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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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Financial Management
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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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
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Financial Management
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