Chapter 01 Foundation


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Chapter 01 Foundation

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