Introduction To Finance - The Ba - Gies College of Business at The

Table of Contents
1. Preface
2. Module 1 Introduction to Finance: The Basics
1. Module 1 Overview
2. Three Legal Forms to Organize Firms
1. Introduction of the Three Legal Forms to Organize
Firms
2. The Sole Proprietorship
3. The Partnership
4. The corporation
5. The Hybrid Form
3. The Goal of Financial Management
1. The Goal of Financial Management
4. The Corporate Governance
1. The Corporate Governance
5. The Agency Problem
1. The Agency Problem
6. Module 1 Wrap Up
1. Module 1 Wrap Up
2. Financials
1. Financials
3. Balance Sheet
1. Balance Sheet: Introduction
2. Balance Sheet: Fiscal Year
3. Balance Sheet: Other Topics
4. Income Statement
1. Income Statement
5. Cash Flow of the Firm
1. Statement of Cash Flow
6. Module 2 Wrap Up
1. Module 2 Wrap Up
2. Standardized Statements
1. Standardized Statements
3. Financial Ratios
1. Financial Ratios: Introduction
2. Financial Ratios: Liquidity Ratios
3. Financial Ratios: Leverage Ratios
4. Financial Ratios: Turnover Ratios
5. Financial Ratios: Profitability Ratios
6. Financial Ratios: Market Value Ratios
4. Financial Planning
1. Financial Forecasting
5. Module 3 Wrap Up
1. Module 3 Wrap Up
2. Present Value and Future Value
1. Present Value and Future Value
3. Net Present Value
1. Net Present Value
2. A P RAPR and E A REAR
4. Perpetuity and Annuity
1. Perpetuity
2. Annuity
5. Module 4 Wrap Up
1. Module 4 Wrap Up
Preface
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made from Professor Xi Yang’s Introduction to Finance: The Basics
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Copyright © 2020 by Xi Yang
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Published by the Gies College of Business at the University of Illinois

at Urbana-Champaign, and the Board of Trustees of the University of
Illinois
Module 1 Introduction to Finance: The
Basics
Module 1 Overview
Module 1 Overview
Media Player for Video
Focus - Slide 1
Basic topics of finance

Roles and structures of firms
Wealth created by firms
Transcript
In this module, let's get introduced to the basics of Finance. In order

to learn finance, we first need to know some basics about the
structure and raw or firms at the center of Finance because they
create the wealth in society. Think about your daily life. In the
morning you may go to your favorite local cafe or Starbucks to get a
Cup of coffee for breakfast. The local cafe is a small business and
Starbucks is the world's largest coffeehouse chain. They have
something in common and they also have a lot of differences.
The Way a Business is Organized - Slide 2
Local cafe vs. Starbucks

Small business vs. large chain
Each have similarities and differences.
Transcript
You may be curious. How they organize their business and why they
organize it that way? If you want to start a new business, what is the
best way to set it up?
Corporations - Slide 3
Provide employment opportunities

What is the government structure of firm?
Who are the owners?
Transcript
When you go to work, it's very likely that you work for a company.
Corporations provide a lot of employment opportunities for us. You
may wonder what is the government structure of the firm? Who are
the owners of the Corporation? Think about the goods and services
we use every day we buy groceries from either local stores or big
retailers such as Walmart or target. We shop online at Amazon. Our
computers are made by Apple, Dell or Hewlett-Packard. We watch
movies produced by Disney or the brothers or universal. We use
streaming services such as Netflix and Disney plus. We deposit our
money in a local bank or national banks such as Bank of America,
Chase Bank, or Citibank. The car we drive to work. Maybe Ford,
Toyota or Volkswagen. When we want to travel to other cities, we
may take on American Airlines or Delta airline flight. We may stay at
a local hotel or Hilton. All of these are examples of business. Is hard
for us to imagine a world without business. Some of the companies
even become American icons. Whenever we want to drink soft
drinks, we think about Coke. McDonald is almost equivalent to
hamburger and French fries. Hershey bars are just synonymous for
candy bars. We want to search for something from the Internet. We
just say Google it. The Thanksgiving Day Parade in New York City is
named after the Department store chain Macy's. These companies
not only satisfy our basic needs but also shape our life and our
culture.
In This Module - Slide 4
What are the basic legal forms to organize firms?

What is the goal of financial management?
What is the best form to organize a business?
What is the agency problem?
How to mitigate the agency problem?
Transcript
In this module, let me introduce you to three basic legal forms to

organize firms and the advantages and disadvantages of each one.
We will cover the goal of financial management and the structure of
corporate governance. On top of that, we will discuss the agency
problem and how companies mitigate agency problems. Let's get
started.
Three Legal Forms to Organize Firms
Introduction of the Three Legal Forms to

Organize Firms
Three legal forms to organize firms - Slide 5
A sole proprietorship
A partnership
A corporation
Transcript
Hello everyone, let's talk about starting a business. When you want
to start a new business, one decision you have to decide what form
of business to establish. This is a very important question because
the form of business determines which income tax return you must
file and how much liability protection you can get in case of failure.
There are three most important forms to organize your business, so
proprietorship, partnership, and Corporation. In the preceding videos
we will talk about each form and also discuss the relationship among
them three.
The Sole Proprietorship

The Sole Proprietorship - Slide 6
A sole proprietorship is an unincorporated business owned and

run by a single person.
The best structure for most small businesses.
This is a good choice for low-risk businesses.
It is also suitable for people who want to test their business
ideas before organizing a more formal business.
Transcript
The first form to organize your business is called sole proprietorship.

It is a business owned by a single owner to start a sole
proprietorship, you just need to register your business with states
business office. In some places there's no such requirement.
Therefore, this is considered as the best structure for small
businesses. Some examples include bakeries, Barber shops,
restaurants, bars, bookstores, higher salons and hardware stores.
You can find some common things for these businesses. There's no
need for a large amount of capital to start with. And you can also
handle the business or by yourself. So you don't need any partners
or stockholders. This structure is also ideal for the business startups
part time and the home based businesses. If you have a great
business idea you want to know whether your business idea will
work or not, and also learn more about entrepreneurship, then you
can just start your own business as sole proprietorship.
Walgreens - Slide 7
In 1901, Charles R. Walgreen Sr., a pharmacist in Chicago,

bough the store he had been working at for $6,000 and became
the sole owner of the store.
By 1916, the business expanded to nine drug stores, and he
incorporated it as Walgreen Co.
Transcript
Here I want to share with some history about Walgreens Company.

The company was first established by Charles Walgreen so
proprietorship in 19 One. And this time he spend $6000 to acquire
the business from the previous owner. This amount of money is
equivalent to about 180 two $1000 in today's dollars. He run the
business as sole proprietor for about 15 years before he
incorporated the business in 1916. Nowadays, Walgreens operated
as the second largest pharmacy store chains in the United States,
just behind the CVS. Walgreens was added as one of the 30
components of the Dow Jones industrial average in 2018. As the
example shown here, a lot of large companies start to organize their
business as sole proprietorships. And later this structure no longer
suited the business and they want to switch to another structure
instead.
Advantages - Slide 8
Easy to form
Few government regulations
No corporate income tax
Transcript
Now we want to talk about the advantages and disadvantages of a

sole proprietorship. The first advantage is that so proprietorship is
easy and inexpensive to form. It is the simplest and least expensive
way to establish a business structure. You just need to register your
business with state and local government. In some areas there's no
requirement for a business license. Not a lot of paperwork involved.
So the costs involved are minimum with legal cars limited to
obtaining the necessary licenses or permits. Suppose you start a
restaurant and you want to sell alcohol to your customers. You need
to apply for a liquor license before you can start your business.
These kind of regulations vary by industry, state and location. There
are a few government regulations. Which means you have the
complete control of your business. Because you are the only owner
of the business, you have full control over all decisions. You don't
have to consult with anyone or report to anyone when you need to
make a quick decision or want to make any changes. You have a lot
of Freedom. You are the boss. Another advantage is about taxes.
You don't have to pay separate taxes for your business. And so it's
easy to fulfill the tax reporting requirements for a sole proprietorship.
All profits are yours, you just need to file personal income taxes and
nothing else.
Disadvantages - Slide 9
Unlimited liability for the owner

Limited to the life of the owner
Difficult to obtain large amounts of funding
Transcript
But this structure also has this down size. The biggest disadvantage
is the unlimited personal liability. Since there's no legal separation
between you and your business, you can be held personally liable
for the debts and obligations such as lawsuits of a business. This
risk extends to any liabilities incurred as a result of employee
actions. If the business goes broke, you need to pay any debt using
your personal belongings such as your car and your home. Your
company and the personal finances are tangled with each other.
Another point is limited life. The life of the company depends pretty
much on the owner. It is limited by the life of the owner. When the
owner quiz or sells the business, the business will be disrupted. And
the value of the company won't worth the same as before.
Customers trust the original owner and this kind of trust may not
transfer easily to a new owner. Because of the unlimited liability and
the limited life of the business, this kind of business is hard to raise
money. Sole proprietors often face challenges when trying to raise
money. You can sell stock in the business which limits investor
opportunity. Banks are also hesitant to lend to a sole proprietorship.
Because of perceived additional risk when it comes to repayment if
the business fails. As a result, the proprietor has to raise capital by
typing savings using credit cards or borrowing from family members.
All these pros and cons are the result of no distinction between the
business and the owner. You are entitled to all profits and are
responsible for all your business debts, losses and liabilities. You
along are ultimately responsible for the business success and
failures.
Sole Proprietorships - Slide 10
Most small businesses with 1 to 10 employees are sole

proprietorships.
More than 70% of the 32.5 million businesses in the United
States are organized as sole proprietorships.
These businesses produce approximately 20% of the total
profits of the US economy.
Transcript
Finally, I want to share some statistics with you since they are small
businesses, the sole proprietorship dominates all business forms in
terms of numbers, is more than 70%. However, is only a small
fraction in terms of profit. Just 20% of the total profit of the
USbusiness economy.
The Partnership
Partnership - Slide 11
Two or more people own a business together.
Transcript
Instead of starting a business on your, you may want to pull money,

an expertise with your friends or business associates. In this case,
you form a partnership. Partnerships enable entrepreneurs to pull
their talents. One partner may be good at this sign, while another
may be good at marketing.
Partnership Agreement - Slide 12
Specify the rights and duties of the partners.

Partnerships are a good choice for businesses with multiple
owners or professional business (like legal, accounting,
engineering, and management consulting firms)
Transcript
In most cases, partners will have a formal partnership agreement in

order to outline how to make important decisions and how to split
profits among partners. This helps to resolve any disputes that may
arise and clear any hurdles in the future. Many big companies were
initially organized as partnerships. Such as Morgan Stanley, Merrill
Lynch, Goldman Sachs and Microsoft. However, eventually these
companies and their financing requirements grew too large for them
to continue as partnerships.
Easily and inexpensively formed

Few government regulations
No corporate income tax
Transcript
Here are the list of advantages and disadvantages of partnership.

You can see that it shares a lot in common with, so prepare
ownership. Partnerships are relatively easy to form and exempt from
most reporting requirements the government imposes on
corporations. And they are also taxed favorably. Partners pay
personal income taxes on their share of profits. But their businesses
are not text.
Unlimited liability for general partners

Difficult to transfer ownership
Difficult to obtain large amounts of capital
Transcript
Partners soap reporters have the disadvantage of unlimited liability.

If the business runs into our financial difficulties, each partner has
unlimited liability for all the business. That's not just his or her own
share. A good advice is that you need to know your partners very
well before you start this journey. One example of partnership. I want
to show you is the accounting industry. The big four accounting
companies still use the partnership structure even if their size is
much larger than a lot of corporations.
Partnerships (1 of 2) - Slide 15
This mechanism provides an incentive for partners since they share

the profits of the firm.
Transcript
On one hand, this provides enough incentives for partners to do their

best work, improve the quality of auditing, and develop a market in
the reputation of brands for individual audit partners.
Partnerships (2 of 2) - Slide 16
Individual partners have unlimited liability in the firm, which

induces high quality audits and more effort.
Partnership structure is used to protect the integrity of the
accounting profession.
Transcript
On the other hand, the partners who directly commit misconduct will
take personal responsibility. There unlimited liability means there's
no place to shield themselves from liability. Other auditors who are
not directly involved will be protected from liability risks.
The corporation
Corporation (1 of 4) - Slide 17
A corporation is a separate legal entity. In a legal context, it is a legal

person that is owned by its shareholders.
Transcript
A Corporation is a legal entity that, separated from its owners.

As a legal person, the corporation can own property, sign

contracts, carry on a business, borrow or lend money, and sue
or be sued.
Corporations pay corporate income tax on their profits.
Transcript
As a legal person, the Corporation enjoys a lot of the legal powers of

natural persons such as make contracts, borrow money, and Sue or
be sued. One Corporation can make a takeover bid for another and
then merge the two businesses together. Corporations can make a
profit, be taxed, and can be held legally liable.
Closely held corporations: at the early stage of development, the

shares of a corporation are privately held by a small group of
shareholders.
Transcript
When a Corporation was initially established. The shares were held

by a small group of people, including founder, the manager, some
employees, and venture capitalists. The shares were not treated in
public markets.
Public companies: when the size of the firm grows, and its shares
are traded in public markets such as the NYSE or NASDAQ.
Transcript
Eventually, when the firm grows and knew shares are issued to raise
additional capital. The shares will be widely treated in stock
exchanges. Such corporations are called public companies. Most
known corporations are public companies. The process of converting
a private company to a public company is called initial public offering
or IPO.
Unlimited life
Easy to transfer ownership
Limited liability
Transcript
Corporations have a completely independent life, separate from its

shareholders. If shareholders want to leave the company, they just
need to sell their shares. The Corporation can continue doing
business without any disturbance. Corporations also offer the
strongest protection to its shareholders from personal liability. This
gives corporations advantage when it comes to raising capital
because they can raise funds through the sale of stock. Which can
also be a benefit in attracting employees.
Double taxation
Complex legal requirements
Transcript
Corporations also have its downsides. Unlike sole proprietorships

and partnerships. Corporations pay income taxes on their profits. In
fact, corporations profits are taxed twice. 1st, when the company
generates a profit, it is taxed at the corporate level and then again
when dividends are paid to shareholders. Dividends are taxed at
personal level. The cost to form a Corporation is higher than other
structures. Corporations also require more extensive bookkeeping,
operational process and reporting. Corporations are required to hold
the shareholders meetings or take those on important management
issues. From the characteristics over here, you can see that
corporations can be a good choice for medium or higher risk
businesses. Business needed to raise money and businesses that
plan to go public or eventually be sold.
In the United States, corporations are formed under state law,

based on the document called Articles of Incorporation
Other names equivalent to Articles of Incorporation: Articles of
Association, Certificate of Incorporation, or Corporate Charter
Transcript
Just when a new baby is born, there's an official document called

birth certificate. When you establish a company, you also need an
official document. This founding document of Corporation is called
Articles of incorporation. It also has other names such as articles of
Association, Certificate of incorporation or corporate charter. Let's
take a look at an example from Target Corporation. A major retailer
in the United States.
Articles of Incorporation (1 of 4) - Slide 24
This slide shows an image of Target corporation's articles of

incorporation. The corporation name, location, and number of
authorized shares are circled in the document.
Transcript
The Articles of incorporation outlines the basic information needed to

form a Corporation, such as the name of the Corporation, the
location, the types, an number of authorized shares, and shareholder
rights.
This slide is the same as slide 24, but with number of votes per
share (one-to-one) circled.
From slide 24: This slide shows an image of Target corporation's

articles of incorporation. The corporation name, location, and
number of authorized shares a circled in the document.
Transcript
No instruction provided on this slide.

This slide shows the article 4 and article 5 headers of the articles of
incorporation circled.
Transcript
You also layout how a Corporation should be governed. It specifies

the composition and the role of the board of directors, and limitation
of director's liability.
This slide shows the article 5 header of the articles of incorporation

circled
Transcript
Actions by stockholders without a meeting and the authority to call

special meetings of shareholders. Another key corporate document
is the bylaws. Which outlines how to run the Corporation. By loss
work jointly with the Articles of incorporation to form the legal
backbone of the Corporation.
Examples of Large Corporations - Slide 28
This slide shows logos for the following large corporations: Google,
Walmart, Microsoft, Starbucks, McDonald’s, Apple, Disney, Nike,
Target, Hilton, and Coca-Cola.
Transcript
Here are some examples of large corporations. They are household

names in the United States. These corporations cover all aspects of
our lives, some of them become our friends, is hard to imagine a
world without them.
In terms of revenue and profits produced, a corporation is

considered the most important type of economic unit.
While less than 20% of business firms in the United States are
corporations, more than 70% of profits can be attributed to the
corporate form of organization.
Transcript
Here are some statistics about corporations. There are only 20% of
business organized as corporations. But they contribute more than
70% of the profits. As the corporations are much larger than sole
proprietorship and partnerships, they also hire more employees than
other formats of businesses.
The Hybrid Form

Hybrid Forms of Business - Slide 30
Combine benefits
Transcript
A business can also be organized. Some hybrids of the basic forms.

For example, some people enjoy vanilla ice cream and some people
enjoy chocolate ice cream. Then we create a new ice cream flavor
which combines Manila with chocolate so that we can enjoy the
benefits of both.
LLC (1 of 2) - Slide 31
Limited Liability Company
Transcript
I'll see is a relatively new form compared with three traditional forms
of organizing a business, but it is growing very fast. More and more
businesses adopt this hybrid form because of its benefits.
LLC (2 of 2) - Slide 32
Limited Liability Company

Enjoys the benefits of the partnership and corporation.
Limited liabilities for owners
No double taxation
Transcript
First, I'll see enjoys the benefits of limited liability just like over
Corporation. Owners of our C are protected from personal liability for
business debts and claims. The maximum amount they can lose is
the money invested in the company. In addition to that, I'll see also
enjoys the tax advantages of a partnership. From I'll see is business
income is passed through to its owners who just need to pay
personal taxes. Except in some very Special Situations.
Legal Documents - Slide 33
LLC: Articles of Organization and Operating Agreement

Corporation: Articles of Incorporation and Bylaws
Transcript
To form our see you need to file articles of organization under state
law. Corporations founding document is articles of Corporation.
When a business is formed as our C is, business name usually has
the abbreviation LLC. So that is future creditors and customers
realized that they are doing business with a limited liability company
instead of a sole proprietorship or partnership, and they realize all
the risks they are in facing. On top of that. Our CSoften have an
operating agreement. This is an optional document, but it's very
important to have this document in place, especially for an LLC with
multiple owners. The operating agreement specifies the rights and
responsibilities of owners. How to divide profits and losses and how
to transfer ownership? This document is Compara Bulto a
corporation's bylaws. The owners of our seas are called members.
Members may include individuals and entities, such as partnerships
and corporations.
Owners - Slide 34
LLC: members and interests

Corporations: shareholders and shares
Transcript
The owners are called shareholders in the Corporation setting. Our

C is a better choice if there are few owners. While the Corporation is
better, if there are a lot of shareholders. The ownership is called
interest. While in chorus setting they are called shares.
Management - Slide 35
LLC: "Member-managed" or "manager-managed"

Corporation: Board of directors, officers, and shareholders
Transcript
In terms of Management LLC's, I either member, managed or

manage are managed. Member managed means all the members
are actively involved in running business. Jointly managed day-to-
day business. This is more common for small alesis. Sometimes our
CSselect managers to run the business and the manager can either
be a member or a non member. The Management Corporation is
much more complicated. They have shareholders, directors and
officers. They need to hold shareholder meetings and board
meetings and keep all the minutes. Generally speaking, an LLC is
much simpler to organize. An has fewer regulations than a
Corporation. So it is better for smaller sized business. But if you
have the ambition of growing your business into a large one. A better
choice is to set it up as a Corporation rather than our LLC.
Disadvantages (1 of 2) - Slide 36
Lack of uniformity with state laws: LLCs have businesses that span
several states, which may not receive the same treatment.
Transcript
Also want to point out some disadvantages of LLCs. I'll see is a

business structure allowed by state statue? For a business that
spends several states, this may cause some trouble. Because each
state has different standards and rules.
Disadvantages (2 of 2) - Slide 37
Unable to issue stock: not suitable for businesses that expect to

expand in the future.
Transcript
LLC's are not able to issue stock. Most of the capital comes from its
members or borrowed from others. Is not a good choice for a
business considering raising large amount of capital and expanding
its business in the future.
The Goal of Financial Management
The Goal of Financial Management

Why is Maximizing Profit Not the Goal? - Slide

38
Transcript
For a public company, the goal of financial management is to

maximize the current share value of the existing stock. If the
company does not have stocks treated in public market. The goal is
to maximize shareholder wealth. Shareholders are owners of the
company. If the value of a company increases, is shares also worth
more? This call provides a very clear direction for financial
management. Is also easy to evaluate. You can check the stock
market and get real time stock price information. Some of you may
wonder. Why maximizing profit is not the goal of a Corporation? It
seems like a common sense that corporations maximize their profits.
But when you take a closer look. You will find out that there are
some problems associated with this goal. The first question is that.
The profit is not accounting term. And there are several ways to
manipulate it.
Which Year's Profit do You Have in Mind? -

Slide 39
Transcript
Another question is. Which years profit do you have in mind? If you
are thinking about next year's profit. Managers can always maximize
it by delaying maintenance and training. These actions will boost the
short term profit. But what harm long term growth? There's no
consensus as of what the appropriate time Horizon of profit
maximization is. This goal is not as clear as maximizing current
share price. Here I want you to think about your question.
Conflict Between Goals - Slide 40
Is there a conflict between the goal of maximizing the current value

of the stock and other goals, such as employee safety, customer
satisfaction, and environmental protection?
Transcript
Do you think there's a conflict between the goal of maximizing the

current value of the stock and some other goals, such as employees
safety, customer satisfaction, and Environmental Protection? The
answer to this question is that. In general. These goals are not
conflict with each other. Because the stock market is believed to be
largely efficient or no, not perfectly efficient. The information will be
reflected in the market. Even if not immediately. In the long run.
Investors will valuate. To dig further into the question, we want to
introduce the concept of stakeholders. Who are the stakeholders of
the company?
Stakeholders - Slide 41
Besides shareholders, stakeholders also include: employees,

customers, suppliers, creditors, and the society.
Transcript
The stakeholders include all the parties related to the business,

including their employees, customers, suppliers, creditors and
Society. The first group of stakeholders is the company's employees.
Nowadays companies are more willing to invest in their employees.
Companies are Investing in Their Employees -

Slide 42
Offer benefits to employees

Improve the working environment
Invest in employee training
Help employees to achieve professional goals
Transcript
A lot of companies offer benefits to employees such as insurance,

paid leave, retirement plan and other perks. The improve working
conditions and create opportunities for employees to accumulate
their human capital. They motivate their employees and help them to
achieve their professional goals. All these practices seems costly
from appearance. But they will help companies to attract more
talents to work for them and in return employees will create more
value for the company and shareholders. Customers are also
important stakeholders of a company.
Improve Customer Satisfaction - Slide 43
Deliver high quality products and services

Foster sustained innovation
Remain competitive in the industry
Transcript
If a company serves their customers with high quality products and

services. Innovate new products and remain competitive in the
industry. The results will be an increase in sales. And customer
loyalty will greatly improve the value of business. Customers have
become more powerful in recent times because they can easily
share a lot of their experiences, whether good or bad, with their
friends and followers on social media such as Facebook, Twitter and
Instagram. When we talk about the goal of financial management or
main focus, is the United States. But how about other countries in
the world? Their situations are quite different from the US. They care
more about the stakeholders.
World Financial Management - Slide 44
Yoshimori (1995) surveyed more than 300 financial managers in

different countries and found:
In the United States and United Kingdom, shareholder interest is
the first priority.
In other countries such as Japan, Germany, and France they
care more about interests of all stakeholders.
Transcript
Based on the research paper done by Massaro Yuji Mori. Financial

managers in the US&UK think shareholders are more important.
Well, in Japan, Germany and France they care more about the
interests of all stakeholders. Other parties are also powerful in their
culture. For example, in Germany, almost half of the board of
directors are chosen by workers. In this case, maximizing
shareholder wealth is not the only goal of the financial manager.
Corporation and Social Responsibility - Slide

45
Transcript
Corporations pay more attention to their social responsibilities. In

addition to financial goals, corporations also fulfill social, ethical and
environmental responsibilities. Here I want to share with you the
story of terms.
TOMS Business Model (1 of 2) - Slide 46
"Buy-one, give-one" donation model

For each pair of TOMS shoes purchased, a pair of new shoes is
given for free to a child in need
Transcript
Toms is a shoe company famous for its one for one business model.
Based on this charitable donation model. For each pair of Toms
Shoes purchased by its customers, a pair of new shoes is given to a
child in the developing world. The intention of the model is to help
children in poverty. But they also received some criticism about
whether this giving is effective or not. What is the impact on the local
shoe industry and whether this model is sustainable or not?
TOMS Business Model (2 of 2) - Slide 47
The company's model for giving has evolved.

Consumers were given more choices. Giving shoes is still one
option, but consumers can also choose other causes they are
interested in such as: clean water, prescription glasses, medical
treatment, women's rights, or ending gun violence
Transcript
Later on, the company's model for giving has evolved. If you buy a
pair of shoes. Consumers were given a wide variety of choices.
Giving shoes is only one option, but consumers can also choose
other causes they want to support, such as Clearwater prescription
glasses, medical treatment and others donating part of their profit to
various charities will certainly sacrificed short-term profit, but this will
attract more customers and create loyalty in the long run. But how
much social responsibility should the business take? Is a question
you may want to think about as you run your own business.
The Corporate Governance
The Corporate Governance

Corporate Governance (1 of 3) - Slide 48
Corporate governance specifies the system of rules, practices,

and procedures by which corporations are managed and
controlled.
Good corporate governance helps the company to achieve its
goal.
Transcript
Now, we are going to talk about Corporate Governance. Corporate

governance refers to the rules, practices, and procedures that direct
how the corporation is managed and controlled. It outlines the
distribution of rights, and the responsibilities among different groups
in the corporation; such as the board of directors, managers, and
other stakeholders. Good corporate governance, makes the
business run more efficiently, and create value for shareholders.
Shareholders are the owners of stocks issued by the company.

Shareholders can be individuals or institutions.
Transcript
If individuals or institutions hold stocks of a company, they are called

the company's shareholders or stockholders. Here, institutions
include the companies, mutual funds, pension funds, hedge funds,
endowment funds, and the insurance companies. Normally, when
they buy and sell large blocks of stocks, they are more powerful than
the small shareholders for a company.
Majority vs. minority shareholders

Transcript
If a shareholder controls more than 50 percent of a company's

outstanding shares, then we call him a majority shareholder. In most
cases, majority shareholders are company's founders, or
descendants of a company's founders. One example is Mark
Zuckerberg, the founder of Facebook. He controls more than 50
percent of all voting shares in Facebook. By controlling more than
half of a company's voting shares, he has effective control of
important operational decisions and won't be ousted by the board. If
the stock holding is less than 50 percent of a company's stock, then
they are called the minority shareholders. For most of the outside
investors, they are minority shareholders. Let's take a look at the
rights of shareholders.
Shareholder Rights - Slide 51
The right to vote on important corporate issues

The right to receive dividends
Transcript
Their rights are mainly two parts. The first one is the voting right. As
shareholders are owners in a company, they can vote on important
corporate issues, such as electing directors and merger and
acquisition decisions. Besides voting, they are also entitled to enjoy
the benefits of the business success. The benefits come in the form
of dividends. In general, we can summarize the rights of
shareholders as voting rights, and cash flow rights.
Board of Directors (1 of 2) - Slide 52
The directors are elected by shareholders to represent the interests

of shareholders and make sure that the company's management
acts on their behalf.
Transcript
The highest governing body of a corporation is the Board of

Directors. The directors are elected by the shareholders, usually
once a year at the annual shareholders meeting to represent best
interests of shareholders. They serve staggered terms, which means
in any certain year, only a fraction of the members will be up for
election. The structure and the powers of a board are determined by
organizations, articles of incorporation, and by-laws. For example,
the number of board members and how the board works. Inside the
director, refers to the director who has a stake in the corporation.
Some examples include the CEO, COO, CFO.
Board of Directors (2 of 2) - Slide 53
Inside directors vs. outside directors

Transcript
Major shareholders, and representatives of employees. Outside

directors are also called independent directors. From the name, you
can tell, they are not stakeholders in a company. Outside directors
are required for big public companies because people believe that
they will bring independent voices to the board. For large
corporations, the board members are usually professionals or
leaders in their industry. Outside directors are often leaders of other
organizations. Good corporate governance requires a balance
between inside directors, and outside directors. Insiders know the
company very well, but their decisions may reflect their personal
interests. Outsiders can provide unbiased perspectives, but they
may not have a deep knowledge about the company.
Committees - Slide 54
Executive committee
Audit committee
Compensation committee
Nominating committee
Transcript
For a traditional board, there are at least four basic committees: the
executive committee, audit committee, compensation committee,
and the nominating committees. For most companies, they have
more committees than that depending on the needs of the boards
and special considerations. Now, let's talk about the four committees
one by one. The executive committee is composed of a small group
of Board Directors. The executive committee meets more often and
set the priorities for the whole Board to discuss. The members of the
audit committee are independent outside Directors. They oversee
the company's internal control and the financial reporting and
disclosures. The compensation committee determines the pay
package for top executives. The nominating committee is
responsible for nominating new board members.
Board of Director responsibilities - Slide 55
Select and appoint senior executives and review their

performance.
Set dividend payout policies and other major policies.
Determine executive compensation.
Approve annual budget.
Planning, decision-making, and oversight.
Transcript
The major responsibilities of the Board of Directors are listed here.

Their main duty is to select and appoint senior executives and
supervise their performance. They also set major policies of a
company, such as how much dividend to pay shareholders. They
also determined the CEO's compensation and approve annual
budgets.
Corporate Hierarchy - Slide 56
This slide depicts a hierarchical flow chart of the organization of

corporations.
1. Board of Directors
2. Chairman of the board & Chief Executive Officer (CEO)
3. President & Chief Operating Officer (COO)
4. Vice President & Chief Financial Officer (CFO)
a. Treasurer
Cash Manager and Credit Manager
capital Expenditures and Financial Planning
b. Controller
Tax Manager and Cost Accounting
Financial Accounting and Data Processing
Transcript
This is a hypothetical organization chart. You can see the Board is in

the highest order. The Board appoints CEO. The CEO is the most
senior executive within the corporation. He or she is responsible for
managing the corporation and making decisions. He or she reports
to the Board of Directors for the performance of the corporation. In a
lot of cases, CEO is also a member of the Board of Directors. CEO
works with other top executive, such as COO to take care of the
daily operations, like production, marketing, and personnel, and CFO
whose authority of the financial side of the company. Often the case,
the company will also have other top executives, such as Chief
Technology Officer, Chief Security Officer, Chief Marketing Officer,
and other depending on the industry of the business. For example,
you will see the position of Chief Medical Officers, CMO, in a
hospital. Here, I want to talk more about the financial officers. CFO,
Chief Financial Officer, is in charge of the financial planning of the
company. The CFO is the most important financial voice of the
corporation. He or she explains earnings results and forecasts to
shareholders and the media. The CFO reports to the CEO and the
Board, and work closely with other top executives to shape the
company's strategies. For example, the Chief Marketing Officer a
comes up with some great ideas of digital marketing campaign, the
CFO has to make sure the ideas financially feasible and there are
enough financial resources to devote to a marketing campaign. The
CFO supervises the financial unit and the work of Treasurer and the
Controller. A Treasurer, yes, mainly responsible for the financial side
of a Corporation. The duties of treasurer include managing cash and
the liquidity, managing risk, and setting up budges. A Controller is
responsible for the accounting side of the business. The Controller
manages the company's internal accounting systems and prepares
financial statements and tax returns. Having a good corporate
governance is just like how you run a country or a region. If you have
a very clear goal and a very clear structure, specify the duties and
responsibilities, and then the goal can be achieved.
The Agency Problem
The Agency Problem

The Agency Problem - Slide 57
Agency relationship exists whenever a principal hires an agent

to represent his/her interests.
Agency problem: The conflict of interest between the firm's
owners and managers.
Transcript
A unique challenge of corporate governance is the agency problem.

A principle Harrison agent to perform part of his duties. Conflict of
interest may arise. This is called the agency problem. For sole
proprietorship and partnership, this agency problem is not a serious
issue because their managers are also their owners. Corporations
suffer from this problem because the owners of the Corporation and
the managers of the Corporation are separated from each other.
Managers care more about their job security rather than maximizing
shareholder wealth.
Agency Costs - Slide 58
Direct costs
Indirect costs
Transcript
Agency costs are the expenses in curd by the agency problem. It

can be divided into direct costs and indirect costs.
Direct Costs - Slide 59
Expenditures that benefit company's management but cost the

shareholders.
Monitoring costs
Transcript
Direct costs include expenditures that benefit managers, but put

additional costs to shareholders. For example, some corporate
managers by luxury corporate jets and other expenditures that are
not so related to their business, and this is considered as this type of
costs. Monitoring costs means the cost associated with monitoring
the activities of managers.
Indirect Costs - Slide 60
Lost opportunities
Transcript
Indirect costs are the expenses incurred due to the lost

opportunities. For example. There is a high risk project that will
create value for shareholders, but the managers may reject the
project because they are afraid that they will lose their jobs if the
project fails. Since this expense is very difficult to value numerically,
it is considered as part of the indirect agency costs.
Agency Problem Solutions - Slide 61
Managerial compensation
Replace management
Transcript
Corporations are also working toward mitigating the agency problem.

There are two ways to address this problem. One is through
managerial compensation. And another one to replace existing
management. There is an active market of merger and acquisition. If
the company's management is underperforming. The company will
become a target for other companies. Those companies will take
over it and replace its management to achieve a turnover.
Managerial compensation is a widely used way to align the interest
of managers and shareholders.
Managerial Compensation (1 of 4) - Slide 62
Roughly 60% of CEO pay came from stock-option awards, most of

which are tied to performance targets.
Transcript
According to statistics. More than 60% of CEO compensation comes

from stock options. Here I want to use a simple example to show you
how the stock option works.
For example, the chief executive is granted with 50,000 options: the
right to purchase shares at the current market price (e.g.,
$50/share).
Transcript
Suppose the CEO of a company is awarded with 50,000 stock

options. The option gives him the right, but not the obligation to buy
shares at $50 per share. The stock is trading at $50 per share at the
stock market. But he cannot exercise the option right now. He signed
a contract of five years with the company.
The option can be exercised 5 years (i.e., at the end of his tenure)
Transcript
So he has to wait for five years until he can exercise the option. If the
company's stock rises above $50.00 for share five years later. Let's
say $7070.00 for share at that time.
Only when the stock price at Year 5 rises above $50, the chief
executive would get the compensation.
Transcript
The earned $20 per share or $1,000,000 in total from the stock
options. If the share price drops below $50, then he earns nothing.
From this example, you can tell the CEO's personal benefit is tide up
with the shareholders interest so that executives will work in the best
interest of shareholders. One extreme example of the agency
problem is ENRON.
ENRON (1 of 2) - Slide 66
The collapse of energy giant ENRON in 2001 is an example of the

agency problem.
Transcript
ENRON was one of the largest companies in the United States.

When the company was losing money from investment and
accumulating that.
ENRON (2 of 2) - Slide 67
ENRON manipulated accounting methods to hide its losses and debt

from investors and creditors.
Transcript
Their management used accounting methods such as off balance

sheet, special purpose vehicles. To hide and financial losses from his
investors and creditors.
ENRON Stock Price - Slide 68
This Slide shows ENRON stock price decrease linearly from 90 to 0

during the timeframe of August 23, 2000 to January 11, 2002.
Transcript
The accounting scandal started to unfold in 2001 when SEC started

investigating ENRON. Is share price dropped from over $90.00 to
almost 0? The company ended up fighting for bankruptcy on
December 2nd, 2001.
ENRON - Slide 69
The company's officers and board of directors, including Chairman

Kenneth Lay, CEO Jeffrey Skilling, and CFO Andy Fastow, were
selling their ENRON stocks at high prices to make a profit.
Transcript
Several senior managers of errands, such as its chairman, CEO and

CFO, were charged with insider trading and securities fraud. As
Aaron's director's, they had a legal obligation to protect interest of
shareholders. But they failed to carry out their responsibilities.
Aaron's collapse led to new regulations and legislation to promote
the accuracy of financial reporting. One example is the Sarbox Act.
Sarbanes-Oxley Act - Slide 70
Establish the Public Company Accounting Oversight Board

(PCAOB)
Promote auditor independence
Mandates that the top executive take responsibility for the
accuracy of financial reports
Transcript
Starbucks created the public companies accounting oversight board.

To establish new audit guidelines and ethical standards. The new
ethical standards are significantly higher than ever before. It also
promotes the independence of auditors. Is prohibits auditing
companies from providing non audit services such as consulting
service for the same client. This regulation is based on Aaron's
lesson. Aaron's auditor firm. Arthur Anderson was one of the five
largest accounting firms in the United States at that time. But it didn't
perform its duty. Because charged hefty fees for his consulting
service and it didn't want to lose a customer. Is requires public
companies auditing committee of corporate boards to include only
independent outside, director's to oversee the annual audits. It also
defines the interaction of the external auditors and corporate audit
committees. Even mandates that officers take personal responsibility
for the accuracy and completeness of corporate financial reports. If
there are any false statements or anything missing from the annual
reports. They are responsible for it. So when we reflect this scandal,
we realized that whenever after a scandal there are new regulations
and new legislation. So it helps us to reflect what is missing in the
regulation. And it also helps us to fill out the loopholes.
Module 1 Wrap Up
Module 1 Wrap Up
Sole Proprietorship - Slide 71
Simplest way to start a business

Owners keep all profits
Pro: No need to pay corporate taxes
Con: Lots of liabilities and debts
Ex. Small businesses
Transcript
In this module. We covered the basics of finance. We got introduced

to three legal forms to organize a business. So pre partnership is the
simplest way to start a business. The owners can keep all the profits
to themselves, and there's no need to pay corporate taxes. But this
comes at a cost. They have unlimited liabilities for business debts
and obligations. For small businesses this is a good choice.
Partnership - Slide 72
Business organized by several owners

Similar pros and cons to a proprietorship
Transcript
The second form to organize a business is through partnership. In

the refers to a business organized by several owners. The
advantages and disadvantages of partnerships are very similar to
the sole proprietorship.
Corporation - Slide 73
Complicated and expensive to form

Con: Double taxation
Pro: Limited shareholder liability
Ex. Large businesses
Transcript
The last form is Corporation. Corporations are complicated and

expensive to form. The big downside of the Corporation is double
taxation. But the good news is that shareholders of corporations
have limited liability. Meaning they are not personally responsible for
the debts and obligations of the Corporation. Most large businesses
are organized as corporations. Besides these three basic structures,
businesses can also be organized using hybrid forms, such as a
limited liability company C.
Limited Liability Company (LLC) - Slide 74
A combination of the three basic forms

Offers liability protection to owners
Doesn't pay corporate taxes
Fastest growing out of all options
Transcript
All else combines a lot of benefits of three basic forms. All else offers
personal liability protection to its owners. And it doesn't need to pay
corporate taxes. Therefore, the number of limited liability companies
are growing faster than three basic structures. Then we focused our
attention on corporations. We discussed the goal of financial
management.
The Goal of Financial Management - Slide 75
Public co: maximize current value per share of existing stock

Employee safety, customer satisfaction, social responsibility
Transcript
For public companies, the goal is to maximize the current value per
share of the existing stock. We also discussed whether this goal
conflict with other goals. Such as employees, safety, customer
satisfaction and social responsibility. Another topic is corporate
governance.
Corporate Governance - Slide 76
Shareholders role, the board of directors, and managers

Paves way for future development
Transcript
We discussed the role of shareholders, the board of directors and

managers. Good corporate governance will pave the way for future
development. A unique question for corporations is the agency
problem.
The Agency Problem - Slide 77
Conflict of interest between management and shareholders

Want to mitigate and have regulations to protect shareholders
Transcript
It refers to the conflict of interest between our companies,

management and shareholders. Corporations come up with multiple
ways to mitigate this problem, and the regulators also tighten
regulations to protect shareholders. This module is just a start of a
journey. Let's work together to explore more about finance in the
following modules.
Module 2 Introduction to Finance: The
Basics
Module 2 Overview
Module 2 Overview
Introduction - Slide 1
Transcript
In this module will learn the basics of financial statements. In order to

help you understand the importance of financial statements, I want
you to think about a daily example.
Parent Example - Slide 2
Transcript
Suppose you are a parent of a high school student and you are
curious about your student's academic performance in school. One
way is to take a look at their transcript. It is an official document that
summarizes a students coursework and grades. The transcripts will
also be used in their college applications, scholarship applications
and others. Financial statements can be thought of as a transcript for
a company. There are official documents that summarize the
financial performance of the company. Financial statements are used
by investors, creditors, researchers and anyone who is interested in
the company. You need some basic knowledge to read a student's
transcript. What are the classes? Are the easy classes or hard
classes? What is the credit assigned to each class and what do the
grades stand for? Follow the same logic. You also need to know
some basic knowledge in order to read financial statements.
Three Basic Financial Statements - Slide 3
The balance sheet

The income statement
The statement of cash flows
Transcript
We will cover 3 basic forms of financial statements. The first one is

the balance sheet. We'll talk about what the balance sheet captures,
how it is organized, and what the items stand for. After that we
introduce income statement. We'll cover how to use income
statement to evaluate the profit or losses of a company. We'll also
explore the link and differences between these two financial
statements. We'll also learn what is the difference between cash
flows and accounting earnings. What are different perspectives of
financiers and accountants and how to derive cash flows? We also
want to talk about the relationship among the three types of financial
statements. After this module you should be able to read financial
statements of a company and interpret the numbers. There's one
more thing I want you to keep in mind before we start to learn
financial statements. Let's go back to the transcript
example.Although the transcript is a quick way to learn the academic
performance of the student, it is impossible to capture everything
about a student. There are a lot of important things that a transcript
cannot tell us.
Beyond the Transcript - Slide 4

Academic Interests
Transcript
For example, what are the academic interests of the student? And
how creative the student is. When you use financial statements to
evaluate the financial performance of the company, you also need to
bear in mind that you should not be restricted by financial
statements. You need to see the whole picture of the business.
Financials
Financials
What are financials? (1 of 3) - Slide 5
Publicly traded companies are required to report their financial

reports (financials) to their shareholders and the general public
Transcript
The first question I want to introduce is the concept of financials.

What are financials? According to the requirement of the Security
and Exchange Commission, as you see, publicly traded companies
in the United States should file financial reports to remain listed on
the Stock Exchange. These reports are called financial statements or
financials for short. In the United States, the rules and procedures
used to prepare financial reports are called Generally Accepted
Accounting Principles (GAAP).
In the United States, the accounting rules that are used to prepare
financial reports are called Generally Accepted Accounting Principles
(GAAP).
Transcript
No instruction is provided for this slide.

Most other countries use International Financial Reporting Standards

(IFRS).
Transcript
In other countries of the world, like the European Union and more
than 140 countries, they use a different set of rules which are called
International Financial Reporting Standards.(IFRS). There are some
differences between these two sets of accounting standards, but the
people are working to make these two standards more consistent
with each other. Since 2007, the SEC allows foreign companies to
prepare their financials using IFRS.
Financial Information - Slide 8
Company website
Transcript
Another question you may have is where can I get the information on
financials? There are two places - one is through the company's
website. Most large public companies publish their financial reports
on their websites. You just need to visit the company's home page
and click a tab called investors or investor relations.
Target Investment Example (1 of 8) - Slide 9
This slide shows the investors portion of Target's website where their
stock quote and financial news is listed.
Transcript
You should be able to find all the financial reports there. Here's an
example from Target Corporation, so this is the Target website for
investors, and if you want to check the findings then you can click
the tab investors and when you click the tab, you can see a bunch of
menus over here like what is the corporate overview, stock
information, annual reports and corporate governance.
This slide shows a list of links to Target's investor tabs such as

annual reports.
Transcript
And here, if you want to check the annual report you can just click
the annual reports.
This slide shows the top of an article of Target's 2019 annual report
on their website.
Transcript
And then you will see this is the most recent corporation annual
report. And if you scroll down a little bit, you will see the historical
information.
This slide shows an image of Target's website's annual report

archive, where annual reports are listed for download from the
webiste.
Transcript
Let's use one year as an example. So let's click the 2017 annual
report.
This slide shows the first page of an annual report showing only the
Target logo.
Transcript
The first page of the report is the logo of the company, and when you
Scroll down a little bit you will see some financial highlights like the
sales numbers, the EBIT numbers, net earnings, and diluted
earnings per share.
This slide shows an infographic of Target's financial highlights

including: sales and net earnings.
Transcript
We will talk about these concepts in the later chapters. When you
scroll down a little bit more, then you can see the total sales - 23%
comes from beauty and household essentials, and 20% comes from
food and beverage. So on and so forth and then followed by a letter
by the CEO and chairman. And after that is the financial summary of
the company.
This slide shows the start of the Financial Summary and the 10-K
form for Target.
Transcript
If you scroll down a little bit more, then you will see the 10K form.
This slide shows the top of an official form 10-K of Target

Corporation.
Transcript
So this is the financial report, and if you are interested in the financial
report you can also click the download button to download it to your
local computer so that you can use it in the future. Another place you
can get the financials is the SEC's website.
Financials Information (1 of 4) - Slide 17
Company website
SEC website
Transcript
Financial filings can be searched at the EDGAR website on the

SEC's website.
Financial filings can be searched at the Electronic Data Gathering,

Analysis, and Retrieval system (EDGAR) database on the SEC's
website.
Transcript
No instruction provided for this slide.

The EDGAR (the Electronic Data Gathering, Analysis, and Retrieval

system) performs automated collection, validation, indexing,
acceptance, and forwarding of submissions by entities who are
required to file forms with the SEC
Transcript
EDGAR stands for the Electronic Data Gathering, Analysis, and

Retrieval system. Companies file the forms required by the SEC
using this system. This database is used widely by academia and
industry researchers.
EDGAR information
Transcript
Now I want to show you how to use the system to search for files
you need.
EDGAR Navigation (1 of 7) - Slide 21
This slide shows the SEC's website with the mouse with the mouse
focused on a link for company filings.
Transcript
So if you go to the SEC's website and in the home page you will find
to the upper right corner, you can click a tab which is called company
filings. If you click that then you will be directed to this web page. So
this is the EDGAR company filings web page.
This slide shows the SEC website: company filings tab, with a
search box to search the database for companies.
Transcript
So you can search the information on the company using a

company's name and then click search. There is another way to do it
much faster, which is to use the fast search tab. So here you can
enter the ticker symbol of the company and then search the
company on here. Suppose I'm interested in Target Corporation, I
would enter the ticker symbol TGT over here and then click search.
This slide shows the results of a search in the EDGAR database, a

list of different filings and different forms from Target.
Transcript
And you will get a web page look like this. So these are all findings
by Target Corporation and you can see a number of findings. South
eight form 8K form is the current report, so they have the findings.
Name the format that description the finding date and also the file
number. And suppose I'm interested in a 10 Q quarterly report.
This slide shows a Target quarterly report that was clicked on from
the EDGAR database that lists all documents available for viewing
from this particular report.
Transcript
I can click documents, and then check the detailed information. So

this is a quarterly report.
This slide shows the beginning of a 10-Q form from Target.
Transcript
So this is the 10 Q form and you can scroll down to see the
information of the 10 Q form.
This slide shows the same Target 10-Q report from slide 25 but in a
different document location showing a portion of financial
statements.
Transcript
And if you want to download it to your computer, you can click

control P and print it to a local computer and save it as a PDF file.
This slide shows the search of the filings with a filter open to filter
results of the filings searched.
Transcript
Let's go back to the search filings, and suppose you are interested in
some specific information or specific date. You can also filter your
result. For example, I'm only interested in the 10K form, so I can just
put 10K over here and then search it. And now you can see all the
filings are 10K filings over here and now you have accumulated all
the 10K forms filed by Target during past years.
Form 10-K: Annual Report - Slide 28
It captures information such as business description, risk factors,

properties, corporate governance, executive compensation, and
audited financial statements.
Transcript
A form 10K is an annual report required by the SEC. It captures a

comprehensive summary of a company's financial position. The 10K
form includes a detailed description of its major businesses,
competition, risk factors and properties. It also has information about
corporate governance, executive compensation, and most
importantly, the audited financial statements. This form is signed by
its directors to make sure the information delivered here captures the
accurate and complete information about the company.
Form 10-Q: Quarterly Report - Slide 29
Transcript
In addition to the 10K form, a company is also required to file

quarterly reports on Form 10 Q. Form 10 Q reports the company's
financial situation after each quarter. It is much shorter than the
annual report, and it is unaudited financial statements.
Form 8-K (Current Report) - Slide 30
Discloses unscheduled material events or corporate changes

File the 8-K report within four business days.
Transcript
The form 8K, also called the current report, must be filed if there are
any major changes to a business or significant events that were not
covered in the 10K or 10 Q reports. What is considered as a
significant event or material event? Some examples, such as the
sudden departure of the CEO , acquisition, bankruptcy or changes in
corporate governance. The public company generally must file a
current report on form 8K within four business days to provide an
update to previously filed quarterly reports and annual reports.
These reports are often important to their shareholders because they
contain information that will affect the share price.
Balance Sheet
Balance Sheet: Introduction

The Balance Sheet (1 of 7) - Slide 31
Transcript
Now we want to learn the basics of the balance sheet.

This slide shows an image of Target Corporation's Balance sheet

from 2019 to 2020.
Transcript
Here is an example of a balance sheet of Target Corporation. You

can get it from the company's annual report. This is a condensed
version of the actual balance sheet because I want to use this
version to illustrate some concepts that apply to all the corporations.
This slide shows the same image as slide 32: an image of Target
Corporation's Balance sheet from 2019 to 2020.
Transcript
The balance sheet takes a snapshot of a firms accounting value at a

certain time. The balance sheet of Target summarizes the value of
the firm as of February 1st, 2020 and February 2nd, 2019. All the
values are in millions.
This slide shows a zoomed image of the same image as slide 32: an
image of Target Corporation's Balance sheet from 2019 to 2020,
showing Current Assets and Fixed Assets.
Transcript
Let's take a look at the left hand side of the balance sheet. The
assets of the company are listed on the left. The assets can be
divided into current assets and fixed assets. Current assets are the
assets that can be converted into cash within a year. Fixed assets
have a life longer than one year. The current assets include three
major components. First, cash and equivalents refer to cash or
assets that can be converted into cash immediately. Cash
equivalents include bank accounts, money market funds, commercial
paper and Treasury bills. It is followed by accounts receivable. We
can also call it receivables for short. It is the amount of money owed
to a company by its customers who purchased goods or services on
credit. Inventory includes raw materials, work in progress and
finished products. Other current assets include prepaid expenses.
For example, a company purchased the insurance that will cover the
next 12 months. It paid $500,000 up front for the insurance policy.
This amount belongs to a prepaid expenses and the company will
book $500,000 as other current assets.

showing Current Assets and Fixed Assets.
Transcript
If we sum up these items, we get the total current assets. 12.9 billion
dollars in 2020 and 12.5 billion dollars in 2019. Fixed assets are
composed of tangible assets and intangible assets. Property, plant,
and equipment are tangible assets because they have physical
forms. The net property plant and equipment is the amount after
deducting depreciation. Intangible assets have no physical form.
Some examples include trademarks, patterns and copyrights. The
sum of tangible assets and intangible assets is equal to total fixed
assets. Total fixed assets increased from 28.77 billion dollars in 2019
to 29.88 billion dollars in 2020. Total assets are calculated as the
sum of current assets and fixed assets. Total assets are 42.78 million
in 2020 and 41.29 billion dollars in 2019. The assets are listed in
descending order of liquidity. Most liquid assets are listed on top and
least liquid assets at the bottom. Let's take a look at the right hand
side of the balance sheet.
showing Current Liabilities and Shareholder Equity.
Transcript
It shows the company's liabilities and equity. From the right hand
side you can tell how the company's assets are financed. The
liabilities are the companies dEBT and other financial obligations. It
is composed of two parts - current liabilities and long-term liabilities.
Current liabilities are the liabilities you have to fulfill within a year. A
company buys goods or services from its suppliers, but has not paid
yet. This amount will be booked as accounts payable. Current
liabilities also include accrued expenses, employee wages not paid
or interest not paid. Long-term liabilities are liabilities that are due
more than one year from the date of the balance sheet. It includes
long-term loans, deferred tax liabilities, and pension liabilities. The
increase from 14.98 billion dollars in 2018 to 16.46 billion dollars in
2020. Let's take a look at the equities part. When a company issues
common stocks and receives more than the par value of the stocks,
the par value part is booked as common stocks and the surplus part
is booked as paid-in capital. The retained earnings, the accumulated
earnings that is retained by the company at the end of the fiscal year,
when we sum up the above items together, we get total stockholders
equity. 11.83 billion dollars in 2020 and around 11.3 billion dollars in
2019. This is also called the book value of the equity. It is quite
different from the equity value traded in the stock market. Total
liabilities and equities are the sum of the current liabilities, long-term
liabilities and stockholders equity.
This slide shows the same image as slide 32: an image of Target
Corporation's Balance sheet from 2019 to 2020.
Transcript
When you compare the left hand side with the right hand side of the
balance sheet, you will find that the value of the total assets is equal
to the value of total liabilities and shareholders equity.
Balance Sheet Identity - Slide 38
Assets = Liabilities + Stockholders' Equity
Transcript
This is not just coincidence. This should always be the case. We

also have a name for it. The balance sheet identity. This is also why
we call it a balance sheet.
Balance Sheet: Fiscal Year

Balance Sheet and Fiscal Year - Slide 39
Transcript
Let's think about when the balance sheet is prepared. In order to

help you understand the question. You can think about yourself.
Suppose you are walking and a photographer takes a picture of you.
At that moment, you are momentarily still in that picture. The same
logic applies to the company. The company is running all the time,
and the balance sheet is a snapshot taken at the end of its fiscal
year. Here comes the question. What a fiscal year is? And how a
company determines its fiscal year? A fiscal year is also called the
financial year or budget year.
Fiscal Year (1 of 5) - Slide 40
A fiscal year is a one-year period used for calculating annual

financial statements in businesses and other organizations.
Transcript
It is a one year period used for calculating annual financial

statements in businesses and other organizations. It is important
because it defines an organization's budget and it is used for
financial reporting.
Fiscal year of the US Federal government runs from October 1 of the

previous year to September 30 of the current year
Transcript
The fiscal year of US Federal government starts from October 1st of

the budget's prior year to September 30th of the current year.
Suppose the federal government spends 10 billion dollars on
transportation and water infrastructure in November 2019. This
amount would belong to fiscal year 2020. The fiscal year for 46 out
of 50 states run from July 1st to June 30th.
Most state governments (46 states) fiscal year runs from July 1 of
current year to Jun 30 of the following year
Transcript
Because a lot of public universities rely on funding from the state,

they also set their fiscal year to be consistent with the state's
physical year. For small businesses, such as sole proprietorships
and partnerships, the IRS requires that their fiscal year be the same
as the calendar year.
Sole proprietorships and partnerships run from January 1 to

December 31 of the same calendar year
Transcript
The main reasoning is that they report all business income as

personal income and the calendar year is used for individual income
tax return. For a big corporation, it has the freedom to choose any
consistent fiscal year when it first forms.
Corporations have freedom to choose any consistent fiscal year

when first formed
65% of big corporations use January 1 to December 31
Transcript
For about 65% of the public traded companies in the United States.
The fiscal year is the same as the calendar year. If they want to
change the fiscal year later, they have to get the approval from the
IRS and file An 8-K report with the SEC.
Corporate Fiscal Year - Slide 45
Doing business with the federal government

Pick September 30 as the end of fiscal year
Transcript
A related question is how to determine the fiscal year for a

corporation. If a company is doing a lot of business with the federal
government, a good choice is to match the fiscal year with the
government. If a business has a strong seasonal component like
retail business, a large percentage of their annual profits are
generated in one or two seasons of the year. A smart choice is to
end the fiscal year shortly after the highest revenue time of the year.
That is why most top retailers end their fiscal years after the
Christmas shopping season.
Fiscal Year Examples (1 of 3) - Slide 46
Target
Transcript
For big companies, the ends of their fiscal years are different from
each other. Let's take a look at some examples of public companies.
When you check their annual 10K reports, the end of their fiscal year
is listed on the first page of the report.
This slide shows an official form 10-K showing that the end of
Target's fiscal year is February 1st, 2020.
Transcript
Target Corporation's fiscal year ends on February 1st, 2020.

According to its rule, Target begins its fiscal year in the first full week
of February and ends its fiscal year on the Saturday nearest January
31st.
This slide shows an official form 10-K showing that the end of
Walmart's fiscal year is January 31st, 2020.
Transcript
Walmart ends its fiscal year at the end of January. Here is the 10-K
form for Walmart. In 2020, it ends on January 31st. The next fiscal
year begins from February 1st. Walmarts fiscal year is consistent
with other large retailers, because by that time they have already
sold out their holiday inventories, collected their receivables and
realized their profits, this is a perfect time to report their financials to
their shareholders.
Balance Sheet: Other Topics

Balance Sheet Liquidity - Slide 49
Transcript
In this part of the lesson, we want to talk about the several questions
we need to pay attention to when we study the balance sheet.
Liquidity (1 of 3) - Slide 50
Liquidity: the ease with which an asset can be converted into cash
without significant reduction in its value
Transcript
The first one is liquidity. Liquidity evaluates how easily assets can be
converted into cash without significant reduction in value. When we
compare current assets with fixed assets, current assets are much
more liquid than fixed assets because they can be converted into
cash within one year or less.
Current assets: high liquidity

Transcript
Within current assets, cash and cash equivalents are the most liquid
because they're already cash. The liquidity of accounts receivable is
higher than inventory. Holding receivables are much closer to cash
than holding inventory, because sales have already been made. The
company just needs to collect the bills from their customers. If a
company wants to get immediate cash, it can sell the receivables to
a factoring company. About 75% of the receivables value will be paid
immediately and the remaining part is rebated once the factor
collects payments from clients.
Fixed assets: low liquidity

Transcript
Fixed assets are much harder to convert into cash. Some examples
of fixed assets include real estate, vehicles, equipment, assembly
lines and patents. A lot of them are highly specific assets and cannot
be used elsewhere, so their resale values are low. Suppose the
company expects to pay its utility bill, pay its suppliers or employees
in the near future. The easiest way to meet that obligation is to use
cash. They need to prepare enough liquid assets in their hands, at
least enough to fulfill their near term obligations. Liquidity is also
important in case of emergency and unexpected expenses.
Otherwise they have to sell their real estate or equipment to pay their
bills. This is not an efficient way to run a business. We talked a lot
about the importance of liquidity for a company. One question I want
you to think about is -
Question - Slide 53
Should a company hold a lot of liquid assets?

Transcript
Should the company hold a lot of liquid assets? The answer is that a
company needs to hold an appropriate level of liquid assets. But too
much liquid assets can be bad for business. In order to understand
the question a little bit better, we need to weigh the benefits and
costs of holding liquid assets.
Benefits of liquid assets - Slide 54
Fulfill short-term obligations

Transcript
The benefit of holding liquid assets is that the more liquid a firm's
assets, the less likely the firm is to experience problems meeting
short term obligations. Even if in an economic downturn a company
with a lot of liquid assets would be able to pay its creditors easily
without liquidating its fixed assets. The company won't be sued by its
creditors or suppliers for unpaid bills. However, holding liquid assets
has its downsides.
Cost of liquid assets - Slide 55
Lower rate of return

Transcript
The rate of return from liquid assets is much lower than fixed assets.
Fixed assets define the nature of the business. A business is
valuable because it produces goods and services with the
investments in fixed assets. By investing in liquid assets, the firm
sacrificed opportunity to invest in more profitable investment
vehicles. The most important lesson here is to achieve a balance
between current assets and fixed assets. A company needs to
prepare enough liquid assets to run day-to-day operations smoothly
without sacrificing its ability to generate revenues in the long run.
Here, I want you to think about one question. What's the implication
of liquidity in your personal financial management? This liquidity
topic will also shed light on how you manage your personal finance.
You should have some liquid savings in your bank account to pay
monthly bills and handle unexpected expenses. How much liquid
savings to have is appropriate? One advice to you is to keep about
three to six months of monthly expenses. However, sitting on too
much cash is a terrible choice because the average bank checking
account is paying almost nothing. The return of cash does not keep
up with the retail inflation. Although you won't have any trouble
paying your bills, your purchasing power is reduced. With enough
cash to pay your bills. You should also invest part of your money in
fixed assets such as a house or apartment, furniture, appliances, a
car and your education or entertainment. These assets are not very
liquid. But they make you happy. Increase your productivity and
boost your human capital. Now we want to introduce another
concept. Net working capital.
Net Working Capital (1 of 2) - Slide 56
Net working capital (NWC) = Current assets − Current liabilities
Transcript
Net working capital is the difference between current assets and

current liabilities. It evaluates whether a company's short term assets
are available to pay short term obligations or not. It is a good
indicator of a firms liquidity in the short term.
Net Working Capital (2 of 2) - Slide 57
Positive Net Working Capital: NWC > 0
Negative Net Working Capital: NWC < 0
Transcript
For example, a positive net working capital indicates that a company

has enough short-term liquidity to pay its current obligations. A
negative net working capital means that a company needs to borrow
money from a bank or raise money from investors to remain solvent.
When we study the balance sheet, we also need to understand
difference between book value and market value. The balance sheet
shows you the book value of assets.
Book value of assets - Slide 58
Assets shown on the balance sheet at their original cost adjusted for
depreciation and amortization
Transcript
It is calculated as the historical value of the asset less accumulated

depreciation and amortization.
Market value of assets - Slide 59
The current price at which buyers and sellers would trade their
assets in the marketplace
Transcript
Market value refers to the current asset price in the marketplace.

The book value of an asset may be quite different from its market
value. For example, a company bought a copy machine for $5000
and booked $1000 as depreciation in the first year. The remaining
book value of the copy machine is $4000. The same machine is
currently trading in the market at $4500. In this case, the market
value of the asset is higher than the book value of the asset.
Book value of Equity - Slide 60
The difference between a company's total assets and total

liabilities
A plug-in number to ensure that the balance sheet is balanced
Transcript
The book value of equity is calculated by subtracting all liabilities

from total assets. This relationship comes from the balance sheet
identity. Because of the current accounting rules and difficulties in
valuing assets and liabilities, the book value of shareholders equity
serves as a plug-in number to make sure the balance sheet is
balanced. The market value is the value of a company based on the
financial markets.
Market value of Equity - Slide 61
Current stock price multiplied by the number of outstanding

shares
Also called market cap
Transcript
The market value of equity is calculated by multiplying the current

share price by the total number of shares outstanding. Market value
of equity is also called market capitalization. Let's compare the book
value and market value of equity for Target. According to the balance
sheet, the book value of shareholders equity is 11.8 billion dollars.
The market value is derived using the total number of shares
outstanding. 510.9 million shares times the current market price.
Target Stock - Slide 62
This slide shows a line graph from Yahoo Finance depicting the price
of Target shares between June 2019 and May 2020.
Transcript
The graph shows you Target's share price information for the past
year. The stocks price is fluctuating between the range of $80.00 per
share and $120.00 per share. The market cap is in the range of $40
billion dollars to 60 billion dollars, which is much higher than the
book value 11.8 billion dollars. Target's market value is greater than
its book value, which means investors trust the earnings capability of
Target and believe the company is worth more than its book value.
Income Statement
Income Statement
Profitable Companies - Slide 63
Transcript
When you are interested in a company, you might be curious about

how profitable the company is. In order to answer that question, you
need to learn another important financial statement - the income
statement.
The Income Statement - Slide 64
Revenue − Expenses = Income
Transcript
The income statement shows the company's revenues, expenses,

and income over an entire fiscal year. The accounting income is
calculated based on the identity here. You can think of income
statement as videotaping all the economic activities carried out by a
company within the fiscal year.
Target Income Statement - Slide 65
This slide shows an image of an income statement for Target

Corporation during 2019 to 2020. It shows expenses and income in
various forms and how this affects net income.
Transcript
The table here shows you the income statement of Target

Corporation for fiscal year 2019. The first line shows the company's
total revenue from February 3rd, 2019 to February 1st, 2020 is 78.1
billion dollars. The cost of sales, 54.9 billion dollars, are the direct
expenses to produce all the goods and services. It includes
production costs, storage costs, and direct labor costs. When you
subtract the cost of sales from total revenue, you get gross profit of
23.2 billion dollars. Gross profit reflects a company's efficiency in
producing goods or services. Selling, general and administrative is
16.2 billion dollars, which is also called as SG&A. It includes indirect
costs or fixed costs of running a business. Some examples are
advertising, insurance, utilities, rent and management salaries.
Almost all the other costs not directly related to production can be
grouped into SG&A. Depreciation and amortization are 2.3 billion
dollars. These are the expenses of the fixed assets spreading out its
useful life. If the fixed asset is a tangible asset, we call the expense
depreciation. We call it amortization if the fixed asset is an intangible
asset. Operating income is 4.66 billion dollars, which is calculated by
subtracting SG&A and depreciation and amortization from gross
profit. For Target Corporation, operating income is the same as
earnings before interest and taxes, also called EBIT. Because there's
no other income, EBIT is a very important indicator to value the
performance of a companies core business without considering the
capital structure and tax expenses. EBIT is also a widely used input
variable for a lot of financial ratios. Interest expense is 468 million
dollars, which is the cost of borrowing money from creditors. This
expense does not depend on operations, but on a companies capital
structure. Interest expense is tax deductible. When you deduct the
interest from EBIT, you derive earnings before income tax, which is
also called EBT or pretax income. Based on EBT and tax rate, you
can calculate how much tax you need to pay to the government.
Target paid 909 million dollars to the government during the year.
When income tax is deducted, you get the net income, 3.28 billion
dollars. This net income is also called net earnings or the bottom
line. This is the total amount a company earned after deducting all
expenses, interest and taxes from revenue. It is an indicator of how
profitable a company is. Using net income and dividing it by total
outstanding shares of common stock, 510.9 million shares, you can
derive the earnings per share EPS. Target earnings per share is 6.42
dollars per share. Part of the earnings is distributed to shareholders
as dividends and the remaining part will be retained by the company.
Target distributes $2.62 per share to shareholders. Dividing cash
dividend, $2.62, by earnings per share, $6.42, yields a dividend
payout ratio of 41%. It means the company pays out 41% of its
earnings as dividends. The remaining part, 59%, is called retention
ratio or plowback ratio. The company retains 59% of its earnings to
support its future growth. For a company with a high growth
potential, a smart choice is to plowback the earnings and the
reinvest them in the company's operations. This is why you observe
a retention ratio of 100% for a lot of fast growing companies.
Cash Flow of the Firm
Statement of Cash Flow

Cash Flow - Slide 66
Transcript
Let's take a look at the cash flow statement. Here you may wonder,
since we already have the balance sheet and income statement.
Why do we need an additional statement? The balance sheet is a
summary of a company's assets, liabilities, and owners equity at a
certain time. The income statement shows the company's revenues
and expenses during a period of time.
The Statement of Cash Flows - Slide 67
It provides information about the change in cash flows.
Transcript
The cash flow statement fills the gap between the balance sheet and
income statement by showing how much cash is generated or spent
operating, investing and financing activities for a specific period of
time. I would like to explain about different perspectives of a financier
and accountant. A financier cares more about the cash inflows and
cash outflows of a company, because cashflows determine the value
of a business.
Financiers vs. Accountants - Slide 68
Financiers: cash inflows and outflows

Accountants: net income
Difference: noncash items such as depreciation and
amortization
Transcript
Accounts pay more attention to accounting net income. The cash

flow is different from earnings because of the non-cash items such
as depreciation and amortization. We can set up an example to help
you understand the problem. Suppose a company buys a copy
machine for $5000, and the life of the machine is 5 years.
Cashflow Example - Slide 69
Financier vs Accountant Cash Outflow
Financiers: Cash Accountants Depreciation
Year
Outflow Expense
1 $5,000 $1,000
2 0 $1,000
3 0 $1,000
4 0 $1,000
5 0 $1,000
Transcript
The financier sees a cash outflow at the very beginning and no cash
flows in the following years. For accountants, they spread out the
cost of $5000 evenly in the five years. The depreciation expense in
each year is $1000 according to the straight line depreciation
method. Here we want to explain why cash flow analysis is so
popular in finance.
GAAP Accounting Principles - Slide 70
Allows for significant subjective decisions to be made

Transcript
Based on GAAP accounting principles, accountants can also use a

different depreciation schedule to spread out the expenses of assets.
There are a lot of leeway in such decisions. Depreciation has an
impact on how much taxes a company pays to the government and
affect net income. Besides depreciation, there other items in the
balance sheet and income statement that also suffer from the same
problem.
Cash Flow Analysis - Slide 71
Difficulty in manipulating and spinning the numbers
Transcript
Cash flow is a more accurate way to capture the company's financial

health because the cash flow numbers are hard to manipulate. The
statement of cash flows is composed of three categories - operating
activities, investment activities and financing activities.
Statement Example (1 of 3) - Slide 72
This slide shows a cash flow statement of the Target Corporation

showing the adjustments made to reconcile non cash items to the
net income.
Transcript
The operating activities part start with net income, 3.28 billion
dollars, which is the bottom line of the income statement. Then we
need to adjust for all the non cash items accordingly. First, we add
back depreciation and amortization which is 2.6 billion dollars.
Because depreciation expense is not a cash outflow, when we
calculate the net income, we deduct it as an expense and now we
need to add it back. We also add other non cash items such as
share based compensation expense, 147 million dollars, and 178
million dollars of deferred income taxes. In addition to that, we need
to adjust for cash flows generated by operating assets and liabilities.
For example, Target's inventory decreased 505 million dollars during
the year. This decrease in inventory is considered a cash inflow of
Target because cash is freed up from inventory and available to be
used elsewhere. Change in other assets brings a cash inflow of $18
million. There is 140 million cash inflow from change in accounts
payable and 199 million dollars cash inflow from change in accrued
and other liabilities. This reflects a net increase in charged expenses
which have not been paid by Target. Overall, Target generated 7.12
billion dollars of cash flow from operating activities for the period
ending February 1st, 2020.

showing the cash required for all investing activites during this
statement period.
Transcript
In fiscal year 2019, Target spent 3.03 billion dollars in capital

expenditure. This amount of money is used to invest in new property,
plant and equipment. According to the annual report of Target. About
the 64.5% of the capital expenditure was invested to remodel
existing stores. 8.7% was used to build new stores and the
remaining 26.8% was spent on information, technology, supply chain
and others. This expenditure won't be shown in the income
statement because it will be spread out over the life of the asset as
depreciation. Target collected $63 million from selling property, plant
and equipment and earned $20 million from other investments. The
total cash required for all investing activities is 2.94 billion dollars.
This represents a cash outflow for the company.

showing the cash changes from all financing activites during this
statement period.
Transcript
The last part of the statement of cash flows is the cash flows from
financing activities. Target raised 1.74 billion dollars by issuing long-
term dEBT, paid back 2.7 billion dollars of previously issued long-
term dEBT to its creditors. It paid out 1.33 billion dollars as
dividends, its shareholders and the repurchased 1.57 billion dollars
from existing shareholders. The company also received $73 million
in cash from stock option exercise. Therefore, the total cash required
for financing activities is 3.15 billion dollars. This reflects the cash
flow to Targets creditors and shareholders. Now we put these three
parts together and calculate the net change in cash and cash
equivalents. Target has total cash inflows of 1.02 billion dollars in
fiscal year 2019. We also want to link this information with the
balance sheet. At the beginning of fiscal year 2019, that is February
2nd, 2019, cash and cash equivalents stood at 1.56 billion dollars.
With cash inflows added during the year. The new cash and cash
equivalence is 2.58 billion dollars. This perfectly matches the
numbers in the balance sheet. When we combine the information
from the statement of cash flows with the balance sheet and the
income statement, we have a better understanding of the company's
financial situation.
Module 2 Wrap Up
Module 2 Wrap Up
Financials - Slide 75
10-K
10-Q
8-K
Transcript
In this module, we introduce the financials. There are some widely

circulated in the reports, including 10-K annual report, 10-Q quarterly
report, and the 8-K current report.
Access to Financials - Slide 76
Company's website
SEC website
Transcript
Financial reports can be easily accessed through companies

websites or SEC EDGAR website.
Financial Statements - Slide 77
The balance sheet

The income statement
The statement of cash flows
Transcript
We learn of three times of financial statements. The balance sheet,

the income statement, and the statement of cash flows.
Balance Sheet - Slide 78
Assets ≡ Liabilities + Stockholders' Equity

Fiscal year
Transcript
The balance sheet shows the company's assets, liabilities, and

shareholder's equity. The balance sheet is organized according to
the balance sheet identity. The assets of a company are listed on the
left side, and the liabilities and shareholders equity are listed on the
right-hand side. We covered the basics of a fiscal year, the definition
of a fiscal year, and how to determine a fiscal year for our business.
Assets - Slide 79
Liquidity
Net working capital
Book value vs. market value
Transcript
Assets are listed based on their liquidity. Well, liabilities are listed
according to their due days. We learn a how to calculate the net
working capital based on the balance sheet. We also talked about
the difference between book value and market value. All the values
in the balance sheet are book values. They might be quite different
from their market values.
Income Statement - Slide 80
Revenue − Expenses ≡ Income

EBIT
Transcript
We also learned the income statement. We start with total revenue

and deduct the cost and other expenses until we reach the bottom
line. Some important concepts I introduced. Earnings before interest
and taxes is a very important indicator to value the performance of a
company's core business without considering the capital structure
and the tax expenses.
Net Income - Slide 81
Transcript
Net income is the bottom line. It is the total amount a company

earned after deducting all expenses, interest, and taxes from
revenues. It can be used to evaluate whether a company make a
profit or not.
Earnings per Share - Slide 82
Transcript
Earnings per share is the earnings based on each outstanding

share. Earnings will either be distributed to shareholders or retained
in the company to finance it's future investments.
Statement of Cash Flows - Slide 83
Cash flow from operating activities

Cash flow from investing activities
Cash flow from financing activities
Transcript
Last, we talked about the statement of cashflows. It shows a

company's inflows and outflows of cash. A cashflow statement can
tell us whether the company generated cash flow or not. Cashflow
statements are grouped into three parts. Each part reports the
cashflow from one of three kinds of activities, operating activities,
investing activities, and financing activities. We talked a lot about
financial statement, but I have one caveat to share with you.
Caveat - Slide 84
Look beyond a company's financial statements
Transcript
In this module, let's get introduced to the basics of Finance. In order

to learn finance, we first need to know some basics about the
structure and raw or firms at the center of Finance because they
create the wealth in society. Think about your daily life. In the
morning you may go to your favorite local cafe or Starbucks to get a
Cup of coffee for breakfast. The local cafe is a small business and
Starbucks is the world's largest coffeehouse chain. They have
something in common and they also have a lot of differences.
Module 3 Introduction to Finance: The Basics
Module 3 Overview
Module 3 Overview
Module Content Overview - Slide 1
Financial Statements Analysis
Financial Models
Transcript
In this module we'll learn financial statements, analysis and financial

models. First, I want you to think about some familiar things in your daily
life. Suppose you make an appointment with the doctor to get an annual
checkup. Your doctor will check your important vital signs, such as your
body temperature, pulse rate, rate of breathing, blood pressure, body mass
index and others. Based on these vitals, your doctor will have a general
idea of whether you are healthy or not. For each vital there is a healthy
range. For example, if your body temperature is in the range of 97 to 99
degrees Fahrenheit, you are considered normal. For some vitals, only the
range information is not enough. For example, the healthy range of BMI,
body mass index, for adults is between 18.5 and 24.9. But you cannot use
this range to evaluate a 2 year old child. You need to know the age of a
person and compare the vital with the same age group. Here you may think.
These are common sense, but is there anything to do with finance? Yes.
What we are learning today is just the vitals of a company. If we want to
know whether a company is healthy or not. We also need some metrics to
help us make the decision. For each metric, you also need to know what it
measures and how to compare it with similar companies or companies in
the same industry. This is just like how you compare the BMI over 2 year
old with the same age group. In the first part of the module we'll introduce
the common size financial statements.
Topics Covered - Slide 2

Use financial statement information
Standardizing statements
Transcript
We'll cover topics such as how to derive common size balance sheet and
common size income statement. How to compare the financial performance
of the company over years and compare one company with another.
Financial Ratios - Slide 3
Financial ratio analysis

Financial forecasting
Transcript
There are some commonly used financial ratios. Each group of the ratios
tell us different aspects of a company. Some financial ratios tell us whether
a company campaigns that or not and others show us whether a company
is profitable or not. We'll explore these ratios in this model. In addition to
that, we want to forecast what will happen in the future. We want to use
financial statements to make predictions so that we can make better
management decisions.
Standardized Statements
Standardized Statements
Financial Comparisons (1 of 5) - Slide 4
Hard to compare financial statements of the companies directly because

their sizes are different.
Transcript
We have learned the basics of financial statements in module 2. They

contain important information for us to understand the financial situation.
However, we cannot use them directly when we want to compare
companies' financial performances. Sometimes we want to compare
financial statements
Compare financial statements over a period of time for the same company.
Transcript
over time for the same company. For example, Target is growing and the
size is larger over years. The total assets increase and total revenues
increases as well. Only based on absolute dollar values of financial
statements is hard for us to tell whether the performance of Target improves
or not. The same logic applies when we want to compare a company
Compare a company to its competitors.
Transcript
with its competitors. Suppose we want to compare the financial

performance of Target and Walmart. It is not appropriate to say Walmart is
better than target because it has more assets and produce more net
income. We should also take their sizes into consideration. In order to make
comparisons, one way is to convert
Common-Size Balance Sheets
Transcript
dollar values to percentages to create the common size statements.

Common size balance sheets are derived by dividing each item by total
assets.

Common-Size Income Statements
Transcript
Common size income statements are calculated by dividing each line item
by total revenue. Working with percentages instead of total dollars.
Standardized statement make it much easier to compare financial
information as the company grows. They are also useful tools for comparing
companies of different sizes within the same industry.
Balance Sheets - Slide 9
Download the Module 3 Excel Sheet Data file
Transcript
Let's use Target as an example. If we look at the standard dollar version of

balance sheet as of February 1st, 2020 and February 2nd, 2019,
Balance Sheet Contents (1 of 3) - Slide 10
Transcript
we can tell the current assets, fixed assets and total assets all increase.
However, we are not sure about the structural change of each item. Total
liabilities and shareholders equity also,

Transcript
rise. But we don't know which one increases more proportionally.
Transcript
When we use each line item divided by the total assets of that year, we get
the common size balance sheets for Target.
Current Assets - Slide 13
Transcript
We can see that there is a small decrease in total current assets in terms of
proportion. Current assets represent the 30.16% of total assets in 2020
compared with 30.32% a year earlier.
Fixed Assets - Slide 14

Transcript
The fraction of fixed assets increased from 69.84% in 2019 to 69.68% in

2020 because Target invested heavily in his property, plant and equipment.
Current Liabilities - Slide 15
Transcript
There is a 2.5% drop in the fraction of current liabilities, which is bigger than
the drop in current assets. From this comparison, we can tell Target is in a
better position to pay its current liabilities.
Long-Term Liabilities - Slide 16
Transcript
Target also increases its fraction of long-term liabilities by 2.2%. Meaning

liabilities are shifting from short term to long term.
Total Shareholders Equity - Slide 17

Transcript
The fraction of total shareholders equity increased by .3%. One advantage

of common size balance sheet is that it is easy to spot any significant
changes in a firm's balance sheet. Now we want to introduce the common
size income statement. Common size income statements include additional
column of data which express each line item as a percentage of total
revenue.
Common Size Income Statement - Slide 18

Transcript
Here is the common size income statement for Target. All percentages are
calculated using total net revenue as the base. For example, the
percentage of cost of sales is 70.24%, which is calculated using 54.86
million dollars of cost of sales divided by total net revenue, 78.11 billion
dollars. It represents that the direct cost of sales accounts for about 70.24%
of total net revenue. In addition, the selling, general and administrative
expenses accounts for 20.78% of total net revenue. About .6% of sales are
used to pay interest. And 1.16% are used to pay taxes. The net income is
4.2% of total revenue. Common size income statements enables us to
compare trends and changes in our business. Common size financial
statements are also used to compare companies within the same industry.
We pulled common size income, statement of Target and Walmart side by
side and study the difference between these two companies. Walmart's
total revenue 523.96 billion dollars is much larger than Target's 78.11 billion
dollars total revenue. When we compare the common size income
statement, we notice that Target's cost of sales as a percentage of total
revenue is 5% lower than Walmart, generating a higher gross margin
percentage. Target's selling, general, and administrative expenses is
slightly higher than Walmart. Target's interest expenses and tax
percentages are also a bit higher than Walmart. Target's net income
percentage is 1.36% higher than Walmart, which means for each dollar of
sales, Target generates more net income than Walmart.
Financial Ratios
Financial Ratios: Introduction

Financial Ratio Analysis - Slide 19
Transcript
In addition to the common size financial statements. There is another way

to evaluate the performance of a company. Which is called financial ratio
analysis. When you first hear about financial ratios, you may feel is hard.
You use ratios a lot in your daily life. But you may not realize you are
making mathematical calculations. For example, when we want to buy a
car, we care about these few efficiency.
MPG Example - Slide 20
Transcript
Using the miles traveled divided by how many gallons of gasoline used?
We get a racial called MPG. If the car has a high MPG number. It means we
can save a lot of money on gasoline and produce less pollution. Just the
MPG example when we use financial ratio analysis, we need to know how
the ratio is calculated. What is measures? A high value is better or a loan
value is better. And how to improve the value through financial
management? In order to evaluate the performance of the company, we
need to compare them with something. There are two major ways of
comparison.
Time-Trend Analysis - Slide 21
How the firm's performance is changing throughout time
Transcript
One way is to perform time trend analysis. Which means we compare the
performance of a company with this past to see whether there's any
improvement or not. Another way to perform peer group analysis.
Peer Group Analysis - Slide 22

Compare to similar companies or within industries
Transcript
We compare the financial ratios of a company with its major competitors

and industry average.
Compare Two Companies During the Same Year -

Slide 23
Target (fiscal year ended on Feb 1, 2020)

Walmart (fiscal year ended on Jan 30, 2020)
Transcript
In this module, we want to compare the financial performance of Target to

Walmart in 2020 because both are large retailers and they can be
considered as competitors.
Financial Ratios - Slide 24
Short-term liquidity ratios

Long-term solvency ratios
Asset turnover ratios
Transcript
Financial ratios can be divided into several categories. Short term liquidity
ratios we should measures the liquidity of a company. Long-term solvency
ratios, which evaluates financial leverage of a company. As I turn over
ratios, which tells us the efficiency of Asset Management. Profitability ratios
and market value ratios.
Financial Ratios: Liquidity Ratios

Liquidity Ratios - Slide 25
Ability to pay short-term obligations
Current ratio
Quick ratio
Cash ratio
Operating cash flow ratio
Transcript
We want to start our ratio analysis from liquidity ratios. Liquidity ratios
evaluate a company's ability to pay its short term liabilities. Several
common liquidity ratios include current ratio, quick ratio, cash ratio, and
operating
Current Ratio - Slide 26
Current assets/Current liabilities
Transcript
cash flow ratio. The current ratio is a ratio of a company's current assets to
its current liabilities. The ratio measures a company's ability to pay its short
term liabilities using cash, accounts receivable, and inventory. We calculate
the current ratio using the balance sheet information of Target and Walmart
for the fiscal year 2020.
Current Ratio Comparison - Slide 27
Target and Walmart Current Ratio
2020 Data ($ Total Current Total Current
Current Ratio
millions) Assets Liabilities
$12,902
Target $12,902 $14,487 $14,487
= 0. 89
$61,806
Walmart $61,806 $77,790 $77,790
= 0. 79
Transcript
Target's current ratio is .89, which means for each dollar in current, liabilities
Target has $0.89 to pay off its debt. Walmart has $0.79 in current assets for
each dollar of current liabilities. When we compare the current ratio of
Target and Walmart, we find that Target's current ratio is higher than
Walmart, which means is liquidity is better. When we use current ratio to
make comparisons, there's one problem we need to be aware of. Current
assets are made of three major parts, and their liquidities are quite different.
Structure of Current Assets Matters - Slide 28
Cash and cash equivalents = high liquidity

Transcript
Cash and cash equivalents are the most liquid asset within the current
assets family, then followed by accounts receivable. Inventory is the least
liquid current asset. Suppose there are two companies and they have
exactly the same current ratio, but the one with more inventory and another
one maintains large accounts receivable. Of course, the liquidities of these
two companies should not be the same. This is why we want to introduce
another liquid ratio in addition to current ratio. The second liquidity ratio we
want to introduce is the quick ratio.
Quick Ratio (Acid Test Ratio) - Slide 29
Cash + Marketable securities + Accounts receivable
Current liabilities
Transcript
Which is also called acid test ratio. It can be calculated as the sum of cash,
marketable securities, and accounts receivable, divided by current liabilities.
The numerator can also be considered as current assets without inventory
and prepaid expenses. Since their liquidity is not as good as cash and
accounts receivable.
Quick Ratio Comparison - Slide 30
Target and Walmart Quick Ratio
2020 Cash and Total
Accounts
data ($ cash current Quick ratio
receivable
million) equivalents liabilities
$2,577 + $962
Target $2,577 $962 $14,487 $14,487
= 0. 24
$9,465 + $6,284
Walmart $9,465 $6,284 $77,790 $77,790
= 0. 20
Transcript
We calculate the quick ratio for Target and Walmart, and we find that
Target's quick ratio, .24, is higher than Walmart's .2, indicating Target is in a
better position to pay its current liabilities using the more liquid portion of its
current assets. Another observation is that the quick ratio of these two
companies are much lower than their current ratios because inventory and
prepaid expenses are more than half of their current assets. Quick ratio is a
more conservative measure of liquidity then current ratio and it is more
useful when inventory percentage is high.
Cash Ratio - Slide 31
Cash and cash equivalents
Current liabilities
Transcript
A company's cash ratio is the ratio of cash and cash equivalents to its
current liabilities. It is considered as the most conservative liquidity ratio
because it only considers cash and near cash financial securities. This ratio
is used more often to evaluate a company in financial distress because at
that time the company is very hard to convert its accounts receivables and
inventory into cash in a short period of time.
Cash Ratio Comparison - Slide 32

Target and Walmart Cash Ratio
2020 data ($ Cash and Cash Total Current
Cash Ratio
million) Equivalents Liabilities
$2,577
Target $2,577 $14,487 $14,487
= 0. 18
$9,465
Walmart $9,465 $77,790 $77,790
= 0. 12
Transcript
We compute the cash ratio for Target and Walmart. Target's cash ratio, .18,
is higher than Walmart's .12, which means Target's proportional cash
balance is more adequate than Walmart. When we study the cash ratio of a
company, we also need to realize that there is a trade off of holding too
much cash. Although creditors are happy to see the company holding a lot
of cash, because they can be paid off, cash and near cash securities have
low returns compared with other assets. Financial managers need to keep
appropriate level of cash balance based on the nature of the industry and
company characteristics.
Operating Cash Flow - Slide 33
Cash flow from operations
Current liabilities
Transcript
Operating cash flow ratio evaluates the capacity a company's cash

generated from operating activities to pay its current liabilities. It is
calculated by dividing the cash flow from operations by the company's total
current liabilities. You can get the cash flow from operations from a
company's statement of cash flows, and the current liabilities from the
balance sheet.
Operating Cash Flow Comparison - Slide 34

Target and Walmart Operating Cash Flow Ratio
2020 data ($ Cash Flow from Total Current Operating Cash
million) Operations Liabilities Flow Ratio
$7,177
Target $7,117 $14,487 $14,487
= 0. 49
$25,255
Walmart $25,255 $77,790 $77,790
= 0. 32
Transcript
Target's operating cash flow ratio, .49, is higher than Walmart's .32, which
indicates a higher capacity to pay his current liabilities out of its operating
cash flow. Combining the current ratio, the quick ratio, the cash ratio, and
the firms operating cash flow ratio, you can generate a pretty solid view of a
company's ability to pay its short term bills. These are commonly used
metrics that lenders often look at in the long approval process.
Financial Ratios: Leverage Ratios

Solvency Ratios (Leverage Ratios) - Slide 35
Total debt ratio

Equity multiplier
Interest coverage ratio
Transcript
We have learned that liquidity ratios are used to measure a company's

short-term obligations. Now we want to talk about how to value a
company's ability to pay the total financial obligations. The ratios to help us
do the job is called solvency ratios or leverage ratios. We will introduce
three widely used solvency ratios. Total debt ratio, equity multiplier and the
interest
Total Debt Ratio - Slide 36
Total assets − Total stockholders' equity
Total assets
Transcript
coverage ratio. The total debt ratio is a ratio of total liabilities to total assets.
Here we use a very broad version of debt, which includes all current
liabilities and long-term liabilities. But in some other versions, the total debt
doesn't include items such as accounts payable and accrued expenses.
When you use this ratio, you also need to investigate whether they use the
broad version of or the narrow version.
Total Debt Ratio Comparison - Slide 37
Target vs. Walmart Total Debt Ratio
Total
2020 Data ($ Total
Shareholders' Total Debt Ratio
millions) Assets
Equity
$42,779 − $11,833
Target $42,779 $11,833 $42,779
= 72. 34%
$236,495 − $81,552
Walmart $236,495 $81,552 $236,495
= 65. 52%
Transcript
Target's debt ratio is computed as 72.34%, which means it finances about

72.34% of these assets with debt and the remaining 27.66% with equity.
Walmart's debt ratio is lower than that. It has 65.52% of debt 34.38% of
equity. Target uses more debt than Walmart, but these ratios are in line with
the industry average. For retail industry, the average total debt ratio is about
60 to 65%.
Equity Multiplier - Slide 38
Total assets
Total stockholders' equity
Transcript
The equity multiplier is defined as total assets divided by total shareholders

equity. The equity multiplier indicates how much equity financing a company
uses. If we know the total debt ratio, we can also calculate the equity
multiplier based on that value.
Equity Multiplier Comparison - Slide 39
Target vs. Walmart Equity Multiplier
2020 Data ($ Total Total Shareholders' Equity
millions) Assets Equity Multiplier
$42,779
Target $42,779 $11,833 $11,833
= 3. 62
$236,495
Walmart $236,495 $81,552 = 2. 90
$81,552
Transcript
The equity multiplier measures the capital structure of a company. Target's

equity multiplier is higher than Walmart, which means Target relies more on
debt. Here you may have a question.
Is It Good to Have a High Leverage Ratio? - Slide

40
Transcript
Is it good to have a high leverage ratio? Our answer is the leverage ratio
should be within the appropriate range, and this range varies by industry
and company. In order to understand how much leverage is appropriate,
Benefits of Using Debt - Slide 41
Interest tax shield

Boost returns for existing shareholders
Transcript
we need to know the benefits and costs of using debt. Using debt helps a
company to lower its taxes because interest payments are tax deductible.
However, dividends paid to shareholders are not tax deductible and come
from after tax next income. Therefore, the cost of debt financing is usually
lower than equity financing. Using debt also benefit existing shareholders
because of the financial leverage. The company finances its operations
using debt. Shareholders keep any remaining prophets after paying
interest. Given the same amount of equity investments, using more debt will
help shareholders to boost their investment returns. On the other hand,
Cons of Using Debt - Slide 42
Financial distress
Transcript
debt represents obligation. If a company fails to pay its interest expenses.

Creditors will sue the company and drive the company to file for bankruptcy.
If the company uses too much debt, the business will become too risky for
creditors and investors. In order to protect themselves, they may charge a
higher interest rate or demand a higher return as a compensation. Another
long term solvency measure we want to introduce is the interest coverage
ratio. Sometimes it is also called times interest earned. There are several
versions of this ratio. We adopted the most commonly used version.
Interest Coverage Ratio - Slide 43
EBIT
Interest expense
Transcript
It is calculated by dividing a company's earnings before interest and taxes,

EBIT, by the company's interest expenses within the fiscal year. The
interest coverage ratio tells us how easily a company can pay its interest
expenses with its earnings.
Interest Coverage Ratio Comparison - Slide 44

Target vs. Walmart Interest Coverage Ratio
2020 Data ($ Interest Interest Coverage
EBIT
millions) expense Ratio
$4,658
Target $4,658 $468 = 9. 95
$468
$21,468
Walmart $21,468 $2,410 $2,410
= 8. 90
Transcript
Target's interest coverage ratio is 9.95, which means the interest expense is
covered 9.95 times over. Walmart's interest coverage ratio, 8.9 times, is
lower than Target, but still higher than the industry average. We can argue
that both companies have no problem paying their debt out of their
earnings. Normally the interest coverage ratio is used by creditors to
determine the riskiness of a company's debt. A common view is that the
interest coverage ratio should be at least 1.5. If a company's earnings is
less than 1.5 times the interest payments, the company might be struggling
paying its debt.
Financial Ratios: Turnover Ratios

Asset Turnover Ratios - Slide 45
Inventory turnover
Days' sales in inventory
Total asset turnover
Transcript
In this part we want to talk about asset turnover ratios. With the help of
these ratios, we can tell whether a company uses its assets efficiently or
not. There are three commonly used the asset turnover ratios. The
inventory turnover ratio, days' sales in inventory and total assets turnover.
Inventory Turnover - Slide 46
Cost of goods sold
Inventory
Transcript
Inventory turnover ratio is the ratio of cost of goods sold to inventory. Cost
of goods sold comes from the income statement and it is measured during
the fiscal year while inventory is from the balance sheet and it is measured
Which Inventory To Be Used? - Slide 47
Transcript
at a specific time. So here comes the question - which inventory should we

use? The beginning inventory, the ending inventory, or the average
inventory. To get the answer to this question, you must look for the industry
norm. See how other people compute inventory turnover, and you just need
to follow their method so that your number is comparable with others.
Inventory Turnover Question - Slide 48

Target vs. Walmart Inventory Turnover
2020 Data Cost of
Beginning Ending
($ Goods Inventory Turnover
Inventory Inventory
millions) Sold
$54,864
Target $54,864 $9,497 $8,992 ($9,497 + $8,992)/2
= 5. 93
Walmart $394,605 $44,269 $44,435

Transcript
For both Target and Walmart, they use the average inventory to compute
the inventory turnover because any extreme values will be smooth. From
you can see that Target sold off or turned over the entire inventory 5.93
times during the year. Now, I want you to use the information on Walmart to
calculate its inventory turnover by yourself.
Inventory Turnover Answer - Slide 49

Target vs. Walmart Inventory Turnover
2020 Cost of
Beginning Ending
Data ($ Goods Inventory Turnover
Inventory Inventory
millions) Sold
$54,864
Target $54,864 $9,497 $8,992 ($9,497 + $8,992)/2
= 5. 93
$394,605
Walmart $394,605 $44,269 $44,435 ($44,269 + $44,435)/2
= 8. 90
Transcript
OK, here's the answer. Walmart sold its inventory 8.9 times during the year.
This means Walmart sells its inventory at a faster speed than Target.
Normally, retailers favor a high inventory turnover because holding
inventory incurs high holding costs, such as storage costs, insurance, and
opportunity costs of the money tied up in the inventory. A low inventory
turnover may indicate either the company has weak sales or it is holding too
much inventory.
Days' Sales in Inventory (DSI) - Slide 50
365 days
Inventory turnover
Transcript
Days' sales in inventory is the inverse of inventory turnover times 365 days.
It measures the average time a company can turn its
Selling Inventory Timeframe - Slide 51
Target vs. Walmart Inventory Timeframe
2020 Data ($ millions) Inventory turnover Days' sales in inventory
365 days
Target 5.93 = 62 days
5.93
365 days
Walmart 8.90 = 41 days
8.90
Transcript
inventory into sales. Based on our calculation, Target's inventory sees 62

days on average before it is sold, while Walmart only takes 41 days to sell
its inventory in hand. Walmart outperforms Target according to this metric.
We also want to show you some days in inventory data for
Days' Sales in Inventory Table 2020 - Slide 52

Days' Sales in Inventory
Company Days' Sales in Inventory (2020 Data)
Ford Motor Co 32.99
General Motors Co 33.29
Hyundai Motor Co 48.08
Honda Motor Co Ltd 48.67
Toyota Industries Corp 54.16
Tesla Inc 64.64
Audi AG 66.58
Porsche Automobile Holding SE 76.04
Ferrari NV 81.93
Daimler AG 83.43
Volkswagen AG 88.52
Industry Median 74.01

Transcript
the auto industry. This table presents the days in inventory for big
automakers in the world and industry medium value. You can see that there
is a lot of variations among the automakers. For example, Ford has a 33
day supply, which is pretty good compared to other automakers. If the days
in inventory is short, it automaker converts the inventory into cash easily,
and the inventory is more liquid. Well Volkswagen's days in inventory is 89
days. Each company's data can be compared to the industry data. 74 days
to decide whether it is better than the industry average or not.
Total Asset Turnover - Slide 53
Total revenues
Total assets
Transcript
Total asset turnover is defined as the ratio of total revenues to total assets.
Total revenues come from the income statement, while total assets from the
balance sheet. Just like the inventory turnover case, we need to decide
which asset value to use. The beginning value, ending value, or average
value. The practice used by Target and Walmart is to use average assets,
but in other industries this may not be the
Total Asset Turnover Comparison - Slide 54

Target vs. Walmart Total Asset Turnover
2020
Total Beginning Ending
Data ($ Total Asset Turnover
Revenues Assets Assets
millions)
$78,112
Target $78,112 $41,290 $42,779 ($41,290 + $42,779)/2
= 1. 86
$523,964
Walmart $523,964 $219,295 $236,495 ($219,295 + $236,495)/2
= 2. 30
Transcript
case. Targets total asset turnover is 1.86, which means for every dollar in
assets, Target generates 1.86 dollars in total revenues. Walmart's total
asset turnover is higher than that of Target's, which indicates its more
efficient at generating revenues from its assets. Both values are higher than
their industry average level.
Financial Ratios: Profitability Ratios

Profitability Ratios - Slide 55
Gross profit margin

Net profit margin
Return on assets (ROA)
Return on equity (ROE)
The DuPont Identity
Transcript
In this part we want to introduce you to several profitability ratios: gross

profit margin, net profit margin, ROA, and ROE. In addition to that, we also
want to explore the relationship between ROA and ROE, and learn the
DuPont identity. When investors decide which company to invest, the
profitability ratios are key variables to consider.
Gross Profit Margin - Slide 56
Gross profit
Total revenues
Transcript
The formula for gross profit margin is gross profit divided by total revenues.
Gross profit is expressed as a company's total revenues minus the cost of
goods sold, also called Cox.
Gross Profit Margin Comparison - Slide 57
Target vs. Walmart Gross Profit Margin
2020 Data ($ Gross Total Gross Profit
millions) Profit Revenues Margin
$23,248
Target $23,248 $78,112 $78,112
= 29. 76%
$129,359
Walmart $129,359 $523,964 $523,964
= 24. 69%
Transcript
Target's gross profit margin is 29.76%, which is higher than Walmart's gross
profit margin, 24.69%. The industry average gross profit margin is about
24% for retail industry. Gross profit margin is good at evaluating how a
company controls its direct cost of operations because the cost of goods
sold is a measure of direct costs required to produce goods or services, not
including overhead costs such as utilities, management wages, and rent.
However, gross profit margin cannot capture the whole picture of a
company's profitability. We need other indicators to help us. Net profit
margin is the most widely used metric of profitability. Sometimes people just
call it profit margin.
Net Profit Margin Comparison - Slide 58

Target vs. Walmart Net Profit Margin
2020 Data ($ Net
Total Revenues Net Profit Margin
millions) Income
$3,281
Target $3,281 $78,112 $78,112
= 4. 20%
$14,881
Walmart $14,881 $523,964 $523,964
= 2. 84%
Transcript
Net profit margin is calculated by dividing net income by total revenues.

Target has a net profit margin of 4.2%. A net profit margin of 4.2% means
target generates 4.2 cents in net income for each dollar in sales. Walmart's
net profit margin is lower than that, mainly because its business model is
quite different from Target. The average net profit margin of retail industry is
2.5%, which means both companies have a higher net profit margin than
the industry average. These ratios may look familiar to you if you still recall
what we have learned in the common size financial statements. You will find
that we calculated the ratios in the common size income statement
implicitly. Net profit margin is a very important indicator of a company's
financial performance. If a company's net profit margin is in line with the
industry or rising compared to its peers, we know the company is good at
generating profits from its sales and controlling its costs.
Return on Assets (ROA) - Slide 59
Net income
Total assets
Transcript
Return on assets is defined as net income divided by total assets. When we

use the ROA numbers, it's important for us to remember that the ROA value
is accounting rate of the return.
ROA Comparison - Slide 60
Use the information of Walmart to calculate ROA by yourself.

Target vs. Walmart ROA Comparison
2020
Net Beginning Ending
Data ($ ROA
Income Assets Assets
millions)
$3,281
Target $3,281 $41,290 $42,779 ($41,290 + $42,779)/2
= 7. 81%
Walmart $14,881 $219,295 $236,495

Transcript
Both Target and Walmart use average total assets as denominator to

calculate their ROA. Now why don't you try it out for yourself and see what
the ROA for Walmart is? Based on the comparison between Target and
Walmart, we can argue that Target is more successful at generating
earnings from its total assets. Return on equity is calculated as net income
divided
Return on Equity (ROE) - Slide 61
Net income
Total equity
Transcript
by total equity. In module one, we mentioned that the goal of a Corporation

is shareholder wealth maximization. ROE is often used to measure how
well management is attaining the goal of shareholder wealth maximization.
Investors are happy to invest a company with high
ROE Comparison - Slide 62
Target vs. Walmart ROE Comparison
2020 Data Net Beginning Ending
ROE
($ millions) Income Equity Equity
$3,281
Target $3,281 $11,297 $11,833 ($11,297 + $11,833)/2
= 28%
$14,881
Walmart $14,881 $79,634 $81,552 ($79,634 + $81,552)/2
= 18%
Transcript
ROE. Overall, we think Target is doing a better job than Walmart based on
the ROE value. But at the same time we are curious what causes the
difference in their performance. We want to explore the story behind the
ROE numbers.
The DuPont Identity - Slide 63
Net Income
ROE =
Total Equity
Multiply by 1 and then rearrange:

Net Income Total Assets
ROE = ×
Total Equity Total Assets
Transcript
We also want to talk about the relationship between ROE and ROA. If we
multiply the ROE numerator and denominator by total assets at the same
time and then manipulate the equation, we derive the relationship that ROE
equals to ROA times equity multiplier. In other words, ROE is different from
ROA because of the financial leverage. As long as a firm has debt, ROE will
always be higher than ROA. If the company uses a lot of debt, ROE will be
higher than ROA. Otherwise, these two metrics will be close
DuPont Identity Formula - Slide 64
Multiply by 1 again and then rearrange:

Net Income Total Assets Total Revenues
ROE = × ×
Total Assets Total Equity Total Revenues
Net Income Total Revenues Total Assets

ROE = × ×
Total Revenues Total Assets Total Equity
ROE = Net Profit Margin × Total Asset Turnover × Equity Multiplier

Transcript
to each other. We can further multiply the right hand side of the equation
with total revenues in the numerator and denominator. After some
manipulation we decompose the ROE into the product of three
components: net profit margin, total asset turnover and the equity multiplier.
This formula is called DuPont Identity. Because it was first adopted by the
DuPont Corporation to evaluate performance of its corporate divisions.
The DuPont Identity - Slide 65
Net profit margin: A measure of operating efficiency
Transcript
The DuPont Identity shows us that the ROE is determined by three factors.
The first one is the net profit margin. It evaluates the operation efficiency of
a company. The second one is total asset turnover, which measures the
asset use efficiency. The last one, equity multiplier, it measures the financial
leverage of a company.
DuPont Identity Comparison - Slide 66
Target vs. Walmart Net Profit Margin
2020 DuPont Total Asset Equity Return on
Data Identity Turnover Multiplier Equity
Target 4.2% 1.86 3.62 28%
Walmart 2.8% 2.30 2.90 19%

Transcript
In this table, we present the result of DuPont Identity for both Target and
Walmart. One small thing is the ROE number is a little bit off because we
use the ending values to calculate the equity multiplier while we use the
average values in total asset turnover. When we compare Target and
Walmart using the DuPont Identity, we find that Target achieved a higher
ROE mainly because it has a higher net profit margin and it uses more debt
than Walmart. Although Walmart manages its assets more efficiently, the
earnings from each sale is low. Here comes a question. How can we
improve the net profit margin? There are two ways you can think of:
increase prices and reduce costs.
How to Improve Net Profit Margin? - Slide 67
Increasing prices requires pricing power and customer loyalty

Transcript
Increasing prices seems easy, but your customers may switch to your
competitors if they can buy the same product with a lower price. Unless a
company has pricing power and has a lot of loyal customers, increasing
prices will harm the business instead of increasing revenues. Another way
is to reduce costs, but you have to make sure that you can do so without
sacrificing the quality of goods and services. Some common practices,
including using the latest technologies to automate the production process
and checking for unnecessary expenses. Another question I want you to
think about is Can we improve a company's ROE by increasing leverage? If
you take a look at DuPont Identity, it seems that we can improve the ROE
by increasing equity multiplier. If a company issues more debt instead of
equity, the equity multiplier will increase. At the same time, the interest
payments will also go up. The net profit margin will go down as a result.
Overall, we don't know the ROE will increase or decrease because of these
two opposite effects. Here you may also notice that a lot of financial ratios
are linked with each other. You need to pay attention to their relationship
when we use them.
Financial Ratios: Market Value Ratios

Market Value Ratios - Slide 68
Price-to-earnings (P/E) ratio

Market capitalization
Transcript
In this lesson, I want to show you 2 market value ratios, P/E ratio and
market capitalization. In order to get these ratios, we also need current
information from the stock market. The values may have already changed
when you learn this part, but I will show you where to get the information
and how to interpret them. For investors, P/E ratio is a key variable that
they want to look at.
P/E Ratio - Slide 69
Current share price
Earnings per share
Transcript
The P/E ratio is calculated by dividing our company current share price by
its earnings per share. It measures how much investors are willing to pay
for each dollar in current earnings. Here comes the question. Where can we
get real time stock price information? One place is Yahoo Finance. Click the
link here and then search for Target Corporation
Real-Time Stock Price Information - Slide 70
https://finance.yahoo.com
Search Target stock ticker "TGT"
Transcript
using stock ticker TGT. You will get directed to this web page.
Current Stock Price - Slide 71

This slide shows a Yahoo stock page for Target Corporation. The current
price for Target's stock is circled, and an arrow from this points to the
numerator of the P/E ratio calculation, which is $122.33. The EPS on the
stock page is also circled, and an arrow from this points to the denominator
of the P/E ratio calculation, which is 6.36. Finally, the P/E ratio on the stock
page is circled, which is 19.23.
Transcript
The current price is listed in red at the very top. 122.33 dollars as of May
29th, 2020. The earnings per share is 6.36 dollar per share. When you use
P/E ratio, there's one thing you need to pay attention to. When the firms
earning is negative, you can no longer use the P/E ratio because it doesn't
make any sense. Sometimes P/E ratio is high, not because its shares price
is high, but its earnings is close to 0. You need to interpret the P/E numbers
carefully and dig a little bit deeper to investigate its earnings.
Exercise - Slide 72
Please find today's P/E ratio for Target and Walmart and compare them.
Transcript
Here is an exercise for you to practice. Please visit Yahoo Finance and
check the most recent information about P/E ratio for both Target and
Walmart and compare which one achieves a higher P/E ratio. As an
investor, which one would you rather pay a higher price for based on its
current earnings?
Market Cap - Slide 73
Market capitalization (market cap) = Current price per share × Shares

outstanding = $122.33 × 499.92 million = $61.155 billion
This slide shows a Yahoo stock page for Target Corporation. The Market
Cap on the page is circled and is referenced by the resulting value from the
formula calculation above, which is 61.155 billion dollars.
Transcript
The market cap is calculated as the current price per share multiplied by the
number of shares outstanding. Market cap measures. How much are
companies worth in the stock market and investors perception of its future
prospects? For Target this is 122.33 dollars per share, times 499.92 million
shares outstanding, which equals to 61.155 billion dollars. We can divide
the companies into three groups based on their market cap. We call a
company large cap
Large-Cap Firm - Slide 74
Market cap > $10 billion
Transcript
when is market value is 10 billion dollars or more. Large cap firms often are
established companies within an industry with high reputation, a steady
growth, and constant dividend payments. Investing in these companies will
generate a pretty safe return for investors.
Mid-Cap Firm - Slide 75
$2 billion – $10 billion
Transcript
Mid cap companies have a market value between 2 billion and 10 billion
dollars. These companies are still growing and expanding its risks and
return are considered as moderate.
Small-Cap Firm - Slide 76

$300 million – $2 billion
Transcript
Small cap companies are businesses with a market value of 300 million
dollars to 2 billion dollars. These are young companies or companies in
emerging industries. There are very vulnerable to business cycles,
especially economic downturn. Meanwhile, they deliver the highest return
among these three groups because of their growth potential. This
represents a wonderful choice for those risk loving investors.
Financial Planning
Financial Forecasting
Financial Forecasting - Slide 77
How to make financial planning based on financial statements?

The percentage of sales approach
Transcript
In this lesson, we want to talk about financial planning. We can also use
financial statements to calculate financial ratios. Another application of
financial statements is to use them to forecast what is going to happen in
the future. We want to introduce you a commonly used method to do that. It
is called percentage of sales approach. The underlying assumption of this
approach is that many items in the income statement and balance sheet will
experience a proportional increase as sales increase.
Income Statements - Slide 78
Transcript
We start our analysis from income statement. First, we calculate each item
as a percentage of sales. This step is very similar to what we have done in
the common size income statement analysis. There's one thing I want to
mention. The income tax expense 21.69% is calculated as a percentage of
EBT, earnings before income taxes, not a percentage of sales. This number
represents the effective tax rate of Target. Next, we assume that the sales
growth is 7% next year. This information is derived from analysts forecast.
You can also check the information through Yahoo
Income Statement Components - Slide 79

Transcript
Finance. The new total net revenue will grow to 83.58 billion dollars. It is the
total net revenue of 2020, 78.112 billion dollars times 1 plus 7% increase.
The new cost of sales is calculated as 70.24% times the new sales number.
This makes sense because when sales increase, the associated costs
should also increase to support the sales growth. The gross profit is the
total net revenue minus the gross sales. The selling, general, and
administrative expenses. Depreciation and amortization will also be a
proportion of the new sales value. We use gross profit minus these two cost
items to derive the operating income. And EBIT is the same as operating
income because there is no other income. Here, we assume the interest
expense is the same as before, because without issuing new debt, the
interest expense won't increase. EBT is calculated as EBIT minus the
interest expense and taxes are derived by EBT times the effective tax rate,
21.69%. The taxes for the next year will increase from 909 million dollars to
980 million dollars because of the increase in pretax income. The new net
income will increase from 3.281 billion dollars to 3.536 billion dollars. Now
we have finished the pro forma income statement. We are also interested in
how the net income is distributed. Based on the retention ratio of 2020,
59.2% are kept in the company for future investments. We assume the
retention ratio will be the same for next year. The retained earnings will be
59.2% times the new net income, 3.536 billion dollars, which is 2.094 billion
dollars. This number will also be used in the pro forma balance sheet. We
start to work with the balance sheet now.
Balance Sheet Components - Slide 80

Transcript
For the left hand side of the balance sheet, we express all items as a
percentage of sales of 2020. We assume that current assets and fixed
assets need to keep pace with the sales so that sales increase can be
achieved. This is a very strong assumption. If the company still has some
extra capacity. They may not need to invest in that much in fixed assets,
and they can still increase their sales. When you collect more information
about the production capacity of the company, you can make further
adjustments. But here, we just use this assumption to simplify our analysis.
The projected assets are calculated using the percentage times the new
sales level. For the right hand side of the balance sheet, only two accounts
increase accordingly with sales, accounts payable and accrued expenses,
because you will have more orders with your suppliers. Other items won't
change automatically with sales, unless the company issues more debt or
equity. The other items will be the same as before. One thing we also need
to take care of is the retained earnings. From the pro forma income
statement, Target generates more retained earnings, and this needs to be
added to the current retained earnings. The retained earnings will be
increased by 2.094 billion dollars. All the other items in the liabilities and
equities part will be the same as before. We take a look at the newly
generated pro forma balance sheet and notice that total assets is 45.774
billion dollars. Well, total liabilities and equities is 45.875 billion dollars. The
projected total liabilities and equity is higher than the projected assets,
meaning Target will generate a surplus of 102 million dollars with a 7%
increase in sales. There's no need to obtain upside financing to support the
growth level. For some other companies, if the projected total assets
exceed total liabilities and equity, it means the company needs to seek
external financing. The profit generated by the sales growth itself is not
enough to support its growth.
Module 3 Wrap Up
Module 3 Wrap Up
Financial Statements - Slide 81
Standardize balance sheets and income statements
Transcript
In this module we learned some applications of financial statements. The

first topic we introduced is the common size balance sheet and common
size income statement. The standardized financial statement help us to
compare the performance of the same company at different times and
different companies in the same industry. Then, we learned several
financial ratios.
Compute Financial Ratios - Slide 82
Short-term liquidity ratios

Long-term solvency ratios
Asset turnover ratios
Profitability ratios
Market value ratios
Transcript
They are grouped into five categories. The liquidity ratio evaluates the
ability of the company to pay its short term liabilities. We focus mainly on
the upper part of the balance sheet. A company's suppliers and short-term
creditors will pay a lot of their attention to these ratios because they want to
be paid on time. The solvency ratio or leverage ratio measures a company's
capability of paying its long term liabilities. We learned total debt ratio,
equity multiplier, an interest coverage ratio. Long-term creditors, such as
bondholders care a lot about these ratios. We measure the asset use
efficiency using asset turnover ratios. Inventory turnover ratio focus on the
short term asset use, while total asset turnover ratio shows us a big picture
of how a company uses its assets. For investors of a company, they care
more about the profitability ratios and the market ratios because these
ratios tell us about earning capability of a company and its market
performance. One useful tool to compare the performance of two
companies is the DuPont Identity. It decomposes the ROE into three
components and examine each part to see whether a company can make
improvement or not.
Financial Forecasting - Slide 83
Percentage of sales approach

Transcript
In addition to financial ratios, we also learn financial planning using

percentages of sales approach. This approach pro forma income statement
and balance sheet to help us identify the financing needs for a given level of
sales increase. When you have time, I suggest that you pick a company
that you're interested in or you want to invest. Suppose you are interested
in social media. You may want to try Facebook or Twitter.
Company Financial Situation - Slide 84
This slide contains the logos of Facebook and Twitter.
Transcript
Try to practice what we have learned in this module. Calculate their

financial ratios and evaluate their financial health. That way you will know
which company's financial situation is better, and which one is a better
investment?
Module 4 Introduction to Finance: The Basics
Module 4 Overview
Module 4 Overview
Time Value of Money - Slide 1
Transcript
Hello, in this module let's discuss the time value of money. First, let's think about
some important financial decisions we make in our life. For most of us, we begin
our career in our 20s, and then we consider buying a car or even at home.
During the initial years of our job, it's difficult to buy a car or home since our
savings would be little. One thing we are sure of is that we can accumulate
enough wealth in our lifetime through our hard work. Yet we wouldn't want to
delay our purchases until we're old. So what we can do is borrow money from a
bank to finance the purchases of both car and home. In this case, financial
institutions, like banks, help us to shift some our future earnings to the present,
so that we can purchase a home worth hundreds of thousands of dollars.
Savings - Slide 2
Transcript
When we have a job and receive our salary, we don't want to spend all our
income. We also want to save some money for retirement. We deposit a portion
of our salary into a savings account such as 401K plan. Some employers may
also make matching contributions.
Retirement Plan - Slide 3

Transcript
We want to allocate some of our current income to the retirement plan because
we want to maintain our standards of living even after we retire. Making
contributions to the retirement account will help us to shift some of our current
earnings to the future so that we can retire, worry free. In addition to the
retirement savings, we also want to make some investments if we have some
extra money. There are a bunch of investment options for us to choose from,
such as stocks, bonds, money markets and others. But our investment goal is
straightforward. We want to sacrifice a part of our current consumption in
exchange for greater future rewards.
Present Value and Future Value - Slide 4
Transcript
From all these daily examples you can see they have something in common.
With the help of financial institutions, we move cash flows either from present to
the future or from future to present so that we can smooth our consumption. If
we want to know how to allocate cash flows across time, we have to value the
tradeoffs between today's dollars and future dollars. This is the time value of
money. In this module, let's get introduced to the concept of present value and
future value. How to convert the present value to future value and vice versa?
To deal with a single cash flows as well as multiple cash flows and how to
calculate the net present value.
Perpetuity and Annuity - Slide 5
Transcript
Next, let's study the compounding frequency. Financial institutions may pay
interest annually semi annually, monthly or daily. So how do we compare the
value of investments if we received different quotes of interest rates from
various financial institutions? How do we convert a stated annual interest rate to
an effective annual interest rate? Lastly, let's study two special categories of
cash flows, perpetuity and annuity. Using these analysis tools, we should be
able to value the cash flows generated by a lot of financial instruments. You can
consider this module as the foundation of financial asset valuation.
Present Value and Future Value
Present Value and Future Value

Time Value of Money - Slide 6
A dollar today is worth more than a dollar tomorrow.

This is the case because of the money's potential earning capacity.
Transcript
The time value of money is an idea that a dollar today is worth more than a
dollar tomorrow. This is the case because you can earn interest on your money.
If you invest $1,000 today at 5% interest rate for one year, what will your
investment grow to?
Transcript
Suppose I offer you two options; one is to receive $1000 now and another is to
receive $1000 one year later. Of course you want the $1000 right now because
you can deposit your money into a bank and get more than $1000 one year
later. But the question is, how much more will you get? Now let's discuss the
concepts of the present value and future value. Suppose you invest $1000 now
and the interest rate is 5%. What is the investment value one year later?
Future Value Calculation - Slide 8
Future Value Calculation Table
Interest Payment $1,000 × 5% = $50
Principal Repayment +$1,000
Total $1,050
Transcript
The ending value is composed of two parts. The first part is interest payments
using the original $1000 times 5% interest rate. You get the interest payment
$50. You'll also receive the $1000 principle repayment, so your investment will
grow to 1050 in total.
Present Value - Slide 9
$1,000 × (1 + 5%) = $1,050
The value of $1,000 today is called present value.
Transcript
You can also derive the value using the original $1000 investment times 1 + 5%
interest rate. Today's the investment of $1000 is called the present value and
$1050 is called the future value because it is expressed as future dollars.
Time Value Timeline - Slide 10
This slide depicts a timeline in the following format: Today: Year 0, PV, next it
states Year 1, FV, and an arrow is pointing from year 0 to year 1. Above the
arrow, it states 1+r.
Transcript
More generally, if the interest rate is R for a given period and the present value
is PV, the future value, FV, can be calculated using the formula. Future value
equals to present value times one plus interest rates R. We also draw the
timeline here to show you the time associated with each value.
Investment Question - Slide 11

Suppose you want to have $1,000 a year from today and the interest rate is 5%
How much should you invest today?
Transcript
Now we want to ask an alternative question. Suppose you want to have $1000 a
year from today and the interest rate is 5%. How much should you invest today?
Present Value Calculation (1 of 2) - Slide 12
$1,000
= $952. 38
1 + 5%
Transcript
You can also solve this question by rearranging the formula we just developed.
Using the future value $1000 divided by 1 plus the interest rate 5%, you get
$952.38.
Present Value Calculation (2 of 2) - Slide 13
FV
PV =
1 + r
FV = Future Value
PV = Present Value
r = The appropriate interest rate
Transcript
This is the amount of money you need to invest today to be able to achieve your
investment goal of receiving $1000 in one year. The value of $952.38 is called
the present value of 1000. We can also generalize this relationship as present
value equals to a future value divided by 1 plus the interest rate R.
Present Value Timeline - Slide 14
This slide depicts a timeline in the following format: on the left, it states Today:
Year 0, PV, on the right, it states Year 1, FV, and an arrow is pointing from the
content on the right to the content on the left. Above the arrow, it states 1+r.
Transcript
Suppose you know the future value. We can use this formula to derive the
present value. This process is called discounting. The interest rates R is also
called the discount rate.
Multiple Periods - Slide 15

Suppose you invest $1,000 today at a 5% interest rate. What will the investment
be in 5 years?
Transcript
Until now, we analyze the one period case, which is the simplest, but in real life
we need to deal with multiple periods. For example, we want to know how much
our investment of 1000 will grow to after five years, if the interest rate is 5%.
Incremental Investment Growth - Slide 16
This slide contains a timeline with incremental markings for Years 0–5. The
monetary values for Years 0–2 are $1,000, $1,050, and $1,102.50 respectiviely.
For each hop to an incremental year, it indicates that it multiplies the current
value by (1 + 5%). This formula is explicitly written out for Year 0 to 1 as follows:
$1,000 × (1 + 5%)
Transcript
To answer that question, at the end of year one, the investment will grow into
$1050, which equals to 1000 time 1 plus 5%. The investment at the end of year
one, $1050, will be reinvested during year 2, and also earn an interest of 5%.
Therefore, the ending value of the investment at the end of year 2 will be 1000
times 1 plus 5% to the power of 2. By following this process we need to get the
investment value at the end of year five that equals to 1000 times 1 plus 5% to
the power of 5, which is $1276.28.
Future Value Formula - Slide 17
The general formula for the future value of an investment over multiple periods:
T
FV = PV (1 + r)
FV = Future Value
PV = Present Value
r = The appropriate interest rate
T = The number of periods over which the cash is invested

Transcript
From the description of the investment process. You may notice that you earn
interest on your initial investment $1000 and you will also earn interest on the
interest you earned previously. This process is called compounding. The general
formula for the future value of an investment over multiple periods is equal to the
present value times one plus interest rate R to the power of T. T is the
appearance of time.
Present Value Formula - Slide 18
FV
PV = T
(1 + r)
Transcript
If we know the future value at period T, we can also derive that the present value
equals the future value divided by 1 plus interest rate R to the power of T. We
want to use an example to show you how to use the formula
Example - Slide 19
Suppose you want to prepare $100,000 for your child's college tuition 10 years
from now. An investment opportunity offers you an interest rate of 8%.
Transcript
If we know the future value at period T, we can also derive that the present value
equals the future value divided by 1 plus interest rate R to the power of T. We
want to use an example to show you how to use the formula
Present Value of Investment - Slide 20
This slide depicts a timeline for the Years 0–10, with years 4–9 implicitly
declared with an ellipsis between increments 3 and 10. Above Year 10, the
value $100,000. An arrow from Year 10 points to the following formula:
$100,000
PV = 10
= $46, 319. 35
(1 + 8%)
Transcript
In order to answer this question, we need to identify that the future value is
$100,000. The appropriate interest rate is 8%, and the number of periods is 10
years. By discounting the required ending investment value of $100,000 to the
present, we will yield a present value of $46,319.35.
Net Present Value
Net Present Value

How to Deal With Multiple Cash Flows? - Slide 21
Suppose a project generates a stream of cash flows: $50,000 one year

from now, $60,000 two years later, and $20,000 at the end of the third year
If the interest rate is 8%, and the initial investment needed $100,000, is it
worthwhile to invest in this project?
Transcript
In the previous lesson, we have learnedhow to work on single cash flow, such
as how to convert cash flow from present to the future value and vice versa.
Now,we want to add a new levelof reality to our analysis. We want to know how
to dealwith a stream of cash flows. Suppose a project generates a stream of
cash flows. $50,000 one year from now, $60,000 at the end of year two, and
$20,000 at the end of year three. If the interest rate is 8%, andthe initial
investment needed is $100,000, do you think it is worthwhileto invest in this
project? In order to solve this question, we cannot simply sum up allthe future
cash flows directly and then compare them with the initial outlay. Cash flows at
different points in time cannot be compared directly because their units are
different. For example, you have 10Euros and $12, you cannot argue that $12 is
worth more than 10 Euros because 12 is greater than 10. You have to convert
them to the same currency and then compare which one yields more value.
What we want to do here is to convert all the future values into the same unit,
the present value,and then compare them. One nice thing about the
presentvalue is that they are all expressed in current dollars, so we can add
them up.
Net Present Value for Multiple Cash Flows - Slide 22
This slide depicts a timeline at the top right with years 0–3. Above years 1, 2,
and 3 are the values $50,000, $60,000, and $20,000 respectiviely. Year 0 is
-$100,000. The years 1, 2, and 3 point to the following formulas, respectiviely.
$50,000
PV = = $46, 296. 30
1
((1 + 8%))
$60,000
PV = 2
= $51, 440. 33
(1 + 8%)
$20,000
PV = 3
= $15, 876. 64
(1 + 8%)
The total of these formulas is $13,613.27
Transcript
First, we convert the cash flow in year one into the present value by dividing
$50,000 by 1 plus the interest rate to the power of 1. The present value is
$46,296.30. We repeat this process for the cash flows in year two and year
three and get the corresponding present values. Then, we sum up all these
present values and deduct the initial cost of $100,000 to compute the total
present value as $13,613.27. Because this value is positive, the project's
discounted cash flows are more than enough to pay his initial cost. This project
is worth taking. What we have done can be generalized using mathematical
formulas.
Discounted Cash Flow Formula - Slide 23
To calculate the present value of a stream of future cash flows extending over a
number of years, use the Discounted Cash Flow (DCF) formula.
C1 C2 CT T Ct
PV = + +. . . + = ∑ t
(1 + r) 2 T t=1
(1 + r) (1 + r) (1 + r)
Transcript
The present value of a stream of future cash flows can be calculated by dividing
each cash flow by 1 plus interest rate, r to the power of the corresponding time
period. And then sum up all the discounted cash flows. This formula is called the
Discounted Cash Flow formula, also called DCF. DCF is a widely used toolin
financial valuation.
Net Present Value Formula - Slide 24
To find the Net Present Value (NPV) we add the (usually negative) initial cash
flow:
T Ct
NPV = C0 + ∑
t=1 t
(1 + r)
Transcript
If we take initial cashflow into consideration, we get the Net Present Value
(NPV) of a project. In most cases, the initial cash flow is negative because a
company needs to purchase equipment, build factories, hire employees, and
build up an inventory to start a new project. After the project is established,
positive cash flows will be generated through making goods or providing
services. Once you have the net present value number, you can make your
decision.
Net Present Value (NPV) - Slide 25
The present value of a stream of future cash flows of the investment
NPV>0 ~ Take the project

NPV ≤0 ~ Reject the project
Transcript
The decision rule is that you should accept projects with positive NPV and reject
those projects with a zero, or a negative NPV. You can think of the decision rule
as a cost-benefit analysis. The present value of cash inflows can beconsidered
as the benefits of a project. Well, the cash outflows,are the cost of a project. If
the net present value is positive, it means the total benefits fromthe project
outweigh the costs. Projects with positive NPV increase the earnings of the
company and also create value for shareholders.
Net Present Value Excel Sheet Example - Slide 26

Transcript
Now, let's work on the Excel spreadsheet. First, we need to label the time
periods clearly. So, we label the time. This is 0, 1, 2, and 3 because we have
three years in total. In the second column,we enter our cash flows. The cash
flow information looks like this. For the first year, we have $100,000 of cash
outflow. In the second year, we have $50,000 of cash inflow. And the second
year, $60,000, the third year, $20,000. We have listed all the cashflows in the
second column. We also need to enter the information of the discount rate. The
discount rate, in this case, is 8%. In order to calculate the net present value of
this project, we can use the function called the net present value. The first
argument of the function is the discount rate, 8%. Then we use a comma. Then
we need to include all the cash flows from year one to year three and then a
parenthesis. This is the net present value. But don't forget we need to add the
initial outlay at the very beginning of the project. The net present value of this
project equals to $13,613.27. This number matches what we have done before.
Here, I also want to bring one question to your attention. When we use the net
present value function, a lot of students put all the cash flowsin the net present
value function. They do it like this. They use the net present value function, and
then they use the rate and followed by all the cash flows. All the cash flows and
then do it like this. This is the wrong way to do it because the initial cash flow is
already expressed as the present value. We cannot put it in the net present
value formula. This is the right way to do it. This is the right way to do it and this
is the wrong way to do it. In this example, we useda discount rate of 8%. But we
didn't explain why wepicked 8% instead of 4% or 10%. What is the reasoning
behind it?
Discount Rate - Slide 27
The discount rate r is also called the rate of return, hurdle rate, or opportunity
cost of capital.
Transcript
The discount rate has other names such as the rate of return, hurdle rate, or
opportunity cost of capital.
Opportunity Cost of Capital - Slide 28
The return of a forgone investment option with the same level of risk
Transcript
It is called an opportunity cost because it is the rate of return that is foregone by

investing in this project rather than investing in financial markets. In our
example, the opportunity cost is 8% because we could earn a return of 8%
byinvesting the same amount of money in other financial securities with the
same level of risk involved as in this project. This project should deliver a return
of at least 8%. Otherwise, it's better to invest in other financial instruments. This
is why it is also calledthe hurdle rate because it is the minimum required rate of
return of this project.
Riskier Projects - Slide 29
Higher discount rate
Transcript
Some projects are riskier, like developing new products or expanding the
business into a whole new market. There are a lot of uncertainties with the cash
flows. So, we need to use a higher discount rate to adjust for the risk. Other
projects are pretty safe, such as renovating an existing facility. We should use a
low discount rate for low-risk projects. Suppose you believe the project is as
risky as an investment in the stock market and that the stock investment offers a
15% expected return.
Net Present Value Excel Sheet Example Revisited -
Slide 30
Transcript
This time, we change the discount rate from 8% to 15%. When we change the
discount rate to 15%, the net present value will be changed automatically to
around $2,000. You can see that when the discount rate increases, the net
present value decreases a lot compared to our previous case. The net present
value is still positive, meaning the project is still worthwhile to explore, but it's
not as attractive as the previous case.
Internal Rate of Return - Slide 31
The discount rate that sets NPV to zero
Transcript
A related concept to judge whether we should accept or reject the project is

called the internal rate of return. The internal rate of return is the rate that makes
a project's net present value equals to zero.
Internal Rate of Return Formula - Slide 32
C1 C2 C3 CT
0 = C0 + + + +. . . +
2 3 T
1 + IRR
(1 + IRR) (1 + IRR) (1 + IRR)
Transcript
Internal rate of return, IRR, can be thought of as a project's inherent growth rate,
so the IRR is the discount rate that sets MPV to 0.
A Single Project - Slide 33
Accept if IRR is greater than the required rate of return
Transcript
The decision rule of using IRR is to accept the project if the IRR is higher than
the required rate of return. This makes sense because it means that the return
from this project is higher than the return from other available investment
opportunities with the same level of risk.
Ranking Multiple Projects - Slide 34
Pick the one with the highest IRR
Transcript
If there are multiple projects foryou to choose from and you have to pick one,
just pick the one with the highest IRR. Solving for IRR manually is very tedious,
but it's pretty easy to solve the equation using an Excel spreadsheet.
Calculating IRR Excel Example - Slide 35

Transcript
Let's use the previous example and solve for the project's IRR. In this Excel
spreadsheet, let's use the previous example and solve for the project’s internal
rate of return. And in this example, we list all the cash flows in the second
column, and we list the time in the first column. In order to calculate the internal
rate of return, we just use the function, internal rate of return, followed by all the
cash flows from the beginning to the end, and this is the internal rate of return.
The internal rate of return 16% is higher than the discount rate, so we can argue
that this project is a good one and we need to go ahead with the project.
Normally, the decision you made using IRR, will be the same as using their net
present value, just like in this example. Both methods are very popular among
financial managers.
APR and EAR

Compounding Interest - Slide 36
Transcript
In previous lessons, we assume that the interest is compounded yearly, but in

reality this may not be the case.
APR With Credit Cards - Slide 37
This slide shows an image of the Citi website and their Citi Simplicity Credit
Card. The page details the features of the card, like the Purchase Rate, which
mentions the APR, Balance Transfer Rate, and Annual Fee.
Transcript
Suppose you buy a certificate of deposit from a bank. The interest payment may
occur daily, monthly or semi annually, depending on which bank you choose.
Some banks pay continuously, the compounded interest rate, which means you
aren't interested at every moment. Let's take a look at some real world
examples and see how to deal with the compounding frequency problem. When
we apply for credit cards, there is a very important term for us to consider, which
is called the annual percentage rate, APR. Here are some example quotes used
by different credit cards. The APR is the rate of the loan based on a person's
credit history. If you have an excellent credit score, you may get a 10% APR.
For a person with a bad credit score, the credit card company may charge a
25% APR.
Annual Percentage Rate (APR) - Slide 38
Annual percentage rate (APR): the rate that a bank is required to quote on
loans it extends
APR is a simple interest rate that does not consider compounding.
Transcript
APR is the rate that a bank is required to quote the loan it offers to borrowers.
APR is a simple interest rate without considering compounding that equals the
periodic interest rate times the number of compounding periods in a year.
APR - Slide 39
What would the end of year payment be if you were offered an APR of 15%
compounded monthly on a $1,000 loan?
Transcript
How do you understand APR? Suppose you have just applied for a new credit
card and the APR is 15% compounded monthly. We want to investigate how
much you need to pay back one year later if you borrow $1000 now. You cannot
use $1000 times 1 plus 15% and say the final repayment is $1150, because the
APR is not compounded annually.
End of Year Payment Formula - Slide 40
12
15%
$1000(1 + ) =
12
Transcript
First, we need to divide 15% by 12 to get the monthly interest rate. And then let
the $1000 compound and that monthly rate for 12 times a year. The end of the
year payment should be $1160.75.
End of Year Value - Slide 41
Compounding an investment m times per year for T years with stated interest
rate r provides the end of year wealth:
mT
r
FV = PV (1 + )
m
Transcript
In general, the end of year value can be expressed as the present value times
one plus the annual percentage rate are divided by compounding periods M and
to the power of M times the number of years T.
Which Loan Would You Want To Get? - Slide 42

1. An APR of 18% compounded daily
2. An APR of 18% compounded monthly
Transcript
Let's take a look at how to use the formula to compare different loan options.
Suppose you want to apply for a three year loan and there are three options
from different financial institutions. The first offers you a 18% APR compounded
daily, while the second offers you an APR of 18% compounded monthly, and the
third offers an APR of 18.5% compounded semiannually. Which one is the best
choice for you?
Calculating Ending Value - Slide 43

Ending Value Calculation
Initial Compounding Ending
APR Formula
Value Frequency Value
365×3
$100,000 18.0% 365 = $100, 000 × (1 +

18%
365
) $171,578
Transcript
From the appearance, the first one and the second one have exactly the same
APR. But they are compounded differently. The third choice charges you a
higher APR, but the compounding frequency is low. Let's work on the numbers.
The first choice is 18% compounded daily, so you need to use 18% / 365 to get
the daily interest rate and compound for each day within three years. If you take
out $100,000 loan, the ending value you need to pay back is $171,578. As you
repeat the process for option two and option three, you will find that the third
choice is the cheapest option, because you just need to pay back $170,031.
Effective Annual Rate (EAR) - Slide 44
The Effective annual rate (EAR) of interest is the true annual rate that would
give us the end of investment wealth.
Transcript
The lesson from this example is that you need to care about the APR as well as
compounding frequency when you take out a loan. The compounding frequency
can also make a big difference. The higher the compounding frequency, the
more interest you need to pay. That's bad news for a person who want to borrow
money. But for an investor who to make investments, a higher compounding
frequency is great news because they can earn interest more frequently, and
their ending value will be higher. APR is an interest rate without considering
compounding. It is not convenient for us to compare different APR offers directly.
In real life, we are also interested in the real rate of return on investment
considering the effect of compounding interest. The concept is called the
effective annual rate, EAR, also called effective annual yield, EAY, or annual
percentage yield, API. Based on the EAR, we can calculate the end of
investment values directly. The major difference between the APR and EAR is
whether they consider compounding or not.
Convert APR to EAR - Slide 45
If the stated annual interest rate r is compounded m times a year, the Effective
annual rate (or effective annual yield) is as follows:
m
r
EAR = (1 + ) − 1
m
Transcript
If we were given the value of APR, we can convert it into EAR using the
equation like this. EAR equals to 1 plus annual percentage rate R divided by the
compounding frequency M and to the power of M minus one.
APR to EAR Conversion Formula - Slide 46

APR to EAR Conversion Table
APR Compounding Frequency Formula EAR
365
18.0% 365 (1 +

18%
) − 1 19.72%
365
12
18.0% 12 (1 +
18%
12
) − 1 19.56%
18.5% 2 (1 +
18.5%
) − 1 19.36%
2
Transcript
Let's use the previous three offers to see what the corresponding EAR for each
option is. The first option, 18% APR compounded daily, is equivalent to 19.72%
compounded annually. 18% compounded monthly is the same as 19.56%
annual interest rate. And the third option, 18.5% compounded semiannually, is
the same as 19.36% compounded annually. Using the relationship, you can
convert any APR into EAR and vice versa. Using the EAR, you can compare the
offers directly, because all of them are annualized interest rates. Since 19.36%
is the lowest EAR among these three options, this is the best choice for a
borrower. From lenders perspective, the first choice is the best one because it
provides the highest return.
Continuous Compounding - Slide 47
Transcript
We learned that interest can be compounded annually, quarterly, monthly, and

daily. You may ask, what is the limit of compounding frequency? Actually, the
compounding frequency can go to infinity, and this is called continuous
compounding, meaning that the interest compounds every single instant. You
can also think of this situation as interest payments
Future Value Formula - Slide 48
The future value of an investment compounded continuously over T years:

rT
FV = PV × e
Where r is the stated annual interest rate, T is the number of years, and e is the
base of natural logarithms i.e., 2.71828
Transcript
evenly spread out the whole year without stopping. The future value of an
investment after T years can be expressed as the present value times E to the
power of stated interest rate R times T years. E is the base of natural log which
equals to 2.71828.
Certificate of Deposit - Slide 49
Suppose you invest $10,000 in a CD (certificate of deposit) for three years.
Transcript
Suppose you invest $10,000 in a certificate of deposit, CD, for three years.
Ending Value of CD - Slide 50
Suppose you invest $10,000 in a CD (certificate of deposit) for three years. The
CD pays 8% annual interest compounded continuously.
What is the value of your investment at the end of Year 3?

Transcript
Here, I would like to explain a little bit about the CD. A CD works like this: You
deposit a certain amount of money for a fixed term, such as one year, three
years, or five years. The bank offers a higher interest rate than a regular savings
account, but you are expected to hold it until maturity. If you want to withdraw it
early, you are subject to a penalty. This CD pays 8% annual interest,
compounded continuously, so what would be the value of your investment at the
end of year 3?
Future Value of CD Formula - Slide 51
rT 0.08×3
FV = PV × e = $10, 000 × e = $12, 712. 49
Transcript
We calculate the ending value by multiplying the initial investment in CD,

$10,000, with E to the power of 8% times 3 years. The CD will grow to
$12,712.49 at the end of three years. With all else equal, continuous
compounding yields the highest return if you compare it to all the other
compounding intervals.
Perpetuity and Annuity
Perpetuity
Perpetuity - Slide 52
A constant stream of cash flow (C) that lasts forever
Transcript
In this lesson, we will discuss some special patterns of cash flows. If cash flows
follow a special pattern, we can use shortcut formulas that will save us a lot of
work. The first one is called perpetuity. A perpetuity is a constant stream of cash
flows that lasts forever.
Stream of Cash Flows - Slide 53
This slide depicts a timeline with years 0-3. Years 1, 2, and 3 are also labeled C.
Transcript
If you pay close attention to the cash flow, you will find that the cash flows are
constant, the time interval between two cashflows are equal, and the first the
cash flow occurs at time one. These characteristics can help us to identify
whether a stream of cash flows is perpetuity or not.
Present Value of Perpetuity - Slide 54
C C C
PV = + 2
+ 3
+. . .
(1 + r) (1 + r) (1 + r)
Transcript
If a stream is perpetuity, the present value of the cash flows can be written as
the sum of each cash flow discounted to the present. Notice all the cash flows
are future values and there's no cash flow at time 0. There are infinite terms in
this geometric series. But the good news is that the sum is a finite number,
which equals to the cash flow C divided by interest rate R. Here, we also
assume the discount rate is constant throughout time.
Perpetuity Concept - Slide 55
When you deposit the $100, the interest it earns each year will be: $100 × 8% =
$8
When you deposit the $100, the interest it earns each year will be: $100 × 8% =
$8 This slide depicts a timeline with years 0-3. Year 0 is labeled with $100.
Years 1, 2, and 3 are each labeled with $8.
Transcript
To understand the meaning of this shortcut, imagine that you deposit $100 in a
bank at an interest rate of 8%. At the end of year one, you will have $108.00 in
your bank account. You then withdraw $8.00 and reinvest the remaining $100
for another year. At the end of each following year, you withdraw the same
amount of money of $8.00 and the reinvest $100. You just create opportunity all
by yourself.
Perpetuity Interest Payment - Slide 56
In general, suppose we deposit the amount

C
The interest it earns each year will be

C
× r = C
r
Transcript
In this example, the cash flow is $8.00 and the interest rate is 8%. Then the
present value of all cash flows is just $100. To generalize the relation, suppose
you deposit a fixed amount of money C over R, in a bank. Then the interest
payment in each period will be this amount of money times the interest rates
are, which is just the amount of cash flow C.
British Consol Bonds (1 of 2) - Slide 57
Perpetual bonds
An investor is entitled to receive an annual interest payment from the British
government forever
Transcript
A real world example of a financial instrument with perpetual cash flows is the
British issued bonds called console bonds. By investing in the consoles, an
investor is entitled to receive annual interest payments from the British
government forever.
British Consol Bonds (2 of 2) - Slide 58

The British government issued consol bonds that pay £50 of interest every
year forever.
The appropriate discount rate is 3.5%
This slide depicts a timeline with years 0–3. Years 1, 2, and 3 are each labeled
with £50.
Transcript
Investors are interested in perpetual bonds because they provide a steady and
reliable cash flow on a regular schedule. Now, we want to see how to value a
console bond. Suppose the British government issued the console bonds that
pay £50 of interest each year forever with an appropriate discount rate of 3.5%.
What would be the price of the console bond?
Console Bound Solution - Slide 59
£50
PV =
C
r
=
3.5%
= £1, 429
Transcript
To solve the price of the console bond, let's use the cash flow amount, which is
50 pounds divided by the appropriate discount rate of 3.5%, and the derived
value, which is 1429 pounds.
Growing Perpetuity - Slide 60
Growing stream of cash flows that lasts forever

2
C C×(1 + g) C×(1 + g)
PV = + 2
+ 3
+. . .
(1 + r) (1 + r) (1 + r)
Transcript
Sometimes the cash flows of perpetuity are not all fixed. They increase at a
constant rate with time. We call this pattern a growing perpetuity. The basic
valuation rule is also the sum of all the present value of cash flows. There are
infinite number of cash flows in the future, but fortunately we have a shortcut
formula for growing perpetuity.
Present Value of Cash Flow with Constant Growth
Rate - Slide 61
C
PV =
r−g
Transcript
Suppose the cash flow is C at time one that increases at a constant growth rate
G with the appropriate discount rate R. The present value of the growing
perpetuity can be expressed as C divided by R minus G.
Growing Perpetuity Example - Slide 62

A mature firm is expected to generate $1.5 million of cash flow next year, and
the cash flow is expected to grow at 5% forever.
Transcript
To use the growing perpetuity formula. You have to make sure that the discount
rate is higher than the growth rate. Otherwise, the formula will not make any
sense. Let's look at an example of how to work with growing perpetuity.
Suppose there is a mature firm that expects to generate 1.5 million dollars of
cash flow next year. And the cash flows are expected to grow at a rate of 5%
each year forever. If we adopt a discount rate of 10%, what is the value of this
firm?
Interest Payment Timeline - Slide 63
This slide depicts a timeline with years 0–3. Year 1 is labeled: $1.50. Year 2 is
labeled: $1.50(1.05). Year 3 is labeled: $1.50(1.05)2. A key shows the units for
the values as $ millions. Above years 1–3, it shows the following 3 values or
formulas:
$1.50
$1.50×(1.05)
2
$1. 50 × (1. 05)
Transcript
First, let's use a timeline to show the future cash flows of the firm. The first cash
flow 1.5 million dollars occurs at the end of year one. Year 2 cash flow is 1.5
million dollars times one plus the growth rate 5%. And third year cash flow is 1.5
million dollars times 1 + 5% to the power of 2, so on so forth until infinity.
Present Value of Perpetuity Formula - Slide 64
$1.5 million
PV = = $30 million
10%−5%
Transcript
We can tell that the cash flows are growing perpetuities. Let's use the growing
property formula and plug in the numbers. The first cash flow, 1.5 million dollars,
divided by the discount rate, 10%, subtracted by 5% growth rate, gives us the
firm value of $30,000,000. We can use this number as a ballpark estimate of the
value of a business. In reality, there are a lot of uncertainties we should be
aware of. For example, the next year's cash flow may not be 1.5 million dollars,
the discount rate and growth rate may change overtime, and the company may
not last forever. This exercise is still helpful because some numbers are better
than no number. At least we will get a rough idea about the value of business.
Annuity
Annuity - Slide 65
A stream of equal cash flow for a given number of periods. Its payments stop
after T periods
Transcript
In this lesson, let me introduce you to another special pattern of cash flows
called annuities. An annuity is a stream of cash flows that last for a given
number of periods.
Timeline of Annuity Cash Flow - Slide 66

This slide depicts a timeline labeled: Annuity. The timeline spans years 0–t and
shows ticks for years 0, 1, 2, and t. Years 1, 2, and t are labeled C.
Transcript
This is a timeline that shows the cash flows of an annuity. We can tell that it
looks a lot like perpetuity. The only difference between the perpetuity and
annuity is whether the cash flow will stop at some point or not.
Difference Between Perpetuity and Annuity - Slide 67
This slide shows 3 timelines, one for Annuity, one for Perpetuity A, and one for
Perpetuity B. The timeline for Annuity covers years 0–t, and the timelines for
Perpetuity A and Perpetuity B cover years 0–t+1. Each of the ticks in each
timeline are labeled C.
Transcript
To derive the present value of an annuity, let's start from what we have learned
before. We can see an annuity as the difference between two perpetuities. The
first one, Perpetuity A, is an ordinary perpetuity that starts at time one. Another
one, Perpetuity B, is a perpetuity that starts at time T plus one. We can also call
it a delayed perpetuity.
Present Value of Perpetuity A - Slide 68
This slide depicts a timeline for Perpetuity A over years 0–t+1. Each tick in the
timeline is labeled C. The following formula is also included:
C
PVA =
r
Transcript
If we can get the present value of these two perpetuities, the annuity can be
valued. The present value of perpetuity A is just C over R.
Value of Perpetuity - Slide 69

This slide shows a timeline for Perpetuity B over years 0–t+2. Years t+1 and t+2
are labeled C. These years are also pointing to the following formula:
C
Value @t =
r
Transcript
Let me explain how to deal with perpetuity B. If we divide C by R, we get the

value of perpetuity B at time T. We need to go one step further to convert this
value to the present value by dividing it by 1 plus R to the power of T.
Present Value of Annuity - Slide 70
This slide shows 3 timelines: one for Annuity, one for Perpetuity A, and one for
Perpetuity B. The Annuity timeline is over years 0–t, and the timelines for
Perpetuity A and B are over years 0–t+1. Each of the tick marks is labeled C.
The following formulas correspond to the Annuity, Perpetuity A, and Perpetuity B
timelines, respectively.
C C 1
PV = PVA − PVB = − [ t
]
r r
(1 + r)
C
PVA =
r
C 1
PVB = [ t
]
r
(1 + r)
Transcript
Since both of them I expressed as today's dollars, we can calculate the

difference of perpetuity A and perpetuity B and get the result for the present
value of the annuity.
Present Value of Annuity Formula - Slide 71
C C 1
Present Value of Annuity = − [ t
]
r r
(1 + r)
C 1
PV = [1 − t
]
r
(1 + r)
1
1−
t
(1 + r)
PV = C[ ]
r
Transcript
The annuity formula can also be simplified into this equation. The first part is the
periodic payment C and the second part, in the parenthesis, is called the annuity
factor.
Annuity (1 of 3) - Slide 72
You are looking to buy a car and applying for auto loans from your local bank.
Transcript
Let's use an example to understand how annuity works. Suppose you are
looking to buy a car and applying for auto loans from your local bank.
Based on your excellent credit score, the local bank charges you an APR of
3.6% compounded monthly.
Transcript
charges you an APR of 3.6%, compounded monthly.
According to your income, the maximum amount you can pay is $600 per month
for three years, and payments are scheduled at the end of each month. In this
case, no down payment is required.
Transcript
According to your income, the maximum amount you can pay is $600 per month
for three years, and the payment is scheduled at the end of each month. In this
case, there's no need for a down payment. How much is the car that you can
afford?
Future Value of Annuity - Slide 75
$600 1
PV = [1 − 36
]= $20, 445
0.3% (1 + 0.3%)
Transcript
The stream of payment is an annuity. One small thing we need to do first is to

convert APR of 3.6% into a monthly interest rate of .3%. The monthly payment
of $600 is the periodic cash flow, and there are 36 payments in total because
you need to pay 12 times a year for three years. By plugging in these values into
the annuity formula, we do get the maximum cost of the car as $20,445.
Annuities with Excel Spreadsheet - Slide 76

Transcript
If you feel this is too much math for, you can also try to solve the question using
Excel spreadsheet. In this example, you need to enter three values in the Excel
spreadsheet. The first one is the discount rate, and for the discount rate we
need to use the APR which is .036 divided by 12 month so that we can get the
monthly discount rate. So the monthly discount rate is .3%. And the next column
is the number of periods. So for the number of periods we need to use 12 times
three years. OK, so the total number of periods equals to 36, and for the
periodic payment, we use -600, because for each month we need to pay $600.
So we have three arguments over here, and using these three arguments, we
can calculate the present value. And in order to calculate the present value, we
use an Excel function PV so equals to the present value, and the first argument
is the monthly discount rate. And the second argument is the number of periods
of payments. And the third argument is the periodic payment and then
parenthesis. So our present value equals to $20,445. And you will find out that
this value is exactly the same as the present value of annuity we calculated
before.
Periodic Payment - Slide 77
Suppose you would like to buy a house that costs $350,000. You plan to make a
20% down payment using your savings and take out a 30-year fixed-rate
mortgage to finance the remaining part. Your local bank charges you an APR of
4.5% compounded monthly.
Transcript
Another application of annuity is to calculate the periodic payment f we know the

present value of an annuity. Let's look at this example. Suppose you would like
to buy a house that cost the $350,000. You plan to make a 20% down payment
using your savings and take out a 30 year fixed rate mortgage to finance the
remaining part. Your local bank charges you an APR of 4.5%, compounded
monthly. How much should you pay each month?
Monthly Interest Rate - Slide 78
Monthly interest rate = 4.5% ÷ 12 = 0.375%
Transcript
To solve this question, we first use the APR, 4.5%, divided by 12, to determine
the monthly interest rate, .375%. Then, we compute the total amount of the loan,
which is 80% of the house price, because you have already paid 20% as down
payment. Then we set up the annuity equation.
Present Value of Annuity Formula - Slide 79
C 1
PV = $280, 000 = [1 − 360
]
0.375% (1 + 0.375%)
C = $1,419
Transcript
The left hand side is the amount of the loan, $280,000, and the right hand side
is the annuity formula with all the numbers plugged in. The only unknown in this
equation is the monthly payment. Solving this equation, we get the monthly
payment of $1,419.
Present Value with Excel Spreadsheet - Slide 80
Transcript
An alternative way to solve this equation is to use an Excel spreadsheet. In this

Excel spreadsheet, we need 3 inputs. The first one is the monthly interest rate.
Because we have the APR over here, we need to use the APR, .045, divided by
12, to get the monthly interest rate. So the discount rate equals to .375%. And
for the number of periods, we use 12 times 30 because there are 12 months and
the 30 years, so the total number of payments equals to 360. And the present
value equals to the total value of the house, $350,000, times 80%. So in total,
the total amount of the loan equals to $280,000, and in order to calculate the
periodic payment, we use a function. So this is a financial function in Excel
called PMT. Using the PMT function, the first argument is the discount rate, the
monthly rate, and the second argument is the number of periods, 360, and then
followed by the present value $280,000, and then we put parenthesis over here.
So we got our periodic payment equals to $1,419. So remember this is a
negative value because this is a cash outflow. And you will find out that the
monthly payment result matches our previous results.
Growing Annuity (1 of 5) - Slide 81
A growing stream of cash flows for a given number of periods
Transcript
Now, let's talk about growing annuity. A growing annuity looks just like growing
perpetuity, but with an ending point.
This slide shows a timeline for years 0–t. Above the years 1, 2, 3, and t, the
following formulas, respectively.
C
C×(1+g)
2
C × (1 + g)
t−1
C × (1 + g)
The following two formulas are also included:

2 t−1
C C×(1+g) C×(1+g) C×(1+g)
PV = + + +. . . + t
2 3
(1+r) (1+r) (1+r) (1+r)
t
C 1+g
PV = [1 − ( ) ]
r−g 1+r
Transcript
Suppose the initial cash flow at time 1 is C. The cash flow rolls at a constant
growth rate G, and the appropriate discount rate is R. To value a growing
annuity, we discount each cash flow to the present, and then sum them up. The
formula can be simplified like this. If you want to understand it better, try to prove
this formula or yourself. You would need to create the two growing perpetuities.
One start at time 1 and the other start at time T plus one. The difference
between the present value of two growing perpetuities is just the value here.

Suppose you get a job offer and the starting salary is $100,000 a year, paid
at the end of each year
The salary is expected to rise by a constant rate of 3% each year and you
are going to work for 40 years.
Transcript
Let's see an example of a growing annuity. Suppose you get a job offer and the
starting salary is $100,000 a year paid at the end of each year. The salary is
expected to rise by a constant rate of 3% each year, and you are going to work
for 40 years. What is the present value of this job offer if the discount rate is
8%?
This slide shows a timeline for the years 0–40. There are ticks for the years 0, 1,
2, and 40. Above years 1, 2, and 40 are the following values or formulas,
respectively:
$100,000
$100,000×(1.03)
39
$100, 000 × (1. 03)
Transcript
To evaluate the job offer, we need to collect all the inputs from the question. The
initial cash flow at time 1 is $100,000, the growth rate is 3%, discount rate 8%,
and the time horizon 40 years.
40
$100,000 1+3%
PV = [1 − ( ) ] = $1, 699, 691
8%−3% 1+8%
Transcript
By plugging in these values into the growing annuity, we get the present value of
this job offer as around 1.7 million dollars. When you have multiple job offers,
you can use this method to compare them and decide which one is more
attractive financially. Of course, salary is not the only thing you need to consider.
You also need to think about the one that provides more opportunities for your
future growth and the one that helps to achieve your career goals.
Module 4 Wrap Up
Module 4 Wrap Up
Transcript
In this module, we learned what time value of money is. First, we introduced two
basic concepts, present value and future value. For any cash flows, you should
be able to convert it from the present value to the future value, and vice versa.
This is the basic skill we need to master before we do any tricks. Based on that,
we learned the net present value.
Net Present Value (NPV) - Slide 87
Transcript
A project should be accepted if its net present value is positive, because it

creates value for shareholders. Otherwise, we reject the project.
Internal Rate of Return (IRR) - Slide 88
Transcript
Alternative criterion to judge a project is the internal rate of return. It is the return
that equates the cash inflows and
APR vs. EAR - Slide 89
Annual Percentage Rate (APR) vs Effective Annual Rate (EAR)
Transcript
cash outflows. If the internal rate of return is higher than the opportunity cost of
capital, then the investment has a positive net present value. The net present
value and internal rate of return are basic tools for us to make financial
decisions. We also learn the difference between the annual percentage rate and
the effective annual rate. The APR is the rate financial institutions quote. It is the
rate without considering compounding. The effective annual rate is the
equivalent interest rate, compounded annually. For any APR, you need to know
how to convert it to an EAR. The last part of the module is devoted to special
patterns
Perpetuity and Annuity - Slide 90
Transcript
of cash flows, such as perpetuity and annuity. We talked about how to identify a
perpetuity, a growing perpetuity, an annuity, and a growing annuity, how to
compute the present values of these cash flows, how to use the Excel
spreadsheet to derive values, and some real world examples? Overall time
value of money has wide applications in our daily life. You will use time value of
money when you apply for a credit card, apply from auto loan, apply for a
mortgage, save for your child's college education, compare multiple job offers,
create your retirement plan, and make any investments. Whenever you make
important financial decisions in the future, I hope you can use what we have
learned in this class to make a better decision.

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Table of Contents

This Gies eBook is based on an extended video lecture transcript

Each Gies eBook is broken down by lessons that are navigable

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Published by the Gies College of Business at the University of Illinois

Basic topics of finance

In this module, let's get introduced to the basics of Finance. In order

The Way a Business is Organized - Slide 2

Local cafe vs. Starbucks

Provide employment opportunities

What are the basic legal forms to organize firms?

In this module, let me introduce you to three basic legal forms to

Introduction of the Three Legal Forms to

Three legal forms to organize firms - Slide 5

The Sole Proprietorship

The Sole Proprietorship - Slide 6

A sole proprietorship is an unincorporated business owned and

The first form to organize your business is called sole proprietorship.

In 1901, Charles R. Walgreen Sr., a pharmacist in Chicago,

Here I want to share with some history about Walgreens Company.

Now we want to talk about the advantages and disadvantages of a

Unlimited liability for the owner

Most small businesses with 1 to 10 employees are sole

Two or more people own a business together.

Instead of starting a business on your, you may want to pull money,

Specify the rights and duties of the partners.

In most cases, partners will have a formal partnership agreement in

Easily and inexpensively formed

Here are the list of advantages and disadvantages of partnership.

Unlimited liability for general partners

Partners soap reporters have the disadvantage of unlimited liability.

This mechanism provides an incentive for partners since they share

On one hand, this provides enough incentives for partners to do their

Individual partners have unlimited liability in the firm, which

A corporation is a separate legal entity. In a legal context, it is a legal

A Corporation is a legal entity that, separated from its owners.

As a legal person, the corporation can own property, sign

As a legal person, the Corporation enjoys a lot of the legal powers of

Closely held corporations: at the early stage of development, the

When a Corporation was initially established. The shares were held

Corporations have a completely independent life, separate from its

Corporations also have its downsides. Unlike sole proprietorships

In the United States, corporations are formed under state law,

Just when a new baby is born, there's an official document called

This slide shows an image of Target corporation's articles of

The Articles of incorporation outlines the basic information needed to

From slide 24: This slide shows an image of Target corporation's

No instruction provided on this slide.

You also layout how a Corporation should be governed. It specifies

This slide shows the article 5 header of the articles of incorporation

Actions by stockholders without a meeting and the authority to call

Here are some examples of large corporations. They are household

In terms of revenue and profits produced, a corporation is

The Hybrid Form

A business can also be organized. Some hybrids of the basic forms.

Limited Liability Company

Limited Liability Company

LLC: Articles of Organization and Operating Agreement

LLC: members and interests