1-1

1-2 Key Concepts and Skills Have a good understanding of: The basic types of financial management decisions and the role of the financial manager The goal of financial management The financial implications of the different forms of business organization The conflicts of interest that can arise between owners and managers

1-3 Basic Areas Of Finance 1.Corporate finance = Business Finance 2.Investments 3.Financial institutions 4.International finance

1-4 Investments Work with financial assets such as stocks and bonds Value of financial assets, risk versus return, and asset allocation

1-5 Financial Institutions Companies that specialize in financial matters –Banks – commercial and investment, credit unions, savings and loans –Insurance companies –Brokerage firms

1-6 International Finance An area of specialization within each of the areas discussed so far May allow you to work in other countries or at least travel on a regular basis Need to be familiar with exchange rates and political risk Need to understand the customs of other countries; speaking a foreign language fluently is also helpful

1-7 Finance and … Marketing –Budgets, marketing research, marketing financial products Accounting –Dual accounting and finance function, preparation of financial statements Management –Strategic thinking, job performance, profitability Personal finance –Budgeting, retirement planning, college planning, day-to-day cash flow issues

1-8 Business Finance Some important questions that are answered using finance –What long-term investments should the firm take on? –Where will we get the long-term financing to pay for the investments? –How will we manage the everyday financial activities of the firm?

1-9 Financial Management Decisions Capital budgeting –What long-term investments or projects should the business take on? Capital structure –How should we pay for our assets? –Should we use debt or equity? Working capital management –How do we manage the day-to-day finances of the firm?

1-10 Forms of Business Organization Three major forms in the United States Sole proprietorship Partnership –General –Limited Corporation –S-Corp –Limited liability company

1-11 Sole Proprietorship Advantages –Easiest to start –Least regulated –Single owner keeps all of the profits –Taxed once as personal income Disadvantages –Limited to life of owner –Equity capital limited to owner’s personal wealth –Unlimited liability –Difficult to sell ownership interest Business owned by one person

1-12 Partnership Advantages –Two or more owners –More capital available –Relatively easy to start –Income taxed once as personal income Disadvantages –Unlimited liability General partnership Limited partnership –Partnership dissolves when one partner dies or wishes to sell –Difficult to transfer ownership Business owned by two or more persons

1-13 Corporation Advantages –Limited liability –Unlimited life –Separation of ownership and management –Transfer of ownership is easy –Easier to raise capital Disadvantages –Separation of ownership and management (agency problem) –Double taxation (income taxed at the corporate rate and then dividends taxed at personal rate, while dividends paid are not tax deductible) A legal “person” distinct from owners and a resident of a state

1-14 International Corporate Forms Joint stock companies Public limited companies Limited liability companies All share: –Public ownership –Limited liability

1-15 Goal Of Financial Management What should be the goal of a corporation? –Maximize profit? –Minimize costs? –Maximize market share? –Maximize the current value per share of the company’s existing stock –Maximize the market value of the existing owners’ equity

1-16 Goal Of Financial Management Does this mean we should do anything and everything to maximize owner wealth? –Outsourcing? –Off-shoring? –Enron? –Corporate support of charities?

1-17 The Agency Problem Agency relationship –Principal hires an agent to represent its interests –Stockholders (principals) hire managers (agents) to run the company Agency problem –Conflict of interest between principal and agent Management goals and agency costs

1-18 Do Managers Act in the Shareholders’ Interests? Managerial compensation –Incentives can be used to align management and stockholder interests –Incentives need to be carefully structured to insure that they achieve their goal Corporate control –Threat of a takeover may result in better management Other stakeholders

1-19 Cash Flows Between the Firm and the Financial Markets Figure 1.2

1-20 Financial Markets Cash flows to the firm Primary vs. secondary markets –Dealer vs. auction markets –Listed vs. over-the-counter securities NYSE NASDAQ

2-21 Key Concepts and Skills Know: –The difference between book value and market value –The difference between accounting income and cash flow –The difference between average and marginal tax rates –How to determine a firm’s cash flow from its financial statements

2-22 The Balance Sheet A snapshot of the firm’s assets and liabilities at a given point in time (“as of …”) Assets −Left-hand side (or upper portion) −In order of decreasing liquidity Liabilities and Owners’ Equity –Right-hand side (or lower portion) –In ascending order of when due to be paid Balance Sheet Identity  Assets = Liabilities + Stockholders’ Equity

2-23 The Balance Sheet Net working capital –Current Assets minus Current Liabilities –Usually positive for a healthy firm Liquidity −Speed and ease of conversion to cash without significant loss of value −Valuable in avoiding financial distress Debt versus Equity −Shareholders’ equity = Assets - Liabilities

2-24 Market vs. Book Value Book value = the balance sheet value of the assets, liabilities, and equity. Market value = true value; the price at which the assets, liabilities, or equity can actually be bought or sold. –Market value and book value are often very different. Why? –Which is more important to the decision- making process?

2-25 Income Statement The income statement measures performance over a specified period of time (period, quarter, year). Report revenues first and then deduct any expenses for the period End result = Net Income = “Bottom Line” –Dividends paid to shareholders –Addition to retained earnings Income Statement Equation: Net Income = Revenue - Expenses

2-26 Financial Statements GAAP Matching Principle: –Recognize revenue when it is fully earned –Match expenses required to generate revenue to the period of recognition Noncash Items –Expenses charged against revenue that do not affect cash flow –Depreciation = most important

2-27 Financial Statements Time and Costs –Fixed or variable costs –Not obvious on income statement Earnings Management –Smoothing earnings –GAAP leaves “wiggle room”

2-28 Taxes Marginal vs. Average tax rates –Marginal – % tax paid on the next dollar earned –Average – total tax bill / taxable income –If considering a project that will increase taxable income by $1 million, which tax rate should you use in your analysis?

2-29 The Concept of Cash Flow Cash flow = one of the most important pieces of information that can be derived from financial statements The accounting Statement of Cash Flows does not provide the same information that we are interested in here Our focus: how cash is generated from utilizing assets and how it is paid to those who finance the asset purchase.

2-30 !! Cash Flow !!

3-31 Key Concepts and Skills Know: –How to standardize financial statements for comparison purposes –How to compute and interpret important financial ratios –The determinants of a firm’s profitability and growth Understand the problems and pitfalls in financial statement analysis

3-32 Standardized Financial Statements Common-Size Balance Sheets –All accounts = percent of total assets (%TA) Common-Size Income Statements –All line items = percent of sales or revenue (%SLS) Standardized statements are useful for: –Comparing financial information year-to-year –Comparing companies of different sizes, particularly within the same industry

3-33 Prufrock Corporation Balance Sheets - Table 3.1

3-34 Prufrock Corporation Common-Size Balance Sheets Table 3.2

3-35 Ratio Analysis Allow for better comparison through time or between companies Used both internally and externally For each ratio, ask yourself: –What the ratio is trying to measure –Why that information is important

3-36 Categories of Financial Ratios Liquidity ratios or Short-term solvency Financial leverage ratios or Long-term solvency ratios Asset management or Turnover ratios Profitability ratios Market value ratios

3-37 Table 3.5

3-38 Liquidity Ratios Current Ratio = CA / CL –708 / 540 = 1.31 times Quick Ratio = (CA – Inventory) / CL –“Acid Test” –( ) / 540 = 0.53 times Cash Ratio = Cash / CL – 98/ 540 =.18 times

3-39 Financial Leverage Ratios Total Debt Ratio = (TA – TE) / TA –(3588-2,591) / 3588 = 0.28 times Debt/Equity = TD / TE –(0.28/0.72) = 0.39 times Equity Multiplier = TA/TE = 1 + D/E –($1 /0.72) = 1.39

3-40 Financial Leverage Ratios Times Interest Earned = EBIT / Interest –691/141 = 4.9 times Cash Coverage = (EBIT + Deprec) / Interest –( ) / 141 = 6.9 times

3-41 Asset Management: Inventory Ratios Inventory Turnover = COGS / Inventory –1344/422 = 3.2 times Days’ Sales in Inventory = 365 / Inventory Turnover –365 / 3.2= 114 days

3-42 Asset Management: Receivables Ratios Receivables Turnover = Sales / AR –2311/188 = 12.3 times Days’ Sales in Receivables = 365 / Receivables Turnover –365 / 12.3 = 30 days

3-43 Asset Management: Asset Turnover Ratios Total Asset Turnover = Sales / Total Assets –2311/3588 = 0.64 times Capital Intensity Ratio = 1/TAT –1/0.64 = 1.56

3-44 Profitability Measures Profit Margin = NI / Sales –363/2311 = 15.7% Return on Assets (ROA) = NI / TA –363/3588 = 10.12% Return on Equity (ROE) = NI / TE –363 / 2591 = 14.01%

3-45 Market Value Measures Market Price = $88 per share = PPS Shares outstanding = 33 million Earnings per Share = EPS = 363/33 = $11 PE Ratio = PPS / EPS –$88 / $11 = 8 times Price/Sales Ratio = PPS/Sales per share –$88/($2,311/33) = 1.26 Market-to-book ratio = PPS / Book value per share –Book value per share = Total Equity/shares outstanding = $2,591/33 = $78.52 –Market-to-Book = $88/78.52 = 1.12 times

3-46 Prufrock Ratios

3-47 Table 3.6

3-48 The DuPont Identity ROE = NI / TE= Basic Formula ROE = PM * TAT * EM= Dupont Identity –PM = Net Income / Sales –TAT = Sales / Total Assets –EM = Total Assets / Total Equity Profit Margin Asset Use Leverage = ROE

3-49 Using the Du Pont Identity ROE = PM * TAT * EM –Profit margin Measures firm’s operating efficiency How well does it control costs –Total asset turnover Measures the firm’s asset use efficiency How well does it manage its assets –Equity multiplier Measures the firm’s financial leverage EM = TA/TE = 1+D/E ratio

3-50 Prufrock’s DuPont Identity ROE = PM * TAT * EM –PM = 15.7% –TAT =.64 –EM = 1.39 ROE =.157 x.64 x 1.39 = = 14%

3-51 Internal and Sustainable Growth Payout and Retention Ratios Dividend payout ratio (“b”) = DPS/EPS = Cash dividends / Net income Retention ratio (“1 – b”) = (EPS-DPS)/EPS = (Addition to Retained Earnings) / Net income

3-52 Internal and Sustainable Growth Payout and Retention Ratios Dividend payout ratio (“b”) = –Cash dividends / Net income (DIV / NI) –121/363 = 33.3%

3-53 Internal and Sustainable Growth Payout and Retention Ratios Retention ratio (“1 – b”) = (NI - DIV)/ NI –Addition to Retained Earnings / Net income –$242/363 = 66.7%

3-54 The Internal Growth Rate How much the firm can grow assets using retained earnings as the only source of financing.

3-55 The Sustainable Growth Rate How much the firm can grow by using internally generated funds and issuing debt to maintain a constant debt ratio.

3-56 Determinants of Growth Profit margin – operating efficiency Total asset turnover – asset use efficiency Financial leverage – choice of optimal debt ratio Dividend policy – choice of how much to pay to shareholders versus reinvesting in the firm

3-57 Table 3.7

3-58 Why Evaluate Financial Statements? Internal uses –Performance evaluation – compensation and comparison between divisions –Planning for the future – guide in estimating future cash flows External uses –Creditors –Suppliers –Customers –Stockholders

3-59 Benchmarking Ratios need to be compared to something Time-Trend Analysis –How the firm’s performance is changing through time –Internal and external uses Peer Group Analysis –Compare to similar companies or within industries –SIC and NAICS codes

3-60 Problems with Financial Analysis Conglomerates –No readily available comparables Global competitors Different accounting procedures Different fiscal year ends Differences in capital structure Seasonal variations and one-time events