This document provides information about a financial management course taught by Min Teng at Huazhong University of Science and Technology. It includes the contact information for the instructor, required textbooks, assessment methods, course objectives, and an outline of topics to be covered in the course including introduction to finance, the goals of financial management, and different types of business entities such as sole proprietorships, partnerships, and corporations.
1.1. Nature and Definition of Auditing
Different scholars have defined auditing in different ways. For example, Auditing is a process of collection and evaluation of evidence for the purpose of reporting on economic transaction. The other definition of auditing given by the Institute of Chartered Accountants of India, in its publication titled, General Guidelines on Internal Auditing has defined auditing as ‘ a systematic and independent evaluation of data, statements, records, operations and performances ( financial or otherwise) of an enterprise for stated purpose. In any auditing situation, the auditor perceives and recognizes the propositions before him for examination, collects evidence, evaluates the same and on this basis formulates his/her judgment which is communicated through audit report.
As it is cited in Kanal Gupta and Arora A.(1996,p6), Arens and Loebbecke defined auditing as the process by which a complete, independent person accumulates and evaluates evidence about quantifiable information related to specific economic entity for the purpose of determining and reporting on the degree of correspondence between the quantifiable information and established criteria. To sum up, Auditing is the process of verifying the assertions produced by accounting, as to whether they present a true and fair view of the entity's financial position in accordance with accounting standards and GAAP. In other words, auditing seeks to verify whether or not financial records have been properly prepared.
Study Note
The term audit is derived from the Latin term ‘audire,’ which means to hear. In early days an auditor used to listen to the accounts read over by an accountant in order to check them Auditing is as old as accounting.
It was in use in all ancient countries such as Mesopotamia, Greece, Egypt. Rome, U.K. and India. The Vedas contain reference to accounts and auditing.
The original objective of auditing was to detect and prevent errors and frauds and most recently objective of audit shifted to ascertain whether the accounts were true and fair rather than detection of errors and frauds.
Auditing evolved and grew rapidly after the industrial revolution in the 18th century with the growth of the joint stock companies the ownership and management became separate.
The shareholders who were the owners needed a report from an independent expert on the accounts of the company managed by the board of directors who were the employees.
1.2. Historical Development of Auditing
The development of auditing is closely linked to the development of accounting. In the early stage of civilization, the number of transaction was usually so small that able to record the transactions himself. However, with the growth of civilization and consequential growth in volume and complexity of transactions, it becomes necessary to entrust the job of recording the transactions to other persons. The trend started with maintenance of accounts to empires by public officials
An Introduction to Managerial Finance prepared for the Graduate School of Business at the University of New England. Slides prepared by Dr Subba Reddy Yarram.
The Very Basics: Forming the Business (Series: The Start-Up/Forming the Busin...Financial Poise
So, you are an entrepreneur and want to start your own business (or you are an attorney, accountant, or other professional advisor working with one). One of the first decisions required is to choose a legal structure for the business and the jurisdiction of entity organization. What factors should be taken into consideration prior to selecting a legal structure and jurisdiction? Does a sole proprietorship, partnership, limited liability company or corporation (C- or S-corp) make the most sense? This webinar focuses on business formation and the pros and cons to the different legal structures, and includes tips on how to keep one’s personal assets safe from the claims of future creditors of the business.
To view the accompanying webinar, go to: https://www.financialpoise.com/financial-poise-webinars/the-very-basics-forming-the-business-2021/
1.1. Nature and Definition of Auditing
Different scholars have defined auditing in different ways. For example, Auditing is a process of collection and evaluation of evidence for the purpose of reporting on economic transaction. The other definition of auditing given by the Institute of Chartered Accountants of India, in its publication titled, General Guidelines on Internal Auditing has defined auditing as ‘ a systematic and independent evaluation of data, statements, records, operations and performances ( financial or otherwise) of an enterprise for stated purpose. In any auditing situation, the auditor perceives and recognizes the propositions before him for examination, collects evidence, evaluates the same and on this basis formulates his/her judgment which is communicated through audit report.
As it is cited in Kanal Gupta and Arora A.(1996,p6), Arens and Loebbecke defined auditing as the process by which a complete, independent person accumulates and evaluates evidence about quantifiable information related to specific economic entity for the purpose of determining and reporting on the degree of correspondence between the quantifiable information and established criteria. To sum up, Auditing is the process of verifying the assertions produced by accounting, as to whether they present a true and fair view of the entity's financial position in accordance with accounting standards and GAAP. In other words, auditing seeks to verify whether or not financial records have been properly prepared.
Study Note
The term audit is derived from the Latin term ‘audire,’ which means to hear. In early days an auditor used to listen to the accounts read over by an accountant in order to check them Auditing is as old as accounting.
It was in use in all ancient countries such as Mesopotamia, Greece, Egypt. Rome, U.K. and India. The Vedas contain reference to accounts and auditing.
The original objective of auditing was to detect and prevent errors and frauds and most recently objective of audit shifted to ascertain whether the accounts were true and fair rather than detection of errors and frauds.
Auditing evolved and grew rapidly after the industrial revolution in the 18th century with the growth of the joint stock companies the ownership and management became separate.
The shareholders who were the owners needed a report from an independent expert on the accounts of the company managed by the board of directors who were the employees.
1.2. Historical Development of Auditing
The development of auditing is closely linked to the development of accounting. In the early stage of civilization, the number of transaction was usually so small that able to record the transactions himself. However, with the growth of civilization and consequential growth in volume and complexity of transactions, it becomes necessary to entrust the job of recording the transactions to other persons. The trend started with maintenance of accounts to empires by public officials
An Introduction to Managerial Finance prepared for the Graduate School of Business at the University of New England. Slides prepared by Dr Subba Reddy Yarram.
The Very Basics: Forming the Business (Series: The Start-Up/Forming the Busin...Financial Poise
So, you are an entrepreneur and want to start your own business (or you are an attorney, accountant, or other professional advisor working with one). One of the first decisions required is to choose a legal structure for the business and the jurisdiction of entity organization. What factors should be taken into consideration prior to selecting a legal structure and jurisdiction? Does a sole proprietorship, partnership, limited liability company or corporation (C- or S-corp) make the most sense? This webinar focuses on business formation and the pros and cons to the different legal structures, and includes tips on how to keep one’s personal assets safe from the claims of future creditors of the business.
To view the accompanying webinar, go to: https://www.financialpoise.com/financial-poise-webinars/the-very-basics-forming-the-business-2021/
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3. 3
Reading List
Core Textbook
Stephen A. Ross, Randolph
W. Westerfield, Jeffrey F.
Jaffe, Corporate Finance
(Ninth Edition), McGraw-
Hill Company Inc.
4. 4
Reading List
Supplementary Reading
Richard A. Brealey, Stewart C.
Myers, Franklin Allen,
Principles of Corporate
Finance (Tenth Edition),
McGraw-Hill Company Inc.
6. Course objectives
To develop expertise and professional skills in resolving
problems that arise in managing a corporation.
To provide preparations for further research of advanced
topics in corporate finance.
8. 8
Introduction to Finance
What is Finance
Entrepreneurs and firms who need funds raise capital from
those who have extra funds.
The raised funds are used to finance value-enhancing
projects.
The value generated is shared among the economic
participants.
9. 9
The Role of Finance
Finance facilitates economic growth
Value-enhancing projects might have been otherwise forgone if
there is no financial markets.
Better projects are more likely to obtain funds due to the value
maximization behavior of those who provide funds.
Financial crisis hurts the economy
Over speculation boosts bubbles in the financial markets.
The burst of the bubble destroys the capital raising function of
financial markets.
10. 10
Three major areas in Finance
Corporate Finance
Asset Pricing/Investment
Financial Markets and Financial Intermediates
11. 11
What is Corporate Finance
Corporate Finance addresses the following three
questions:
What long-term investment projects should the firm
engage in? (investment decision)
How can the firm raise the money for the required
investment projects? (financing decision)
How much short-term cash flow does a company need to
pay its bills? (net working capital)
12. 12
Balance Sheet Model of the Firm
Total Value of Assets: Total Firm Value to Investors:
13. 13
The Capital Budgeting (Investment) Decision
What long-
term
investments
should the
firm engage
in?
14. 14
The Capital Structure (Financing) Decision
How can the firm
raise the money
for the required
investments?
15. 15
The Net Working Capital Investment Decision
How much short-
term cash flow
does a company
need to pay its
bills?
Net
Working
Capital
16. 16
The Corporate Firm
Three basic legal forms of organizing firms
The Sole Proprietorship
The Partnership
The Corporation
17. 17
The Sole Proprietorship
A sole proprietorship is a business owned by one person
Some factors of considering proprietorship
The sole proprietorship is the cheapest to form.
A sole proprietorship pays no corporate income tax, but individual income
tax.
The sole proprietorship has unlimited liability for business debts and
obligations.
The life of the sole proprietorship is limited by the life of the sole proprietor.
The equity money that can be raised by the sole proprietor is limited to the
proprietor’s personal wealth.
18. 18
The Partnership
Any two or more people can get together and form a partnership
A partner agree to provide some fraction of the work and cash, and
to share the profits and losses
The general partner is liable for all of the debts of the partnership
The limited partner is permitted the liability to be limited to the amount of
cash he/she contributed to the partnership.
The limited partnership usually require that
At least one partner be a general partner
The limited partners do not participate in managing the business
19. 19
The Partnership (Cont.)
Factors of considering partnership
Partnerships are usually inexpensive and easy to form
If one general partner is unable to meet his or her commitment, the
shortfall must be made up by the other general partners
It is difficult for a partnership to transfer ownership. Usually all
general partners must agree.
Income from a partnership is taxed as personal income to the
partners
Management control resides with the general partners
20. 20
The Disadvantages of Proprietorship and Partnership
It is difficulty for large business organizations to exist as sole proprietorships or
partnerships. The main advantage to a sole proprietorship or partnership is the
cost of getting started.
Unlimited
liability
Limited life of
the enterprise
Difficulty of transferring
ownership
Difficulty in raising cash
21. 21
The Corporation
In a corporation, the ownership is divided into shares with equal
value and voting rights.
The liability of the shareholders, the owners of the shares, is
limited to the value of their shares.
The corporation comprises three sets of distinct interests: the
shareholders (the owner), the directors, and the corporation
officers (the top management).
The shareholders elect a board of directors, who in turn select top
management.
Top management should manage the operations of the corporations
in the best interest of the shareholders.
22. 22
Advantages of the Separation of Ownership from Management
Because ownership in a corporation is represented by shares of
stock, ownership can be readily transferred to new owners.
The corporation has unlimited life.
The shareholders’ liability is limited to the amount invested in the
ownership shares.
Limited liability, ease of ownership transfer, and perpetual
succession are the major advantages which gives the corporation
an enhanced ability to raise funds.
23. 23
One Great Disadvantage to Corporation
Double taxation on corporation
The government taxes corporate income (based on the earnings
within corporations).
In addition when earnings are distributed to the shareholders
receive as dividend, they need to pay personal income tax.
When shareholders sell their shares they have to pay capital
gain tax. [In China, there is no capital gain tax currently. But
dividend is taxed as personal income]
Proprietorship and partnership pays only personal income
tax.
24. 24
A Comparison
Corporation Partnership
Liquidity Shares can be easily
exchanged
Subject to substantial restrictions
Voting Rights Usually each share gets one
vote
General Partner is in charge;
limited partners may have some
voting rights
Taxation Double Partners pay taxes on distributions
Reinvestment and dividend
payout
Broad latitude All net cash flow is distributed to
partners
Liability Limited liability General partners may have
unlimited liability; limited
partners enjoy limited liability
Continuity Perpetual life Limited life
Corporation Partnership
Liquidity Shares can be easily
exchanged
Subject to substantial restrictions
Voting Rights Usually each share gets one
vote
General Partner is in charge;
limited partners may have some
voting rights
Taxation Double Partners pay taxes on distributions
Reinvestment and dividend
payout
Broad latitude All net cash flow is distributed to
partners
Liability Limited liability General partners may have
unlimited liability; limited
partners enjoy limited liability
Continuity Perpetual life Limited life
25. What are corporations from the financial perspective?
Corporations
Capital budgeting
decision
Financing decision
26. What do we care in corporate finance?
Capital
budgeting
decision
Financing
decision
Firms
Financial
markets
Risk and
return
Return on projects>cost of capital Cost of capital =investors expected return
27. 27
Cash Flows between Firms and Markets
Market value of the firm ≠ Book value of the firm because
of growth assets.
In what situation will the firm create values for the
investors?
From a view of corporate finance, Cash is King.
28. 28
The Financial Manager
The Financial Manager’s primary goal is to increase the
value of the firm by:
Selecting value creating projects
Making smart financing decisions
29. 29
The Financial Managers
In large firms the chief financial officer (CFO) is in charge of the
financial activity.
The treasurer and the controller report to the CFO.
Treasurer (财务总监)
Handling cash flows, managing capital expenditure decisions, and
making financial plans.
Controller (总会计师)
Handle the accounting functions, which includes taxes, cost of
financial accounting, and information system.
30. 30
Hypothetical Organization Chart
Chairman of the Board and
Chief Executive Officer (CEO)
President and Chief
Operating Officer (COO)
Vice President and
Chief Financial Officer (CFO)
Treasurer Controller
Cash Manager
Capital Expenditures
Credit Manager
Financial Planning
Tax Manager
Financial Accounting
Cost Accounting
Data Processing
Board of Directors
Chairman of the Board and
Chief Executive Officer (CEO)
Board of Directors
President and Chief
Operating Officer (COO)
Chairman of the Board and
Chief Executive Officer (CEO)
Board of Directors
Vice President and
Chief Financial Officer (CFO)
President and Chief
Operating Officer (COO)
Chairman of the Board and
Chief Executive Officer (CEO)
Board of Directors
Treasurer
Vice President and
Chief Financial Officer (CFO)
President and Chief
Operating Officer (COO)
Chairman of the Board and
Chief Executive Officer (CEO)
Board of Directors
Controller
Treasurer
Vice President and
Chief Financial Officer (CFO)
President and Chief
Operating Officer (COO)
Chairman of the Board and
Chief Executive Officer (CEO)
Board of Directors
Cost Accounting
Controller
Treasurer
Vice President and
Chief Financial Officer (CFO)
President and Chief
Operating Officer (COO)
Chairman of the Board and
Chief Executive Officer (CEO)
Board of Directors
Data Processing
Cost Accounting
Controller
Treasurer
Vice President and
Chief Financial Officer (CFO)
President and Chief
Operating Officer (COO)
Chairman of the Board and
Chief Executive Officer (CEO)
Board of Directors
Tax Manager
Data Processing
Cost Accounting
Controller
Treasurer
Vice President and
Chief Financial Officer (CFO)
President and Chief
Operating Officer (COO)
Chairman of the Board and
Chief Executive Officer (CEO)
Board of Directors
Financial Accounting
Tax Manager
Data Processing
Cost Accounting
Controller
Treasurer
Vice President and
Chief Financial Officer (CFO)
President and Chief
Operating Officer (COO)
Chairman of the Board and
Chief Executive Officer (CEO)
Board of Directors
Credit Manager
Financial Accounting
Tax Manager
Data Processing
Cost Accounting
Controller
Treasurer
Vice President and
Chief Financial Officer (CFO)
President and Chief
Operating Officer (COO)
Chairman of the Board and
Chief Executive Officer (CEO)
Board of Directors
Financial Planning
Credit Manager
Financial Accounting
Tax Manager
Data Processing
Cost Accounting
Controller
Treasurer
Vice President and
Chief Financial Officer (CFO)
President and Chief
Operating Officer (COO)
Chairman of the Board and
Chief Executive Officer (CEO)
Board of Directors
Cash Manager
Financial Planning
Credit Manager
Financial Accounting
Tax Manager
Data Processing
Cost Accounting
Controller
Treasurer
Vice President and
Chief Financial Officer (CFO)
President and Chief
Operating Officer (COO)
Chairman of the Board and
Chief Executive Officer (CEO)
Board of Directors
Capital Expenditures
Cash Manager
Financial Planning
Credit Manager
Financial Accounting
Tax Manager
Data Processing
Cost Accounting
Controller
Treasurer
Vice President and
Chief Financial Officer (CFO)
President and Chief
Operating Officer (COO)
Chairman of the Board and
Chief Executive Officer (CEO)
Board of Directors
Chairman of the Board and
Chief Executive Officer (CEO)
Board of Directors
31. 31
Firms and Financial Markets
Cash flow
from assets (C)
Firm issues securities (A)
Retained
cash flows (E)
Dividends and
debt payments (F)
Ultimately, the firm
must be a cash
generating activity.
The cash flows from the
firm must exceed the
cash flows from the
financial markets.
Firm
Idea
Invests in
assets
(B)
Taxes
Government (D)
Financial
Markets
Debt
Equity
32. 32
The Goal of Financial Management
Possible goals
Survive.
Avoid financial distress and bankruptcy.
Beat the competition.
Maximize sales or market share.
Minimize costs.
Maximize profits.
Maintain steady earnings growth.
33. 33
The Goal of Financial Management
To create value, the financial manager should:
1. Try to make smart investment decisions.
2. Try to make smart financing decisions.
3. Try to make smart use of net working capital.
34. 34
The Goal of Financial Management
Since that financial managers make decisions for the shareholders
in their best interests, the shareholders’ point of view on a good
financial management decision is important.
Shareholders buy stocks because they seek to gain financially:
Good decision increase the value of the stock, and poor decisions
decrease the value of the stock.
The goal of financial management is to maximize the current
value per share of the existing stock.
36. 36
Share Value or Firm Value
Is share value maximization consistent with firm value
maximization?
The value of a firm is the value of its assets, which is the sum of
debt holders’ value and shareholders’ value.
Given a fixed firm value, the managers can increase the
shareholders’ value by destroying debt holders value.
Is this a good strategy?
37. 37
Share Value or Firm Value (Cont.)
Shareholders do have the incentive to enhance their own value at the
expense at debt holders.
One extreme case: shareholders sell all the assets of the firm. They
can distribute all the proceeds as dividend and then announce
bankruptcy.
If debt holders are rational they will do as the following in advance.
Require a higher interest rate to compensate their potential loss.
Do not lend.
Actually the incentive of shareholders to expropriate debt holders
eventually hurt themselves (higher borrowing costs or even no credit).
38. 38
Share Value or Firm Value (Cont.)
It is in shareholders’ interest to convince debt holders that they will
not hurt debt holders.
For example, debt covenants could be written in the debt
contract, which impose restrictions on the behavior of
managers.
In this course we assume that shareholders are able to convince
debt holders, and the only way to maximize shareholder value is to
maximize firm value.
Shareholder value maximization is consistent with firm value
maximization.
39. 39
The Classical Objective Function
STOCKHOLDERS
Maximize
stockholder
wealth
Hire & fire
managers
- Board
- Annual Meeting
BONDHOLDERS/
LENDERS
Lend Money
Protect
bondholder
Interests
FINANCIAL MARKETS
SOCIETY
Managers
Reveal
information
honestly and
on time
Markets are
efficient and
assess effect on
value
No Social Costs
All costs can be
traced to firm
40. 40
What can go wrong?
STOCKHOLDERS
Managers put
their interests
above stockholders
Have little control
over managers
BONDHOLDERS
Lend Money
Bondholders can
get ripped off
FINANCIAL MARKETS
SOCIETY
Managers
Delay bad
news or
provide
misleading
information
Markets make
mistakes and
can over react
Significant Social
Costs
Some costs cannot be
traced to firm
41. 41
Stockholder Interests vs. Management Interests
In theory: The stockholders have significant control over management.
The two mechanisms for disciplining management are the annual
meeting and the board of directors. Specifically, we assume that
Stockholders who are dissatisfied with managers can not only express their
disapproval at the annual meeting, but can use their voting power at the
meeting to keep managers in check.
The board of directors plays its true role of representing stockholders and
acting as a check on management.
In Practice: Neither mechanism is as effective in disciplining
management as theory posits.
42. 42
The Annual Meeting as a disciplinary venue
The power of stockholders to act at annual meetings is diluted by
three factors
Most small stockholders do not go to meetings because the cost of going
to the meeting exceeds the value of their holdings.
Incumbent management starts off with a clear advantage when it comes
to the exercise of proxies. Proxies that are not voted becomes votes for
incumbent management.
For large stockholders, the path of least resistance, when confronted by
managers that they do not like, is to vote with their feet.
Annual meetings are also tightly scripted and controlled events,
making it difficult for outsiders and rebels to bring up issues that
are not to the management’s liking.
43. 43
Board of Directors as a disciplinary mechanism
In 2010, the median board member at a Fortune 500 company was
paid $212,512, with 54% coming in stock and the remaining 46%
in cash. If a board member is a non-executive chair, he or she
receives about $150,000 more in compensation.
A board member works, on average, about 227.5 hours a year (and
that is being generous), or 4.4 hours a week, according to the
National Associate of Corporate Directors. Of this, about 24 hours
a year are for board meetings.
Many directors serve on three or more boards, and some are full
time chief executives of other companies.
44. 44
The Agency Problem
Agency Relationship
The dark side of the separation of ownership from management is the agency
relationship between the managers and shareholders.
The agency relationship exists whenever someone (the principal) hires another
(agent) to represent his or her interests.
Agency Problem
The essential problem of the agency relationship lies in the conflict of interest
between the principal and agent, which is called the agency problem.
Agency Cost
The costs incurred by the conflicts of interest between the principal and agent are
agency costs.
45. 45
Some Types of Typical Agency Problems
Consumption of perquisites (在职消费)
Top managers are able to enjoy non-pecuniary benefits more
than necessary which may hurt shareholders.
This may happy even if top managers themselves are
shareholders.
– For example, if managers who hold 5% of the firm’s shares
purchase a 4 million Rolls-Royce for business purpose, their
cost is only 200 thousand.
– They enjoy the vehicle which is not necessary. But
shareholders share most of the cost.
46. 46
Some Types of Typical Agency Problems
Overinvestment (过度投资)
Managers prefer excessive growth of their firms
– Large firms have more perquisites
– One incentive of managers is to prevent bankruptcy to
protect their jobs. They are safer in large firms.
Managers tend to invest beyond the optimal level, which
destroys share value.
Example: Over-investment in China?
47. 47
Why Shareholders Cannot Control Managers
Ownership structure of U.S. listed firms is well dispersed.
Listed firms are held by millions of investors, which means an
average investor hold only a tiny fraction of a firm’s shares.
Individuals are not able to replace the managers, while it is also
difficult for shareholders to act collectively to monitor the
management due to the free-rider problem.
Ownership structure outside U.S. especially in East Asia is much
more concentrated.
Does it mean less severe agency problem in Asia?
48. 48
The Agency Problem in East Asia
In East Asia, the ownership structure is heavily concentrated.
Generally a large fraction of a listed firm’s shares are held by its parent
company or a family.
It is easy for large shareholders to control management.
The agency problem lies in the conflict of interest between large
shareholders and minority shareholders.
It is easy for large shareholders to expropriate the interest of minority
shareholders.
Example: asset diversion (listed firms are cashier of their parent firms.)
49. 49
Corporate Governance Mechanism
Managerial compensation
Board of directors
Takeover market
Production market
CEO market
Ownership structure
Use of corporate debt
50. 50
Raising Capital in the Financial Markets
Firms raise debt and equity capital from both public and
private sources.
Public Sources of Capital
Capital raised from public sources must be in the form of
registered securities.
Securities are publicly traded financial instruments. They are
traded on public secondary market, after issued on primary
market.
Most securities must be registered with the Securities and
Exchange Commission (SEC).
51. 51
Raising Capital in the Financial Markets
Private Sources of Capital
Private capital comes either in the form of bank loans or as
what are know as private placements (私募).
Private placements are financial claims exempted from the
registration requirements that apply to securities.
– To be qualified for exemption the issue muse be restricted to a
small group of sophisticated investors (fewer than 35) with
minimum income or wealth requirements
Privately placed financial instruments cannot be traded on
public markets.
Rule 144A allows institutions with assets exceeding $100
million to trade these financial claims among themselves.
52. 52
Primary and Secondary Markets
Primary and Secondary Markets (一级/二级市场)
Firm
Stock
Bond
Capital
Primary Market
Financial Market
(Investors)
Investor
A
Investor
B
Securities
Secondary Market
53. 53
Secondary Markets
A corporation is directly involved only in the primary market.
A secondary market transaction involves one owner or creditor
selling to another.
The secondary markets provide the means for transferring ownership
of corporate securities.
The secondary market is critical to large corporation though they do
not involve in it.
Investors are more willing to buy securities that can be resoled easily.
It will be easier for a corporation to raise capital if their securities are traded
actively (liquid securities).
54. 54
Dealer vs. Auction Markets
The dealer markets (over-the-counter, OTC markets)
Dealer (market marker 坐市商): principals that buy and sell
securities on their own account.
Broker (经纪商): agents who facilitate the transactions between
the buyers and sellers, and charge commissions.
In the dealer market, in most of the cases, it is the dealers who
provide the bid – ask spread quotes.
The dealers add liquidity to the marketplace and seek to profit
from the bid – ask spread.
55. 55
Examples of Dealer Markets
U.S. treasury bills, treasury notes and treasury bonds markets
Large financial institutions purchase the debt instruments in the
primary markets and then become dealers in the secondary
markets.
NASDAQ (National Association of Securities Dealers
Automated Quotation System)
It is a large OTC market for stocks.
Foreign exchange market
56. 56
Auction Markets
Auction markets differ from dealer markets in two ways:
An auction market has a physical location (like stock exchanges on
Wall Street).
A dealer market, most of the buying and selling is done by the dealer.
While the primary purpose of an action market is to match those who
wish to sell with those who wish to buy.
Examples of auction markets:
New York Stock Exchange (NYSE), which accounts for more than
85 percent of all the shares traded in the auction market.
American Stock Exchange (AMEX).
Shanghai and Shenzhen Stock Exchange.
57. 57
The Role of Financial Intermediaries
Commercial bank
Commercial banks receives deposits from those who have extra
money and lend to those who need money.
Financing through bank loan is called indirect financing.
Investment bank
When firms need to raise capital from the public, investment
banks help to sell the securities. They help to prepare registration
forms, price the security, search potential institutional investors
and marketing the firms to the public.
Raising capital from the public is called direct financing.
58. 58
Quick Review
What are the three basic questions Financial Managers
must answer?
What are the three major forms of business organization?
What is the goal of financial management?
What are agency problems, and why do they exist within
a corporation?
60. 60
Balance Sheet
Balance sheet is an accountant’s snapshot of a firm’s
accounting value on a particular date.
Assets ≡ Liabilities + Stockholder’s Equity
Three concerns when analyzing the balance sheet
Liquidity
Debt versus Equity
Value versus Cost
61. 61
Liquidity
Liquidity (流动性): the ease and quickness with which
assets can be converted to cash (without significant loss
in value).
The assets in the balance sheet are listed in order by the
liquidity.
Cash is the most liquid asset, while fixed assets are
difficult to be converted to cash quickly.
But on the other hand liquid assets frequently have lower
rates of return than fixed assets.
62. 62
The Balance Sheet of the U.S. Composite Corporation
(in $ millions)
20X2 and 20X1
Balance Sheet
U.S. COMPOSITE CORPORATION
Liabilities (Debt)
Assets 20X2 20X1 and Stockholder's Equity 20X2 20X1
Current assets: Current Liabilities:
Cash and equivalents $140 $107 Accounts payable $213 $197
Accounts receivable 294 270 Notes payable 50 53
Inventories 269 280 Accrued expenses 223 205
Other 58 50 Total current liabilities $486 $455
Total current assets $761 $707 Long-term liabilities:
Fixed assets:
Deferred taxes $117 $104
Property, plant, and equipment $1,423 $1,274
Long-term debt 471 458
Less accumulated depreciation -550 -460
Total long-term liabilities $588 $562
Net property, plant, and equipment 873 814
Intangible assets and other 245 221
Stockholder's equity:
Total fixed assets $1,118 $1,035
Preferred stock $39 $39
Common stock ($1 per value) 55 32
Capital surplus 347 327
Accumulated retained earnings 390 347
Less treasury stock -26 -20
Total equity $805 $725
Total assets $1,879 $1,742 Total liabilities and stockholder's equity $1,879 $1,742
The assets are listed in order by
the length of time it normally
would take a firm with ongoing
operations to convert them into
cash.
Clearly, cash is much more
liquid than property, plant and
equipment.
63. 63
Debt versus Equity
Liabilities are obligations of the firm that require a payout of
cash within a stipulated period.
When the firm borrows, it gives the bondholders first claim on
the firm’s cash flow.
Stockholders’ equity is a claim against the firm’s assets that is
residual and not fixed.
Stockholders’ equity is the residual difference between assets
and liabilities:
Assets – Liabilities ≡ Stockholders’ equity.
64. 64
Value versus Cost
Under Generally Accepted Accounting Principles
(GAAP), audited financial statements of firms in the
United States carry the assets at costs.
Accounting value (book value) of an asset generally
reflects the costs of obtaining that asset, not the market
value.
Market value is the price at which willing buyers and
sellers would trade the assets.
65. 65
The Income Statement
The income statement measures performance over a
specific period of time.
The accounting definition of income is
Revenue – Expenses ≡ Income
Income is different from cash flow
66. 66
Example: U.S.C.C. Income Statement
(in $ millions)
20X2
Income Statement
U.S. COMPOSITE CORPORATION
Total operating revenues
Cost of goods sold
Selling, general, and administrative expenses
Depreciation
Operating income
Other income
Earnings before interest and taxes
Interest expense
Pretax income
Taxes
Current: $71
Deferred: $13
Net income
Retained earnings:
Dividends:
The operations
section of the income
statement reports the
firm’s revenues and
expenses from
principal operations
$2,262
- 1,655
- 327
- 90
$190
29
$219
- 49
$170
- 84
$86
$43
$43
67. 67
Example: U.S.C.C. Income Statement
(in $ millions)
20X2
Income Statement
U.S. COMPOSITE CORPORATION
Total operating revenues
Cost of goods sold
Selling, general, and administrative expenses
Depreciation
Operating income
Other income
Earnings before interest and taxes
Interest expense
Pretax income
Taxes
Current: $71
Deferred: $13
Net income
Retained earnings:
Dividends:
$2,262
- 1,655
- 327
- 90
$190
29
$219
- 49
$170
- 84
$86
$43
$43
The non-
operating
section of the
income
statement
includes all
financing
costs, such as
interest
expense.
68. 68
Example: U.S.C.C. Income Statement
(in $ millions)
20X2
Income Statement
U.S. COMPOSITE CORPORATION
Total operating revenues
Cost of goods sold
Selling, general, and administrative expenses
Depreciation
Operating income
Other income
Earnings before interest and taxes
Interest expense
Pretax income
Taxes
Current: $71
Deferred: $13
Net income
Retained earnings:
Dividends:
$2,262
- 1,655
- 327
- 90
$190
29
$219
- 49
$170
- 84
$86
$43
$43
Usually a
separate
section reports
as a separate
item the
amount of
taxes levied on
income.
69. 69
Example: U.S.C.C. Income Statement
(in $ millions)
20X2
Income Statement
U.S. COMPOSITE CORPORATION
Total operating revenues
Cost of goods sold
Selling, general, and administrative expenses
Depreciation
Operating income
Other income
Earnings before interest and taxes
Interest expense
Pretax income
Taxes
Current: $71
Deferred: $13
Net income
Retained earnings:
Dividends:
$2,262
- 1,655
- 327
- 90
$190
29
$219
- 49
$170
- 84
$86
$43
$43
Net income is the
“bottom line”.
70. 70
Example: U.S.C.C. Income Statement
(in $ millions)
20X2
Income Statement
U.S. COMPOSITE CORPORATION
Total operating revenues
Cost of goods sold
Selling, general, and administrative expenses
Depreciation
Operating income
Other income
Earnings before interest and taxes
Interest expense
Pretax income
Taxes
Current: $71
Deferred: $13
Net income
Retained earnings:
Dividends:
$2,262
- 1,655
- 327
- 90
$190
29
$219
- 49
$170
- 84
$86
$43
$43
Distribution of
the income
71. 71
Income Statement Analysis
There are three things to keep in mind when
analyzing an income statement:
Generally Accepted Accounting Principles
(GAAP)
Non-Cash Items
72. 72
GAAP
The matching principal of GAAP dictates that
revenues be matched with expenses.
Thus, income is reported when it is earned,
even though no cash flow may have occurred.
Income Statement Analysis
73. 73
Noncash Items
Net income is not cash flow!
There are several noncash items that are expenses against revenues
but do not affect cash flow.
Depreciation:
– cash outflow occurs at the time when fixed assets are purchased,
but the total cash outflow is expensed over the life time of the
fixed assets.
– Depreciation, which is not real cash outflow, is deducted from
the revenue.
– It should be added to net income to reach the real cash flow.
74. 74
Noncash Items
Deferred Tax
– When the taxable income is less than the accounting income
(on the income statement), the accounting tax (on the income
statement) should be break down into two components,
Current tax: the portion of the accounting tax currently sent to
the tax authority.
Deferred tax: the portion which will be paid later.
– The deferred tax, which is not a cash outflow in the current
year, is deducted from the revenue.
– The deferred tax should be added to net income to reach cash
flow.
75. 75
Financial Cash Flow
The most important item that can be extracted from
financial statements is the actual cash flow of the firm.
The cash from received from the firm’s assets must equal
the cash flows to the firm’s creditors and stockholders:
CF(A)≡ CF(D) + CF(E)
The value of the firm is its ability to generate financial
cash flow.
76. 76
Financial Cash Flow
Cash flow of the firm=
Operating cash flows (OCF) –
Net capital spending –
Increase in net working capital
77. 77
First Step: Cash Flow from Operation
Operating cash flow is the cash flow generated by
business activities, including sales of goods and services.
Operating cash flow reflects tax payments, but not
financing, capital spending, or changes in net working
capital.
Operating cash flow = Earnings before interest and taxes
– Taxes (current portion) + Depreciation
78. 78
Total Cash Flow of the U.S.C.C.
(in $ millions)
20X2
Financial Cash Flow
U.S. COMPOSITE CORPORATION
Cash Flow of the Firm
Operating cash flow $238
(Earnings before interest and taxes
plus depreciation minus taxes)
Capital spending (173)
(Acquisitions of fixed assets
minus sales of fixed assets)
Additions to net working capital (23)
Total $42
Cash Flow of Investors in the Firm
Debt $36
(Interest plus retirement of debt
minus long-term debt financing)
Equity 6
(Dividends plus repurchase of
equity minus new equity financing)
Total $42
Operating Cash Flow:
EBIT $219
Depreciation $90
Current Taxes ($71)
OCF $238
79. 79
Second Step: Capital Spending
Operating cash flow can be used on capital spending
Two methods to calculate capital spending:
Statement of Cash Flow:
– Acquisition of fixed assets – Sales of fixed assets
Balance Sheet:
– Ending net fixed assets – Beginning net fixed assets +
Depreciation
80. 80
Total Cash Flow of the U.S.C.C.
(in $ millions)
20X2
Financial Cash Flow
U.S. COMPOSITE CORPORATION
Cash Flow of the Firm
Operating cash flow $238
(Earnings before interest and taxes
plus depreciation minus taxes)
Capital spending
(Acquisitions of fixed assets
minus sales of fixed assets)
Additions to net working capital
Total
Cash Flow of Investors in the Firm
Debt
(Interest plus retirement of debt
minus long-term debt financing)
Equity
(Dividends plus repurchase of
equity minus new equity financing)
Total
Capital Spending
Ending net fixed assets
$1,118
Beginning net fixed assets
(1,035)
Depreciation 550 -460 = 90
Capital Spending $173
(173)
(23)
$42
$36
6
$42
81. 81
Third Step: Change in Net Working Capital
Cash flow can also be used for making investment in Net Working
Capital.
Net working capital is current assets minus current liabilities.
The increase in net working capital means the use of cash flow.
The increase (decrease) in current assets (liabilities) means the
use of cash flow.
The decrease (increase) in current assets (liabilities) means the
source of cash flow.
82. 82
The Balance Sheet of the U.S.C.C.
2010 2009 2010 2009
Current assets: Current Liabilities:
Cash and equivalents $140 $107 Accounts payable $213 $197
Accounts receivable 294 270 Notes payable 50 53
Inventories 269 280 Accrued expenses 223 205
Other 58 50 Total current liabilities $486 $455
Total current assets $761 $707
Long-term liabilities:
Fixed assets: Deferred taxes $117 $104
Property, plant, and equipment $1,423 $1,274 Long-term debt 471 458
Less accumulated depreciation (550) (460 Total long-term liabilities $588 $562
Net property, plant, and equipment 873 814
Intangible assets and other 245 221 Stockholder's equity:
Total fixed assets $1,118 $1,035 Preferred stock $39 $39
Common stock ($1 par value) 55 32
Capital surplus 347 327
Accumulated retained earnings 390 347
Less treasury stock (26) (20)
Total equity $805 $725
Total assets $1,879 $1,742 Total liabilities and stockholder's equity $1,879 $1,742
Here we see NWC grow to $275
million in 2010 from $252
million in 2009.
This increase of $23 million is
an investment of the firm.
$23 million
$275m = $761m- $486m
$252m = $707- $455
83. 83
Total Cash Flow of the U.S.C.C.
(in $ millions)
20X2
Financial Cash Flow
U.S. COMPOSITE CORPORATION
Cash Flow of the Firm
Operating cash flow $238
(Earnings before interest and taxes
plus depreciation minus taxes)
Capital spending
(Acquisitions of fixed assets
minus sales of fixed assets)
Additions to net working capital
Total
Cash Flow of Investors in the Firm
Debt
(Interest plus retirement of debt
minus long-term debt financing)
Equity
(Dividends plus repurchase of
equity minus new equity financing)
Total
NWC grew from
$275 million in
20X2 from $252
million
in 20X1.
This increase of
$23 million is the
addition to NWC.
(173)
(23)
$42
$36
6
$42
84. 84
Total Cash Flow of the U.S.C.C.
(in $ millions)
20X2
Financial Cash Flow
U.S. COMPOSITE CORPORATION
Cash Flow of the Firm
Operating cash flow $238
(Earnings before interest and taxes
plus depreciation minus taxes)
Capital spending
(Acquisitions of fixed assets
minus sales of fixed assets)
Additions to net working capital
Total
Cash Flow of Investors in the Firm
Debt
(Interest plus retirement of debt
minus long-term debt financing)
Equity
(Dividends plus repurchase of
equity minus new equity financing)
Total
(173)
(23)
$42
$36
6
$42
Total Cash Flow of the Firm/
Free Cash Flow from the
Assets
85. 85
Cash Flow Paid to Creditors
Cash flow paid to creditors is interest payments plus
repayments of principal (that is, retirement of debt).
Two methods to calculate
Income Statement and Balance Sheet:
– Interest expense – Net new borrowing = Interest paid –
(Ending long-term debt – Beginning long-term debt)
Income Statement and Statement of Cash Flow:
– Interest expense – (Proceeds from long-term debt –
Retirement of long-term debt)
86. 86
Total Cash Flow of the U.S.C.C.
(in $ millions)
20X2
Financial Cash Flow
U.S. COMPOSITE CORPORATION
Cash Flow of the Firm
Operating cash flow $238
(Earnings before interest and taxes
plus depreciation minus taxes)
Capital spending
(Acquisitions of fixed assets
minus sales of fixed assets)
Additions to net working capital
Total
Cash Flow of Investors in the Firm
Debt
(Interest plus retirement of debt
minus long-term debt financing)
Equity
(Dividends plus repurchase of
equity minus new equity financing)
Total
Cash Flow to Creditors
Interest $49
Ending long term debt
471
Beginning long term debt
458
Total
36 = 49 - (471 -458)
(173)
(23)
$42
$36
6
$42
87. 87
Cash Flow Paid to Stockholders
Cash flow paid to stockholders = Dividends – (Stock sold –
Stock repurchased)
Two methods to calculate stock sold and repurchased
Balance Sheet:
– Stock sold = change in the common stock and capital
surplus
– Stock repurchased = change in the treasury stock
Statement of Cash Flow:
– Stock issue and repurchased can be directly obtained
88. 88
Total Cash Flow of the U.S.C.C.
(in $ millions)
20X2
Financial Cash Flow
U.S. COMPOSITE CORPORATION
Cash Flow of the Firm
Operating cash flow $238
(Earnings before interest and taxes
plus depreciation minus taxes)
Capital spending
(Acquisitions of fixed assets
minus sales of fixed assets)
Additions to net working capital
Total
Cash Flow of Investors in the Firm
Debt
(Interest plus retirement of debt
minus long-term debt financing)
Equity
(Dividends plus repurchase of
equity minus new equity financing)
Total
Cash Flow to Stockholders
Dividends $43
Repurchase of
stock 6
Cash to Stockholders 49
Proceeds from new
stock issue (43)
Total $6
(173)
(23)
$42
$36
6
$42
Change in the treasury
stock = 6 = 26 – 20
Change in the common
stock and the capital
surplus = 43 = (55 - 32) +
(347 -327)
89. 89
Total Cash Flow of the U.S.C.C.
(in $ millions)
20X2
Financial Cash Flow
U.S. COMPOSITE CORPORATION
Cash Flow of the Firm
Operating cash flow $238
(Earnings before interest and taxes
plus depreciation minus taxes)
Capital spending
(Acquisitions of fixed assets
minus sales of fixed assets)
Additions to net working capital
Total
Cash Flow of Investors in the Firm
Debt
(Interest plus retirement of debt
minus long-term debt financing)
Equity
(Dividends plus repurchase of
equity minus new equity financing)
Total
)
(
)
(
)
(
E
CF
D
CF
A
CF
The cash received
from the firm’s assets
must equal the cash
flows to the firm’s
creditors and
stockholders:
(173)
(23)
$42
$36
6
$42
90. 90
The Statement of Cash Flows
There is an official accounting statement called the
statement of cash flows.
This helps explain the change in accounting cash.
The three components of the statement of cash flows are:
Cash flow from operating activities
Cash flow from investing activities
Cash flow from financing activities
91. 91
The Statement of Cash Flows
U.S. COMPOSITE CORPORATION
Cash Flow from Operating Activities ($ in millions)
Net income $86
Depreciation 90
Deferred taxes 13
Change in assets and liabilities
Accounts receivable -24
Inventories 11
Accounts payable 16
Accrued expense 18
Other -8
Cash flow from operating activities $202
To calculate cash
flow from
operations, start
with net income,
add back non-
cash items like
depreciation and
adjust for changes
in current assets
and liabilities
(other than cash).
92. 92
The Statement of Cash Flows
U.S. COMPOSITE CORPORATION
Cash Flow from Investing Activities ($ in millions)
Acquisition of fixed assets -$198
Sales of fixed assets 25
Cash flow from investing activities -$173
Cash flow from investing activities involves changes in capital
assets: acquisition of fixed assets and sales of fixed assets (i.e.,
net capital expenditures).
93. 93
The Statement of Cash Flows
U.S. COMPOSITE CORPORATION
Cash Flow from Financing Activities ($ in millions)
Retirement of long-term debt -$73
Proceeds from long-term debt sales 86
Change in notes payable 3
Dividends -43
Repurchase of Stock -6
Proceeds from new stock issue 43
Cash flow from financing activities $4
Cash flows
to and from
creditors
and owners
include
changes in
equity and
debt.
94. 94
The Statement of Cash Flows
U.S. COMPOSITE CORPORATION
Statement of Cash Flows ($ in millions)
Total cash flow from operations $202
Total cash flow from investing activities -$173
Total cash flow from financing activities $4
Change in cash (on the balance sheet) $33
The statement of cash flows is the addition of cash
flows from operations, investing, and financing.
95. 95
Quick Review
Total cash flow of the firm, which is used to calculate the firm’s
value can be obtained using the following formula,
Total cash flow = operating cash flow – capital spending – change
in net working capital,
Operating cash flow = Earnings before interest and taxes - taxes +
depreciation
The total cash flow of the firm can be calculated using only the
balance sheet and income statement.
Interest expense is not in the statement of cash flow. It should be
careful to use the statement of cash flow to compute total cash
flow of the firm