1-1 What is Finance? The study of how people allocate scarce resources over time The study of how people allocate scarce resources over time Costs and benefits of financial decisions are: Costs and benefits of financial decisions are: spread out over time spread out over time not known with certainty at time of decision not known with certainty at time of decision Central concept: valuation Central concept: valuation Valuation deals with looking forward Valuation deals with looking forward

1-2 A Simplified Organizational Chart (Figure 1.1) Chairman of the Board and Chief Executive Officer (CEO) Board of Directors President and Chief Operations Officer (COO) Vice President Marketing Vice President Finance (CFO) Vice President Production Treasurer Controller Cash Manager Credit Manager Tax Manager Cost Accounting Manager Capital Expenditures Financial Planning Financial Accounting Manager Data Processing Manager

1-3 The Corporation Advantages Advantages unlimited life unlimited life easy transfer of ownership easy transfer of ownership limited liability limited liability ease of raising capital ease of raising capital Disadvantages Disadvantages double taxation double taxation set-up and reporting costs set-up and reporting costs agency costs agency costs

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1-5 Goal of Financial Management What are firm decision-makers hired to do? What are firm decision-makers hired to do? “ “General Motors is not in the business of making automobiles. General Motors is in the business of making money.” Alfred P. Sloan Possible goals Possible goals Three equivalent goals of financial management: Three equivalent goals of financial management: maximize shareholder wealth maximize shareholder wealth maximize share price maximize share price maximize firm value maximize firm value

1-6 Agency Relationships An agency relationship exists whenever a principal hires an agent to act on their behalf An agency relationship exists whenever a principal hires an agent to act on their behalf Within a corporation, agency relationships exist between: Within a corporation, agency relationships exist between: shareholders and managers shareholders and managers shareholders and creditors shareholders and creditors

1-7 Shareholders versus Managers Managers are naturally inclined to act in their own best interests Managers are naturally inclined to act in their own best interests But the following factors affect managerial behavior: But the following factors affect managerial behavior: compensation plans compensation plans direct intervention by shareholders direct intervention by shareholders threat of firing threat of firing threat of takeover threat of takeover Board of Directors Board of Directors

1-8 Shareholders versus Creditors Shareholders could take actions to maximize stock price that are detrimental to creditors Shareholders could take actions to maximize stock price that are detrimental to creditors In the long run, such actions will raise the cost of debt and ultimately lower stock price In the long run, such actions will raise the cost of debt and ultimately lower stock price

1-9 Factors that Affect Stock Price Projected cash flows to stockholders Projected cash flows to stockholders Timing of the cash flow stream Timing of the cash flow stream Risk of the cash flows Risk of the cash flows VALUE (price) = the discounted value of all relevant future cash flows VALUE (price) = the discounted value of all relevant future cash flows P =  t CF t × (1 + r ) –t P =  t CF t × (1 + r ) –t

1-10 Computing Cash Flows Why Do We Care About This Topic? Why Do We Care About This Topic? Financial managers need accurate forecasts of cash flows to make accurate investment and financing decisions Financial managers need accurate forecasts of cash flows to make accurate investment and financing decisions Investment bankers and deal makers need to know how much to bid for a company in an acquisition and/or merger Investment bankers and deal makers need to know how much to bid for a company in an acquisition and/or merger Managers need to know how much cash flow is generated by assets to get feedback on their strategic decisions Managers need to know how much cash flow is generated by assets to get feedback on their strategic decisions Investors and creditors need to know how much cash is generated from assets and operations to determine the financial solvency of a company Investors and creditors need to know how much cash is generated from assets and operations to determine the financial solvency of a company

1-11 The Balance Sheet (Figure 2.1) Total Value of Liabilities and Shareholders’ Equity Total Value of Assets Net Working Capital Current Assets Fixed Assets 1. Tangible fixed assets 2. Intangible fixed assets Current Liabilities Long-Term Debt Shareholders’ Equity

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1-15 GAAP Net Income vs. Cash Flows General Accepted Accounting Principles (GAAP) govern audited financial statements General Accepted Accounting Principles (GAAP) govern audited financial statements The objective of GAAP is to provide a consistent account of a firm's financial status based on historical cost, where revenues and expenses are matched over the appropriate time period. The objective of GAAP is to provide a consistent account of a firm's financial status based on historical cost, where revenues and expenses are matched over the appropriate time period. Cash flow does not equal GAAP net income. Cash flow does not equal GAAP net income. GAAP recognizes revenue at time of sale, and matches expenses to these revenues, but cash flow may occur at different time. GAAP recognizes revenue at time of sale, and matches expenses to these revenues, but cash flow may occur at different time. Depreciation and other non-cash items are included in GAAP net income. Depreciation and other non-cash items are included in GAAP net income. Items are recorded on an accrual basis, not when the money actually comes into the firm. Items are recorded on an accrual basis, not when the money actually comes into the firm. Cash Flow = difference between dollars in and dollars out Cash Flow = difference between dollars in and dollars out

1-16 Cash Flow Summary 1.The cash flow identity Cash flow from assets = Cash flow to creditors (bondholders) + Cash flow to stockholders (owners) 2.Cash flow from assets Cash flow from assets = Operating cash flow – Net capital spending – Additions to net working capital (NWC) where: Operating cash flow = Earnings before interest and taxes (EBIT) + Depreciation – Taxes Net capital spending = Ending net fixed assets – Beginning net fixed assets + Depreciation Change in NWC = Ending NWC – Beginning NWC 3.Cash flow to creditors Cash flow to creditors = Interest paid – Net new borrowing 4.Cash flow to stockholders Cash flow to stockholders = Dividends paid – Net new equity raised

1-17 A Closer Look at Operating Cash Flow (OCF) OCF = EBIT + Depreciation - Taxes OCF = EBIT + Depreciation - Taxes EBIT has already subtracted depreciation. EBIT has already subtracted depreciation. Depreciation is excluded from OCF. It is a non-cash item. By adding depreciation, we have a cash flow number that includes costs associated with operating activities and excludes non-cash items. Depreciation is excluded from OCF. It is a non-cash item. By adding depreciation, we have a cash flow number that includes costs associated with operating activities and excludes non-cash items. Taxes are included in OCF because the taxes are paid on the revenues associated with operating activities. Taxes are included in OCF because the taxes are paid on the revenues associated with operating activities.

1-18 A Closer Look at NWC What is additions to NWC?What is additions to NWC? What does this number mean? Is it a cash inflow or a cash outflow?What does this number mean? Is it a cash inflow or a cash outflow? =160 50

1-19 Cash Flow Summary for Quincy A.Cash flow from assets 1.Operating cash flow = EBIT + Depreciation – Taxes = $ – 200 = $400 2.Additions to Net Working Capital (-/-) = Ending NWC – Beginning NWC = $350 – $300 = $50 3.Net capital spending (-/-) = End. net fixed assets + Depreciation – Beg. net fixed assets = $ – 400 = $200 4.Cash flow from assets = OCF – Additions to NWC – Net Capital spending = $400 – 50 – 200 = $150

1-20 Cash Flow Summary for Quincy, cont’d. B.Cash flow to creditors and stockholders 1.Cash flow to creditors = Interest paid – (Ending LTD - Beg. LTD) = $100 – ($420 - $400) = $80 2.Cash flow to stockholders = Dividends paid – (Ending Common - Beg. Common) = $80 – ($60 - $50) = $70 Check: $150 from assets = $80 to bondholders + $70 to stockholders

1-21 Statement of Cash Flows Summarizes the flow of cash receipts (inflows) and cash payments (outflows) during a given period of time Summarizes the flow of cash receipts (inflows) and cash payments (outflows) during a given period of time summarizes sources and uses of cash summarizes sources and uses of cash reconciles change in cash balance over time reconciles change in cash balance over time Restatement of balance sheet and income statement Restatement of balance sheet and income statement 3 primary categories 3 primary categories operating activities operating activities investing activities investing activities financing activities financing activities

1-22 The Statement of Cash Flows Operating activities Operating activities + Net income + Net income + Depreciation + Depreciation + Decrease in current assets (except cash) + Decrease in current assets (except cash) + Increase in current liabilities (not notes payable) + Increase in current liabilities (not notes payable) – Any increase in current assets (except cash) – Any increase in current assets (except cash) – Decrease in current liabilities (not notes payable ) – Decrease in current liabilities (not notes payable ) Investment activities Investment activities – (Increase in net fixed assets + Depreciation) – (Increase in net fixed assets + Depreciation)

1-23 Statement of Cash Flows, cont’d. Financing activities Financing activities – Decrease in notes payable – Decrease in notes payable + Increase in notes payable + Increase in notes payable – Decrease in long-term debt – Decrease in long-term debt + Increase in long-term debt + Increase in long-term debt – Decrease in common stock – Decrease in common stock + Increase in common stock + Increase in common stock – Dividends paid – Dividends paid

1-24 Hermetic Inc., Balance Sheet as of December 31 ($ in thousands) Assets Current assets Cash$ 45$ 50 Accounts receivable Inventory Total$ 625$ 745 Fixed assets Net plant and equipment Total assets$1610$1845

1-25 Hermetic Inc., Balance Sheet Liabilities and equity Current liabilities Accounts payable$ 210$ 260 Notes payable Total$ 320$ 435 Long-term debt Stockholders’ equity Common stock and paid-in surplus Retained earnings Total$1085$1185 Total liabilities and equity$1610$1845

1-26 Hermetic Inc., Income Statement ($ in thousands) Net sales$ Cost of goods sold Depreciation Earnings before interest and taxes$ Interest Taxable income Taxes Net income$ Retained earnings $  Dividend = $26.55

1-27 Cash Flow from Assets Cash flow from assets: Operating cash flow: EBIT$ Depreciation – Taxes– $ $ Net capital spending: Ending net fixed assets $ 1, – Beginning net fixed assets– Depreciation $ Change in net working capital: Ending net working capital$ – Beginning net working capital– $ 5.00 $ 5.00 Cash flow from assets: $ 26.55

1-28 Cash Flow from Assets, cont’d. Total cash flow to creditors and stockholders: Cash flow to creditors: Cash flow to creditors: Interest paid$ – Net new borrowing – $ 0.00 Cash flow to stockholders: Cash flow to stockholders: Dividends paid$ – Net new equity raised $ Cash flow to creditors and stockholders$ 26.55

1-29 Hermetic Inc., Statement of Cash Flows Operating activities Operating activities + Net income Net income Depreciation Depreciation Increase in payables Increase in payables – Increase in receivables– – Increase in receivables– – Increase in inventory– – Increase in inventory– Investment activities Investment activities – Increase in net fixed assets– – Increase in net fixed assets– – Depreciation– – Depreciation– (145.00) (145.00)

1-30 Hermetic Inc., Statement of Cash Flows Financing activities Financing activities + Increase in notes payable Increase in notes payable Increase in long-term debt Increase in long-term debt Increase in equity Increase in equity 0.00 – Dividends – – Dividends – Putting it all together Putting it all together – = 5.00

1-31 Identify whether an activity is an operating activity (O), investment activity (I), financing activity (F) and if it is a source (+) or use (-) of cash. OperatingSource Operating Use InvestmentSource FinancingSource