Chapter 01 Foundation

8/8/2019 Chapter 01 Foundation

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Slides developed by:

Pamela L. Hall, Western Washington University

Foundations

Chapter 1


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Main Areas of Finance

Investments and financial markets

Financial management of corporations

Fields are separate but related


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Financial Assets

Real assetan object that provides a service, such as ahouse, car, art, coin

Financial asseta document representing a claim toincome

Stockownership interest in a company Entitled to a share of the firms profits, either dividends or future

growth

Bonddebt interest in a company Entitled to interest and repayment of principal

Investing involves buying financial assets in the hope ofearning a return Can be made directly or indirectly (buying shares in a mutual

fund)


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Financial Markets

Financial Market Financial assets are issued by corporations

and bought by investors in financial markets

A framework or organization in which people canbuy/sell securities

Stock market (NYSE, AMEX, OTC)--entire network of brokersand exchanges all connected together

Stockbroker (broker)--person who is licensed to tradesecurities for a commission


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Financial Markets

Secondary marketplace where investors tradesecurities among themselves (NYSE, etc.) Most transactions are of this type

Primary marketmarket where securities areinitially 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


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Figure 1.1: Simplified FinancialSystem


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Raising Money

Financing means raising money to acquiresomething

Forms of Financing

Issuing stock (equity financing) Borrowing money (debt financing)

Bank

Issuing bonds

Leasing

Internal financing (retaining earnings) Still considered equity financing


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Raising Money

Field of finance includes raising moneyand 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


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Financial Management

Financial Management is the management andcontrol of money and money-related operationswithin 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


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Refers to the functions of the financedepartment Keeping records

Receiving payments from customers Making payments to suppliers

Borrowing funds

Purchasing assets

Selling stock

Paying dividends, etc.

Accountingdepartment is

included in thebroad definition

of finance.


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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


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Oversight Finance department must also perform an

oversight function

Looking over everyones shoulder to make certainmoney is being used effectively

For example,

Are manufacturing costs too high?

Are advertising costs too high?


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The Price of SecuritiesA LinkBetween the Firm and the Market

Investors buy securities for the future cash flowsexpected 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 betweenprice and expected financial results Everything firm does is evaluated by market and

graded by either an,, or no change in securityprice


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The Price of SecuritiesA LinkBetween the Firm and the Market

Does management care what grade itreceives? YES! Why?

Management will need to issue new securities inthe future (to raise $) and therefore want a highsecurity price

Stockholders own the firm and if the stock price

declines shareholders will be disgruntled


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Finance and Accounting

Accounting: a system of record-keepingdesigned to portray a firms operations in afair/unbiased manner

Generate financial statements which are provided tothe marketplace

Finance: a process of decision-making relatedto raising money, analyzing results, etc.

Use the outputgenerated by accountants as inputsin finance


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Finance and Accounting

Finance department generally consists of boththe accounting department and the treasurydepartment

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


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Figure 1.2: FinanceDepartment Organization


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The Importance of Cash Flow

Accounting attempts to reflect a firmsfinancial results in a way that representswhat is physically occurring

Finance is interested in how cash isflowing (or expected to flow) We need a cash amount because well be

looking at returns on money invested, andyou cant invest a non-cash number

Cash is King


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The Importance of Cash Flow

Q: Example: In 1999 we purchased a $1,000 asset that willbe depreciated over five years using straight-linedepreciation. Explain how that asset will be viewed fromboth an accounting and finance viewpoint.

A: Accounting: The initial cost of the asset of $1,000 will bereflected on the books as will the $200 annualdepreciation.

Finance: We are interested in the $1,000 cash outflowand the taxes saved from the depreciation deductionnotthe depreciation itself.

Example


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The Language of Finance

Accounting is the language of finance Thus all finance professionals need some

accounting knowledge

Level of accounting knowledge needed dependson job Financial analyst needs to know LOTS of accounting because

s/he investigates companies and makes recommendationsconcerning their value in market (must decipher complexfinancial statements as part of that process)

Stockbrokers do not need as thorough an understandingbecause they generally trade securities based on the financialanalysts recommendation


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Financial TheoryTheRelationship with Economics

Financial theory developed fromeconomics 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 governmentand attempt to model the behavior

Figure 1 3: The Influence of Accounting


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Figure 1.3: The Influence of Accounting,Economics and Financial Theory onFinancial Management


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Forms of Business Organizationand 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


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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


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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 individuals

personal tax rate


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The Corporate FormExample

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 relevantrates are 34% for corporations and 30% for individuals on theentire amounts subject to those taxes. Compare the total tax

bills under the sole proprietorship and corporate forms oforganization.

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 Hazelwere to take these earnings she would have to declare them as

a dividend and pay personal taxes at 30%, or $19,800. In asole proprietorship the $100,000 is taxed only once at thepersonal rate of 30%, for a total tax bill of $30,000. Thedifference in taxes of $23,800 is significant.

Examp

le


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The Corporate Form

Raising Money Money for a corporation can be raised by

Borrowing

A corporation faces the same issues as a sole proprietorshipwhen raising money

Offering stock to investors

If less than a 50% interest is sold, original owner still maintainseffective control

Owning stock is risky

Best possible outcome: may get rich

Worst possible outcome: may lose all of your investment

Th T th Ab t Li it d


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The Truth About LimitedLiability

Limited liability states that a stockholder is notliable for a corporations debts Implies that the most stockholder can lose is 100% of

his investment in the stock

In a sole proprietorship, the business ownerstands to lose his personal property if all theassets of the business are insufficient to coverall liabilities Personal guarantees make entrepreneurs liable for

loans made to their business Destroys the value of limited liability


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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


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Goals of Management

Economicsgoal is to maximize profit But what about R&D?

If you eliminate R&D youll increase short-term profit andhurt long-term profit

FinanceStockholders own the company so thegoal is to maximize their wealth, generally bymaximizing the stock price This goal bypasses the concern of whether the short-

term or long-term is more important, because stockprice incorporates both!

If R&D were eliminated the stock price would not rise, butrather, drop

St k h ld d C fli t f


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Stakeholders and Conflicts ofInterest Constituencies of the company who have a

vested interest in the way the firm is operatedand include

Stockholders Employees

Customers

Community

Management Creditors

Suppliers

C fli t f I t t A


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Conflicts of InterestAnIllustration Example: Employees want management to

build an athletic facility on corporate grounds Benefitmore effective employees (feel better,

happier, therefore more productive) Costwill 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

M t A P i il d


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ManagementA PrivilegedStakeholder Group Management represents a privileged stakeholder group The ownership of a widely held company is very

dispersed so no one has enough control to influencemanagement

IBM has almost 2 billion shares outstanding, and over600,000shareholdersso 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 theirown benefit


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The Agency Problem

Management (agent) is controlling resourcesowned by stockholders (principal) and may notmake the decisions stockholders want

The Abuse of Agency Privileges and luxuries provided to executives are

called perquisites or perks Examplemanagement compensation

Management receives exorbitant salaries/bonuses ($50+

million) while the company performance is poor Additional perks include boats, airplanes, country clubmemberships, etc.


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The Agency Problems

Controlling the agency problem Efforts to manage agency problem include

Monitor management (audits)

Tie management bonuses to corporate stockperformance via a stock option or to corporateprofit


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Creditors Versus StockholdersAFinancially Important Conflict of Interest

A creditor is anyone owed money by abusiness including lenders, vendors,employees, or the government

Actions taken by the leveraged companythat are riskier than before they borrowedmoney place creditors at risk

Lenders generally put clauses in loanagreements to prevent this from occurring

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Chapter 01 Foundation