.9 million, nearly 3 times more than the median pay for CEOs from non-U.S. companies. British CEOs earned the second highest median pay at $10.5 million. On the European continent, German and French CEOs earned roughly half of what their British counterparts make, at $5.4 million and $4.0 million, respectively. Japanese CEOs received even less, with median pay at $1.5 million. Copyright © 2019, 2015, 2012 Pearson Education, Inc. All Rights Reserved. Matter of Fact (2 of 3) Given these large differences in total compensation, the base salaries of CEOs were surprisingly similar. For instance, the median base salary for a U.S. CEO was $5.1 million, compared with $4.1 million for a German CEO. What, then, caused the variations in total CEO pay? These were driven mostly by differences in the use of equity-based compensation. As an example, the portion of CEO pay coming in the form of stock or stock options was 60% for U.S. and U.K. firms, but in Germany and France, the fraction paid in equity totaled less than 24%. Japan was an even more dramatic outlier, with equity-based compensation accounting for just 10% of total CEO pay. Copyright © 2019, 2015, 2012 Pearson Education, Inc. All Rights Reserved. Matter of Fact (3 of 3) Recall that the U.S. and U.K. legal systems emphasize the duty of managers to shareholders, whereas legal systems elsewhere place more emphasis on stakeholders. Those differences are reflected in equity-based CEO compensation around the world. Source: “How CEO pay differs around the globe,” Equilar.com press release, August 17, 2016. Copyright © 2019, 2015, 2012 Pearson Education, Inc. All Rights Reserved. 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 Copyright © 2019, 2015, 2012 Pearson Education, Inc. All Rights Reserved. 1.4 Developing Skills for Your Career Critical Thinking Communication and Collaboration Financial Computing Skills Copyright © 2019, 2015, 2012 Pearson Education, Inc. All Rights Reserved. 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 Copyright © 2019, 2015, 2012 Pearson Education, Inc. All Rights Reserved. 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. Copyright © 2019, 2015, 2012 Pearson Education, Inc. All Rights Reserved. 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. Copyright © 2019, 2015, 2012 Pearson Education, Inc. All Rights Reserved. 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 Copyright © 2019, 2015, 2012 Pearson Education, Inc. All Rights Reserved. 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 Copyright © 2019, 2015, 2012 Pearson Education, Inc. All Rights Reserved. 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 Copyright © 2019, 2015, 2012 Pearson Education, Inc. All Rights Reserved. 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 Copyright © 2019, 2015, 2012 Pearson Education, Inc. All Rights Reserved. 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 Copyright © 2019, 2015, 2012 Pearson Education, Inc. All Rights Reserved. Copyright Copyright © 2019, 2015, 2012 Pearson Education, Inc. All Rights Reserved.