Professional Documents
Culture Documents
Chapter 01 Foundation
Chapter 01 Foundation
Foundations
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Financial Assets
Real asset—an object that provides a service, such as a
house, car, art, coin…
Financial asset—a document representing a claim to
income
Stock—ownership interest in a company
• Entitled to a share of the firm’s profits, either dividends or future
growth
Bond—debt interest in a company
• Entitled to interest and repayment of principal
Investing involves buying financial assets in the hope of
earning a return
Can be made directly or indirectly (buying shares in a mutual
fund)
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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 can
buy/sell securities
• Stock market (NYSE, AMEX, OTC)--entire network of brokers
and exchanges all connected together
• Stockbroker (broker)--person who is licensed to trade
securities for a commission
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Financial Markets
Secondary market—place where investors trade
securities among themselves (NYSE, etc.)
Most transactions are of this type
Primary market—market where securities are
initially sold (I.P.O.)
Investments
Making decisions about buying and selling stock and
bonds
Financial management
Decisions about raising money and how to spend it
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Figure 1.1: Simplified Financial
System
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Raising Money
Financing means raising money to acquire
something
Forms of Financing
Issuing stock (equity financing)
Borrowing money (debt financing)
• Bank
• Issuing bonds
• Leasing
Internal financing (retaining earnings)
• Still considered equity financing
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Raising Money
Field of finance includes raising money
and investing money
Changing Focus of Finance
Finance used to be narrowly limited to
financial market activity
However has expanded to include
• Portfolio formation and analysis
• A portfolio is a collection of securities
• Financial management within an organization
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Financial Management
Financial Management is the management and
control of money and money-related operations
within a business
Executive in charge of finance department
CFO: Chief Financial Officer (AKA: VP of Finance)
• Typically reports directly to the President of the corporation
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Financial Management
Refers to the functions of the finance
department
Keeping records
Receiving payments from customers
Making payments to suppliers
Borrowing funds Accounting
Purchasing assets department is
Selling stock included in the
Paying dividends, etc. broad 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 everyone’s shoulder to make certain
money is being used effectively
• For example,
• Are manufacturing costs too high?
• Are advertising costs too high?
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The Price of Securities—A Link
Between the Firm and the Market
Investors buy securities for the future cash flows
expected from them
Price investors are willing to pay depends on
expectations of how well the companies are likely to
do
Link between company management and
investors comes from this relationship between
price and expected financial results
Everything firm does is evaluated by market and
‘graded’ by either an , , or no change in security
price
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The Price of Securities—A Link
Between the Firm and the Market
Does management care what ‘grade’ it
receives?
YES! Why?
• Management will need to issue new securities in
the future (to raise $) and therefore want a high
security price
• Stockholders own the firm and if the stock price
declines shareholders will be disgruntled
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Finance and Accounting
Accounting: a system of record-keeping
designed to portray a firm’s operations in a
fair/unbiased manner
Generate financial statements which are provided to
the marketplace
Finance: a process of decision-making related
to raising money, analyzing results, etc.
Use the output generated by accountants as inputs
in finance
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Finance and Accounting
Finance department generally consists of both
the accounting department and the treasury
department
Controller is in charge of the accounting department
Treasury department deals with finance activities
Crossover is possible
Usually easier for an accountant to move to the
treasury department
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Figure 1.2: Finance
Department Organization
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The Importance of Cash Flow
Accounting attempts to reflect a firm’s
financial results in a way that represents
what is physically occurring
Finance is interested in how cash is
flowing (or expected to flow)
We need a cash amount because we’ll be
looking at returns on money invested, and
you can’t invest a non-cash number
• Cash is King
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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.
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 depends
on job
• Financial analyst needs to know LOTS of accounting because
s/he investigates companies and makes recommendations
concerning their value in market (must decipher complex
financial statements as part of that process)
• Stockbrokers do not need as thorough an understanding
because they generally trade securities based on the financial
analyst’s recommendation
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Financial Theory—The
Relationship with Economics
Financial theory developed from
economics
Modern financial theory began as a branch of
economics in the 1950s
• Today finance is viewed as a separate field
Scholars in both fields make observations
between business world and government
and attempt to model the behavior
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Figure 1.3: The Influence of Accounting,
Economics and Financial Theory on
Financial Management
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Forms of Business Organization
and Their Financial Impact
Businesses can be legally or organized as
A sole proprietorship
A partnership
A corporation
Legal organization has an impact on
Raising money
Taxation
Financial liability
Issues really only important regarding small businesses
Virtually all large corporations are organized as C-type
organizations
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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 individual’s
personal tax rate
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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
Example
organization.
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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 proprietorship
when raising money
• Offering stock to investors
• If less than a 50% interest is sold, original owner still maintains
effective control
• Owning stock is risky
• Best possible outcome: may get rich
• Worst possible outcome: may lose all of your investment
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The Truth About Limited
Liability
Limited liability states that a stockholder is not
liable for a corporation’s debts
Implies that the most stockholder can lose is 100% of
his investment in the stock
In a sole proprietorship, the business owner
stands to lose his personal property if all the
assets of the business are insufficient to cover
all liabilities
Personal guarantees make entrepreneurs liable for
loans made to their business
• Destroys the value of limited liability
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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
Economics—goal is to maximize profit
But what about R&D?
• If you eliminate R&D you’ll increase short-term profit and
hurt long-term profit
Finance—Stockholders own the company so the
goal is to maximize their wealth, generally by
maximizing the stock price
This goal bypasses the concern of whether the short-
term or long-term is more important, because stock
price incorporates both!
• If R&D were eliminated the stock price would not rise, but
rather, drop
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Stakeholders and Conflicts of
Interest
Constituencies of the company who have a
vested interest in the way the firm is operated
and include
Stockholders
Employees
Customers
Community
Management
Creditors
Suppliers
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Conflicts of Interest—An
Illustration
Example: Employees want management to
build an athletic facility on corporate grounds
Benefit—more effective employees (feel better,
happier, therefore more productive)
Cost—will come from profits that belong to
stockholders
• This represents a conflict of interest between
stockholders and employees
• Something that benefits one group and takes away from
another
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Management—A Privileged
Stakeholder Group
Management represents a privileged stakeholder group
The ownership of a widely held company is very
dispersed so no one has enough control to influence
management
IBM has almost 2 billion shares outstanding, and over 600,000
shareholders—so no one person has enough control to
influence management
This allows top management to become entrenched in
positions controlling large amounts of resources
Management is able to use these resources for their
own benefit
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The Agency Problem
Management (agent) is controlling resources
owned by stockholders (principal) and may not
make the decisions stockholders want
The Abuse of Agency
Privileges and luxuries provided to executives are
called perquisites or ‘perks’
• Example—management compensation
• Management receives exorbitant salaries/bonuses ($50+
million) while the company performance is poor
• Additional perks include boats, airplanes, country club
memberships, etc.
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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 stock
performance via a stock option or to corporate
profit
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Creditors Versus Stockholders—A
Financially Important Conflict of Interest
A creditor is anyone owed money by a
business including lenders, vendors,
employees, or the government
Actions taken by the leveraged company
that are riskier than before they borrowed
money place creditors at risk
Lenders generally put clauses in loan
agreements to prevent this from occurring
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