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Chapter 01 Foundation
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Chapter 01 Foundation




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  • 1. Foundations Chapter 1
  • 2. Main Areas of Finance
    • Investments and financial markets
    • Financial management of corporations
      • Fields are separate but related
  • 3. Financial Assets
    • Real asset—an object that provides a service, such as a house, car, art, coin…
    • Financial asset—a document representing a claim to income
      • Stock—ownership interest in a company
        • Entitled to a share of the firm’s profits, either dividends or future growth
      • Bond—debt interest in a company
        • Entitled to interest and repayment of principal
    • Investing involves buying financial assets in the hope of earning a return
      • Can be made directly or indirectly (buying shares in a mutual fund)
  • 4. Financial Markets
    • Financial Market
      • Financial assets are issued by corporations and bought by investors in financial markets
        • A framework or organization in which people can buy/sell securities
          • Stock market (NYSE, AMEX, OTC)--entire network of brokers and exchanges all connected together
          • Stockbroker (broker)--person who is licensed to trade securities for a commission
  • 5. Financial Markets
    • Secondary market—place where investors trade securities among themselves (NYSE, etc .)
      • Most transactions are of this type
    • Primary market—market where securities are initially sold (I.P.O.)
    • Investments
      • Making decisions about buying and selling stock and bonds
    • Financial management
      • Decisions about raising money and how to spend it
  • 6. Figure 1.1: Simplified Financial System
  • 7. Raising Money
    • Financing means raising money to acquire something
    • Forms of Financing
      • Issuing stock (equity financing)
      • Borrowing money (debt financing)
        • Bank
        • Issuing bonds
        • Leasing
      • Internal financing (retaining earnings)
        • Still considered equity financing
  • 8. Raising Money
    • Field of finance includes raising money and investing money
    • Changing Focus of Finance
      • Finance used to be narrowly limited to financial market activity
      • However has expanded to include
        • Portfolio formation and analysis
          • A portfolio is a collection of securities
        • Financial management within an organization
  • 9. Financial Management
    • Financial Management is the management and control of money and money-related operations within a business
    • Executive in charge of finance department
      • CFO: Chief Financial Officer (AKA: VP of Finance)
        • Typically reports directly to the President of the corporation
  • 10. Financial Management
    • Refers to the functions of the finance department
      • Keeping records
      • Receiving payments from customers
      • Making payments to suppliers
      • Borrowing funds
      • Purchasing assets
      • Selling stock
      • Paying dividends, etc .
    Accounting department is included in the broad definition of finance.
  • 11. Financial Management
    • Business Decisions
      • Finance department is in charge of:
        • Determining which assets a firm should purchase
          • Acquiring another firm
          • Expanding operations
            • A different product line
            • Current operations expanding to another country
        • Deciding how those assets will be financed
          • Equity
          • Debt
            • Loan via bank
            • Bond issue
  • 12. Financial Management
    • Oversight
      • Finance department must also perform an oversight function
        • Looking over everyone’s shoulder to make certain money is being used effectively
          • For example,
            • Are manufacturing costs too high?
            • Are advertising costs too high?
  • 13. The Price of Securities—A Link Between the Firm and the Market
    • Investors buy securities for the future cash flows expected from them
      • Price investors are willing to pay depends on expectations of how well the companies are likely to do
    • Link between company management and investors comes from this relationship between price and expected financial results
      • Everything firm does is evaluated by market and ‘graded’ by either an  ,  , or no change in security price
  • 14. The Price of Securities—A Link Between the Firm and the Market
    • Does management care what ‘grade’ it receives?
      • YES! Why?
        • Management will need to issue new securities in the future (to raise $) and therefore want a high security price
        • Stockholders own the firm and if the stock price declines shareholders will be disgruntled
  • 15. Finance and Accounting
    • Accounting: a system of record-keeping designed to portray a firm’s operations in a fair/unbiased manner
      • Generate financial statements which are provided to the marketplace
    • Finance: a process of decision-making related to raising money, analyzing results, etc.
      • Use the output generated by accountants as inputs in finance
  • 16. Finance and Accounting
    • Finance department generally consists of both the accounting department and the treasury department
      • Controller is in charge of the accounting department
      • Treasury department deals with finance activities
    • Crossover is possible
      • Usually easier for an accountant to move to the treasury department
  • 17. Figure 1.2: Finance Department Organization
  • 18. The Importance of Cash Flow
    • Accounting attempts to reflect a firm’s financial results in a way that represents what is physically occurring
    • Finance is interested in how cash is flowing (or expected to flow)
      • We need a cash amount because we’ll be looking at returns on money invested, and you can’t invest a non-cash number
        • Cash is King
  • 19. The Importance of Cash Flow Q: Example: In 1999 we purchased a $1,000 asset that will be depreciated over five years using straight-line depreciation. Explain how that asset will be viewed from both an accounting and finance viewpoint. A: Accounting: The initial cost of the asset of $1,000 will be reflected on the books as will the $200 annual depreciation. Finance: We are interested in the $1,000 cash outflow and the taxes saved from the depreciation deduction—not the depreciation itself. Example
  • 20. The Language of Finance
    • Accounting is the language of finance
      • Thus all finance professionals need some accounting knowledge
        • Level of accounting knowledge needed depends on job
          • Financial analyst needs to know LOTS of accounting because s/he investigates companies and makes recommendations concerning their value in market (must decipher complex financial statements as part of that process)
          • Stockbrokers do not need as thorough an understanding because they generally trade securities based on the financial analyst’s recommendation
  • 21. Financial Theory—The Relationship with Economics
    • Financial theory developed from economics
      • Modern financial theory began as a branch of economics in the 1950s
        • Today finance is viewed as a separate field
    • Scholars in both fields make observations between business world and government and attempt to model the behavior
  • 22. Figure 1.3: The Influence of Accounting, Economics and Financial Theory on Financial Management
  • 23. Forms of Business Organization and Their Financial Impact
    • Businesses can be legally or organized as
      • A sole proprietorship
      • A partnership
      • A corporation
    • Legal organization has an impact on
      • Raising money
      • Taxation
      • Financial liability
    • Issues really only important regarding small businesses
      • Virtually all large corporations are organized as C-type organizations
  • 24. The Proprietorship Form
    • Getting started
      • Easy to do
    • Taxes
      • Profit is taxed as personal income to the business owner
        • Are taxed only once
        • Taxed at personal income tax rates
    • Raising money
      • If entrepreneur decides to go outside the firm to raise money, s/he can obtain a loan
        • Lending money is risky
          • Best possible outcome: repayment of principal and interest
          • Worst possible outcome: lose everything
        • Thus, most lenders require collateral
          • Many entrepreneurs use their house as collateral
  • 25. The Corporate Form
    • Getting started
      • Requires a legal incorporation process
        • Takes time, work and money
    • Taxes
      • When business makes a profit taxes are paid twice
        • The corporation pays a tax at the corporate tax rate
        • Dividends paid to individuals are taxed at an individual’s personal tax rate
  • 26. The Corporate Form—Example Q: Hazel Gilroy owns a business that earns $100,000 before taxes. She wants to take the earnings home and spend them on herself. Assume a simplified tax system in which the relevant rates are 34% for corporations and 30% for individuals on the entire amounts subject to those taxes. Compare the total tax bills under the sole proprietorship and corporate forms of organization. A: Under the corporate form the $100,000 is first subject to a 34% corporate tax of $34,000, leaving earnings of $66,000. If Hazel were to take these earnings she would have to declare them as a dividend and pay personal taxes at 30%, or $19,800. In a sole proprietorship the $100,000 is taxed only once at the personal rate of 30%, for a total tax bill of $30,000. The difference in taxes of $23,800 is significant. Example
  • 27. The Corporate Form
    • Raising Money
      • Money for a corporation can be raised by
        • Borrowing
          • A corporation faces the same issues as a sole proprietorship when raising money
        • Offering stock to investors
          • If less than a 50% interest is sold, original owner still maintains effective control
          • Owning stock is risky
            • Best possible outcome: may get rich
            • Worst possible outcome: may lose all of your investment
  • 28. The Truth About Limited Liability
    • Limited liability states that a stockholder is not liable for a corporation’s debts
      • Implies that the most stockholder can lose is 100% of his investment in the stock
    • In a sole proprietorship, the business owner stands to lose his personal property if all the assets of the business are insufficient to cover all liabilities
      • Personal guarantees make entrepreneurs liable for loans made to their business
        • Destroys the value of limited liability
  • 29. S-Type Corporations
    • Major financial advantage of corporate form
      • Ability to raise money by issuing stock
    • Major financial disadvantage
      • Double taxation of earnings
    • Government encourages formation of small businesses because they create numerous jobs
      • Government allows creation of S-type corporation
        • Lets small businesses avoid double taxation
        • Offers limited liability
        • Offers ability to sell stock to raise money
  • 30. Goals of Management
    • Economics—goal is to maximize profit
      • But what about R&D?
        • If you eliminate R&D you’ll increase short-term profit and hurt long-term profit
    • Finance—Stockholders own the company so the goal is to maximize their wealth, generally by maximizing the stock price
      • This goal bypasses the concern of whether the short-term or long-term is more important, because stock price incorporates both !
        • If R&D were eliminated the stock price would not rise, but rather, drop
  • 31. Stakeholders and Conflicts of Interest
    • Constituencies of the company who have a vested interest in the way the firm is operated and include
      • Stockholders
      • Employees
      • Customers
      • Community
      • Management
      • Creditors
      • Suppliers
  • 32. Conflicts of Interest—An Illustration
    • Example: Employees want management to build an athletic facility on corporate grounds
      • Benefit—more effective employees (feel better, happier, therefore more productive)
      • Cost—will come from profits that belong to stockholders
        • This represents a conflict of interest between stockholders and employees
          • Something that benefits one group and takes away from another
  • 33. Management—A Privileged Stakeholder Group
    • Management represents a privileged stakeholder group
    • The ownership of a widely held company is very dispersed so no one has enough control to influence management
      • IBM has almost 2 billion shares outstanding, and over 600,000 shareholders—so no one person has enough control to influence management
    • This allows top management to become entrenched in positions controlling large amounts of resources
    • Management is able to use these resources for their own benefit
  • 34. The Agency Problem
    • Management (agent) is controlling resources owned by stockholders (principal) and may not make the decisions stockholders want
    • The Abuse of Agency
      • Privileges and luxuries provided to executives are called perquisites or ‘perks’
        • Example—management compensation
          • Management receives exorbitant salaries/bonuses ($50+ million) while the company performance is poor
        • Additional perks include boats, airplanes, country club memberships, etc .
  • 35. The Agency Problems
    • Controlling the agency problem
      • Efforts to manage agency problem include
        • Monitor management (audits)
        • Tie management bonuses to corporate stock performance via a stock option or to corporate profit
  • 36. Creditors Versus Stockholders—A Financially Important Conflict of Interest
    • A creditor is anyone owed money by a business including lenders, vendors, employees, or the government
    • Actions taken by the leveraged company that are riskier than before they borrowed money place creditors at risk
    • Lenders generally put clauses in loan agreements to prevent this from occurring